Distressed investing involves an investor buying into securities such as stocks or bonds in a company that have lost value. Chand Sooran, chief investment officer of Point Frederick Capital Management, told Financial Pipeline that this 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.
CS: A distressed investment is an investment in a security which has fallen significantly in value for any one of a number of reasons. A distressed investment might be, for example, in the equity or the bonds issued by a company that has disappointed in terms of its financial results.
So let’s say that there’s a company that’s got a fairly stable business and they decide that they’re going to pay themselves a big dividend So they borrow a whole bunch of money and with that cash, they pay the owners of the business a big dividend because they know, or they’re confident, that the business is stable for a long enough window that the stability of the business will generate sufficient cash to pay off that debt.
So by borrowing, they are just borrowing into the future that stable cash flow that they are confident in obtaining but if anything, business is less stable than it used to be because of the accelerated pace of technological change. Fast forward a couple of years, there’s some sort of disruption in the markets and there’s a new technology, let’s call it the Internet, which throws the stability of that business out the window and all of a sudden, the cash flow that the business thought was stable starts to fall significantly.
So one of two things is going to happen; either they’ll turn the ship around and make some structural changes to the business which will get it back to the trajectory that satisfies the cash flow requirements of that obligation or they’re going to have to restructure the obligation itself. They either restructure the business or they restructure the obligation. And by restructuring the obligation that means they either negotiate with the people that lent them money outside of court or they file for some sort of solvency protection depending on where they are, it can be called by different names, but in the United States, it’s called Chapter 11.
For a company, they’ll file for chapter 11 protection in order to have a more rigorously organized framework negotiating with the people that lent them the money and you’re either restructuring the business and/or you’re restructuring the balance sheet. And a distressed investment is something where there is an event that has taken place or that there is some trend in technology or in the fundamental underlying of the business that precipitates either the restructuring of the business and/or the restructuring of the balance sheet.