Our ultimate guide to deep value investing introduced readers to a potentially lucrative realm of finance — distressed debt. But, how exactly do you buy it and what do you need to watch out for?
Enter our comprehensive roadmap, How to Buy Distressed Debt. This article will help you discover how to transform distressed assets into profitable investments, mastering the art of deep value investing.
How to Buy Distressed Debt
Here’s a step-by-step guide on how to buy distressed debt:
Understand Distressed Debt – Distressed debt is the debt instruments of companies or funds that are undergoing financial hardship or are in bankruptcy. Distressed debt consists of the following:
- Corporate Bonds
- Convertible Bonds
- Municipal Bonds (Muni)
- Bank Loans
- Trade Claims
- Debtor-In-Possession (DIP) Financing
- Subordinate Debt
- Mortgage -Backed Securities (MBS)
- Asset-Backed Securities (ABS)
- Sovereign Debt
- Distressed Debt Funds
Purchasing distressed debt can produce substantial investor returns if the company or entity recovers from successful restructuring.
Education and Research – Educate yourself about the distressed debt market, its major and minor players, and any independent study resources. Understand key concepts, strategies, and terminology prior to making any investment capital commitment.
Identify and research several companies with distressed debt, the more firms researched, the better knowledge lattice you will develop. Learn how to value the firm and its debt instruments, and its business model. Do your due diligence and determine if the company’s current challenges are temporary or permanent, for this will give you an indication of its current fiscal health and recovery potential.
How to Buy Distressed Debt chronicles the necessary steps you need to be successful in your pursuit of profits hiding in plain sight.
Prospecting for Potential Investments – Distressed debt trades for less than its face value providing savvy investors with a profit opportunity predicted on pricing discrepancy. Prospect for firms with debt agency ratings of CCC or lower. Moody’s Investor’s Service, Standard & Poor’s (S&P) Global Ratings, and Fitch Ratings are prominent credit rating agencies. Follow financial social media, dedicated website content, and local and national news outlets for company updates and announcements. I am, of course, partial to Event Driven Daily for my contrarian, ahead-of-the-crowd competitive advantage. Once a potential company of interest has been identified, read as many years of annual and quarterly reports as possible (10-K, US and 20-F, international) and quarterly reports (10-Q, US and IAS 34, international).
Due Diligence – This foundational piece of the buying process cannot be stressed enough. Analyze and scrutinize a firm’s revenue, operating income, margins, earnings, free cash flow and capital structure contained in its financial statements. Understand the debt quality and set yourself apart by reading the financial statement footnotes.
Understand the firm’s regulatory status and legal implications, coupled with applicable bankruptcy law and jurisdictional priority of claims. Your time will be well invested as you’ll gain a deeper understanding of the company’s chances of recovery, which can help determine the size of your investment, if any, and a realistic return on investment (ROI) time horizon.
Professional Advisory – Do not make decisions in a vacuum. Consider consulting with financial professionals who specialize in distressed debt and partner with bankruptcy attorneys offering corporate restructuring experience.
Target a Purchasing Avenue – There are three common purchase channels available to distressed debt investors:
- Direct Purchase – Buying distressed debt directly for a company or through private placement.
- Secondary Market – Buying through brokers and dealers specializing in distressed debt gives you access to the liquidity of the secondary market.
- Distressed Debt Funds – Investing in dedicated distressed debt funds will provide you with portfolio diversification under the guidance of a fund manager. Familiarize yourself with the industry fee structure and gravitate to the lower end of the spectrum because fees reduce assets under management (AUM) and your overall ROI.
How to Buy Distressed Debt provides a clear investment strategy explanation and an emphasis on research and due diligence to develop solid risk management.
Monitor Your Money – Monitoring the firm and the value of its debt instruments in a fluctuating market is monitoring your investment dollars. Remain flexible to alter your strategy based on underlying financial changes in the company and positive or adverse market news.
Exit Strategy – Know and strategically pre-plan for your exit. Here are your available options:
- Market Sale – You can sell your distressed debt to a buyer offering a profit on your investment and willing to assume the risk.
- Restructuring – If the firm successfully restructures, you can elect to sell at a profit or hold your investment until maturity.
- Bankruptcy – In bankruptcy, there are multiple ways to win and lose. Being a secure debt investor greatly increases your chances of realizing liquidation proceeds. Unsecured debt holders are paid after secured creditors and are subject to the availability of remaining sales proceeds, if any
How to Buy Distressed Debt details the research-to-execution process to investing in the debt of financially challenged companies. Distressed debt investing requires a deep understanding of financial analysis, market conditions, and legal implications. Conduct thorough research and consider seeking professional advice to navigate this lucrative, complex, and high-risk investment strategy.
Read next: How Do Distressed Debt Funds Make Money?
