Distressed Securities. Turnaround Partners

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Often, distressed securities investors solicit the help of experienced executives to manage the troubled companies. In the case of the WorldCom/MCI bankruptcy, one such investor was quoted in the Wall Street Journal, when the investor urged Michael D. Capellas, the former chairman and CEO of Compaq Corporation, to join Worldcom Inc., as saying, ”You run the business and we’ll run the bankruptcy process.”Investors need to assess the risks that a particular distressed securities strategy may entail.The risks may include one or more of the following:

• Event risk.Any number of unexpected company-specific or situation-specific risksmay affect the prospects for a distressed securities investment. Because the event riskin this context is company specific, it has a low correlation with the general stockmarket.

•     Market liquidity risk.Market liquidity in distressed securities is significantly less than forother securities, althoughthe liquidity has improved in recent years. Also, market liquidity,dictated by supply and demand for such securities, can be highly cyclical in nature. This isa major risk in distressed securities investing.

•     Market risk. The economy, interest rates, and the state of equity markets are not asimportant as the liquidity risks.

•    J factor risk. Barnhill, Maxwell, and Shenkman (1999) referred to the judge’s track recordin adjudicating bankruptcies and restructuring as”J factor risk. The judge’s involvementin the proceedings and the judgments will decide the investment outcome of investing inbankruptcy. Branch and Ray (2002) noted that the judge factor is also an important variablein determining which securities, debt or equity.

Other risks may also be present. Some are associated with the legal proceedings of areorganization: The actions of the trustees as well as the identity of creditors can affect theinvestment outcome. The distressed securities investor may lack information about the otherinvestors and their motivations. Tax issues may arise in reorganizations.

A normality assumption is not appropriate in evaluating this class of strategies. It hasbecome quite well known that the return distribution from this strategy is not normallydistributed (it has negative skewness and positive kurtosis); thus, if normal distribution isassumed, risk measurement tends to underestimate the likelihood of downside returns.

Distressed securities are illiquid and almost nonmarketable at the time of purchase. Asthe companies turn around, values of the distressed securities may go up gradually. Typically,it takes a relatively long time for this strategy to play out; thus, valuing the holdings may be aproblem. It is difficult to estimate the true market values of the distressed securities, and stalepricing is inevitable. Stale valuation makes the distressed securities appear less risky. The riskof this strategy is probably understated, and its Sharpe ratio overstated.

Whether a distressed securitiesinvestment will be successful or not depends on manyfactors. The outcome depends heavily on the legal process and may take years. Of course, thevulture investor’s timeframe is often months, not years. The role played by vulture investors hasa significant bearing on the outcome. If vulture investors do not participate in the restructuring(as in the case of MCI, where two of the vulture investors named to the board declined to takeboard seats) or if they decide to sell prior to the final settlement, the flood of shares into themarket will create further downward pressure on the stock price. This may have a significantimpact on the whole industry. Because any move by vulture investors may be heeded by otherinvestors, they take great care not to divulge their intentions.

Thus, investing in distressed securities/bankruptcies requires legal, operational, andfinancial analysis. From an investment perspective, the relevant analysis involves an evaluationof the source of distress. The source could be the operations, finances, or both. This is acomplex task, and each distressed situation requires a unique approach and solution. As a result,distressed investing involves company selection.

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