Distressed Investing – ValueWalk Premium
Yarra Square Investing Greenhaven Road Capital

Distressed Investing

“How did you go bankrupt?” Two ways. Gradually, then suddenly.” – Ernest Hemingway, The Sun Also Rises

Q4 2020 hedge fund letters, conferences and more

Investing Greenhaven Road Capital

Distressed securities is a niche space. It’s a big contrarian playground. It’s an area filled with mispriced assets. When companies become distressed, they go through restructurings. If you like reading long complicated legal documents then there’s an investing space just for you. Besides lawyers, investors willing to do the work can profit from bankrupt companies. Investing in distressed securities is the practice of trying to find inefficiently priced securities in companies that are restructuring and going through significant change. Because it’s a complicated, risky, and messy space, lots of investors shy away. The inefficiency and lack of investors creates opportunities for the investor willing to get their hands dirty.

First a little background on bankruptcy. Up until the mid-19th century defaulters were treated harshly. Defaulters were thrown into debtor’s prison called the Schuldturm—the prison tower that was the destination, in the past, for those who couldn’t pay their debts. The word “bankrupt” derives from banco rotto, the practice in medieval Italy of smashing the benches that merchants sold their goods from if they did not pay their debts. Unless you deal with the mafia, which has inherited some of the old Italian ways if you don’t honor your debt, today’s bankruptcy proceedings are less violent.

Because of culture differences, borrowing and bankruptcy in America and Europe are seen differently. Europe is more old school in their ways. In Europe borrowing is discouraged. Germans barely use credit cards unless they travel outside the country. There’s a negative stigma attached to bankruptcy that carries for years.

In American borrowing is not only encouraged, but if you default you can have a 2nd and 3rd chance. But the higher risk comes at a price: higher interest rate. Everything has a price. The market functions as a price discovery mechanism, telling you how much it cost to borrow according to your risk level.

The way business bankruptcy is treated is also different between the old world and new world. In many European countries businesses mostly end in liquidation rather than restructuring. In America firms are encouraged to restructure rather than go broke.

When a business fails to pay its creditors on time, it is said to go into “default”, the equivalent of going bankrupt. The aim of bankruptcy law is to provide relief from unpayable debts. A bankruptcy judge is appointed and his number one job is to reclaim as money as possible for creditors. This is why a bankruptcy judge approved a creditor controlled Hertz to sell new shares to pay off creditors even though the shareholders were predetermined to lose everything. He was doing his job but the SEC stepped in to stop the madness.

There are two types of bankruptcy that companies may file: Chapter 7 and Chapter 11. Under Chapter 7 the company is out of business and a trustee liquidates and distributes all of its assets to the company’s creditors and owners.The owners of common stock shares are last in line for a share of the firm’s liquidated assets and are usually worthless.

Chapter 11 the company might get a second chance. Chapter 11 is the part of the bankruptcy code directed at preserving businesses rather than winding them up. Declaring Chapter 11 bankruptcy can be the most beneficial route if a business believes that it can be saved through restructuring. Chapter 11 keeps the debtor in possession of the business and is the most common type of corporate bankruptcy for public companies. When a company files Chapter 11 they have to present a recovery plan where owners and creditors have to vote for or against.

Many questions are asked: Is the liquidity crunch temporary? Can performance be improved? Can the company bounce back?  Are the assets worth anything? Expected future cash flow and the liquidation value of the assets are big influence

Bankruptcy is not a creditor versus debtor. When a business default lenders are in control. It is a wrangle between creditors. And secured bondholders are at the top of the list and therefore are mostly in control of the process. Once the lender is in control the most important factor that will guide their decision is how much will they be able to recover?

For investors, where is the opportunity?  If going concern prospects look good, the company (creditors in control) will opt for debt-for-equity exchanges, also called a recapitalization, so they get the upside when the business recovers.

Investors in companies that are financially distressed can look at restructuring opportunities.You have to look through the entire capital structure for opportunities.What if you can buy bonds at extreme discount, pennies on the dollar, that will not default?  What about the preferred shares? Risky with no chance of guarantee, betting on a successful turnaround can pay off handsomely. Each case is different and needs its own due diligence. But done properly you can spot opportunities the market has missed. Maybe they have a new CEO with a history of successful turnaround, or maybe the company has hidden assets that the market hasn’t recognised. Maybe the company suffered a terrible downturn during a recession and is due for a rebound during the recovery?

Summary

Done properly, investors in distressed companies or countries can turn a negative (bankruptcy/distressed) into a positive (recycled capital, jobs created, and a saved company with a new lease on life). Understanding what you are doing eliminates some of the risk. When you make an investment in distressed debt your ownership interest can (under certain circumstances) convert into equity ownership, which gives you certain control rights that can be helpful in generating the return you desire.

Strong fundamental analysis combined with a brave and aggressive personality will help you succeed in the space.

Article by Brian Langis


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