What is Distressed Securities?

Google+ Pinterest LinkedIn Tumblr +

Distressed securities are securities of companies that have filed or are close to fil­ing for bankruptcy court protection, or that are seeking out-of-court debt restructuring to avoid bankruptcy. The legal framework of bankruptcy proceedings differs across countries. In the Uinted States, two types of bankruptcy pro­tection are available: protertion for liquidation and protection for reorganization. Valuation of such securities requires legal, operational, and financial analysis.

To understand distressed securities, one must appreciate the inherent diver- genre of interests between the stockholders and bondholders of a company. Stockholders own the successful company, but bondholders have a prior claim to the assets of the bankrupt company. In reorganizations, bondholders’ prior claim can allow them to negotiate for ownership in the postbankmptcy company, thus diluting the original shareholders’ claims. Investing in distressed serurities, then, usually means investing in distressed company bonds with a view toward equity ownership in the eventually reconstituted company. In this regard, such investments have characteristics somewhat similar to those of venture capital investing. For example, they are illiquid and require a long horizon, as well as intense investor participation in guiding the venture to a successful outcome. Another similarity, though, is the possibility of mispricing. I look (1998) reports on the disappointment of some traditional distressed-securities investors that these investments are attracting attention and efficient prices; but he suggests that business volatility and high leverage will guarantee many problem compa­nies with inevitable value discrepancies (mispricing).

Distressed-security investing may be viewed as the ultimate in value investing. A distressed company with low enterprise value (EV) to earnings before interest, taxes, depreciation, and amortization (EBITDA) will attract the attention ol an investor looking for positive, postrestructuring cash flows. The primary question for any distressed security is the question of the distress source. Is die company operationally sound but financially hampered by too much gearing (leverage), or is the company weak operationally? If the company is weak operationally, is it a candidate to be turned around by cost cutting and improvement in the busi­ness cycle or else by new management and/or a new competitive strategy? distressed securitiesinvesting requires intense industry analysis, as well as analysis of business strategies and of the management team that will conduct the restructuring.

Share.

About Author

Leave A Reply