The Penny King's Free and Clear M&A Fund

[thepennyking]

Distressed securities can be defined as those publicly held and traded debt and equity securities of firms that have defaulted on their debt obligation and/or have filed for protection under Chapter 11 of the U.S. Bankruptcy Code. Distressed securities can include bank loans and other private debt of the same similar entities with operating and/or financial problems. Opportunities in the distressed debt market generally originate from companies that issue high yield debt and leveraged loans. These markets experienced dramatic growth through the 1990s. During 2002, roughly $510 billon of debt defaulted or became distressed, at a default rate of 12.8%, the highest level since 1991, which was believed to be the first distressed cycle.

The supply of distressed debt is now at an historic high that is only projected to grow. The default portion of the public high yield debt market has risen 43 % from the start of 2002. In addition, the credit quality of the high yield market is at an historic low and still declining, as these are all indications of a second distressed cycle which has created a lucrative opportunity for experienced investors operating in this asset class.

Defaulted debt securities have outperformed the S&P 500 Stock Index for the second year in a row and high yield bonds have significantly outperformed 10-year US treasury bonds in recent years. According to a McKinsey research report, portfolios of the same risk level would have performed better with the addition of distressed-debt securities (please refer to the attached presentation). Top defined-benefit plans doubled their allocation to distressed debt to more than $3 billion invested, which is 10 times their allocation 10 years ago. Demand continues to increase.

Not only has distressed debt has been one of the best performing asset classes over the past year but also, certain fund managers are confident because of the positive returns being maintained by a number of good-quality companies currently in distressed situations. In term of investment strategy, most private equity managers are implementing.

Control-oriented distressed funds are generating increased interest among institutional investors as they seek to acquire companies outright, through the purchase of debt, not equity. Control players salvage value by restructuring its operations and finances and, eventually, by selling their stake. Control play is considered to be the least risky of the distressed strategies because managers are able to influence the outcome of the portfolio companies.

There is another interesting dynamic in this strategy that institutional investors are finding quite intriguing. In the late 1990’s through early 2000, a number of middle market buyout firms implemented “roll up” strategies with a number of portfolio companies. In some cases the equity is severely impaired at these portfolio companies as the bonds are trading at significant discounts (one also has to wonder why private equity firms continue to hold these equity investments at costs!). A distressed manager looking to acquire the company through the date is very well positioned to create these companies at EBITDA multiple substantially lower than through equity.


An overview of the distressed market, by Norris Lam, CFA, of Links Private Equity in New York
http://www.privateequitycentral.net/index.cfm?member=yes