Distressed investing involves an investor buying into securities such as stocks or bonds in a company that have lost value. The drop in value could happen for a variety of reasons, such as taking on too much debt, a disruption on the financial markets or a completely unforeseen technological change. Chand Sooran, chief investment officer of Point Frederick Capital Management, told Financial Pipeline that such investing is complex and can involve what he calls renegotiating the balance sheet of the company.
CS: In terms of renegotiating that balance sheet, what I mean by that is saying to some creditors you’re going to have to take a haircut. If you thought that I owed you $1 billion, you’re going to come out of this with only a $700 million claim because there just isn’t any value there. So it’s sometimes referred to as rightsizing the balance sheet for the new company. So the company came out with this trajectory, in theory, when they issued the debt and the trajectory went down when the disruptive event – whatever it was – happened. They may not get all the way back to their original level, they may get back to a lower trajectory and the balance sheet that the new company can sustain has to be suitable for whatever trajectory it’s reasonable to think they can sustain once they leave the (creditor) protection of the court. And as you can imagine, there is a tremendous amount of controversy as to what trajectory they will actually obtain once they leave. That’s the risk.
There’s all kinds of risks. The risk is, one, you are too optimistic about the trajectory they could sustain, they come out and then they fall down again and then they end up filing for (creditor) protection again. So the common colloquialism that people use in the distressed market is that the company is in chapter 22 – it goes in chapter 11 level one time (and) comes out. (But) It was inappropriately capitalized or its plan was the wrong plan or there was another event that took place, a second technological tsunami – whatever it was and forced it into chapter 11 again. Eleven plus 11 is 22. Sometimes you see chapter 33. So that’s one problem.
The second problem is that the trajectory might turn out to be much better. And why is that a problem? Because in the bankruptcy plan or the insolvency plan, there are certain creditors that the way in which the value for the pie is allocated between the different creditors is going to be determined by what is deemed to be the trajectory that the company will be able to sustain. So if that deemed trajectory turns out to be too conservative to what they actually do, there are going to be certain people who got zeroed out who actually should have been in the money.
So if you can think about the capital structure as a pie and it’s sliced eight ways and some slices are big and some slices are small, that pie – that size of the pie, shrinks because of the distressed event because the company has taken a header in terms of the original plan. The pie is shrinking, (the company) goes into chapter 11, we have to recut the pie and different people get first cut at the pie and different people have different rights as to how they can access the pie. And so, if you’re senior enough in the capital structure you want to argue that that pie is mine. You should get the whole pie to yourself. You’re barely getting covered. And if you are in the equity, you want to argue that that pie is going to be as big as possible because you want the option coming out because it actually succeeds much more than its plan suggests it will and these plans are games and there’s a lot of game theory as to how you make coalitions and play the negotiations around that. Insolvency in the United States, much less so in other countries, but insolvency in the United States is just a court supervised framework for renegotiating the division of a pie.