What to Know About Distressed Securities

George Schultze

We speak with Schultze Asset Management Founder George Schultze about what investors may want to understand about distressed securities and under what circumstances they should consider them.

What are distressed securities?  

Distressed securities are shares of stock or corporate bonds issued by a company that is in financial trouble, often due to unsustainable debt, failure to adapt to changing market conditions or unexpected secular change, and probably headed into bankruptcy. Distressed investors buy these securities when they have fallen in value and believe there is a potential for profit from a restructuring or a bankruptcy payout. 

The goal of distressed investing is to identify companies trading at levels below their fundamental value or where a positive emergence from distress is expected. It’s a style of investing that looks to take advantage of inefficiencies in the market and can deliver strong returns in both bull and bear markets. 

Regardless of what ultimately forces a company into bankruptcy, a complex bankruptcy can take years to resolve, presenting many opportunities along the way to invest in distressed securities (before, during and after distress.) Events like spinoffs, mergers and special dividends can help generate the final gains at the tail end of a distressed securities investment cycle. 

Distressed investing is not a momentum philosophy or a quant trading philosophy. Instead, it’s very much a deep value investment philosophy. It entails finding companies that are trading at a sharp discount to fair value and buying them through their debt that will eventually turn into equity. The opportunity comes from the arbitrage between those two markets – debt and equity. 

What should investors know about investing in distressed securities? 

The first thing that people should know is that investing in distressed securities is beyond the ken of most retail investors. The key to successful distressed investing entails doing solid and comprehensive research that pays attention to the fundamentals coupled with an understanding and analysis of macroeconomic trends.

Speaking as someone who has practiced distressed investing for more than 25 years, I think that successful distressed investing is both an art and a science. Where science comes into play is in doing deep fundamental research. You not only have to be able to read a balance sheet, but also understand what all those numbers mean. You have to be able to analyze debt ratios and EBITDA and other fundamentals of the business. 

The art is in knowing what to do with the product of all that scientific research. You have to be able to look at secular market trends and try and figure out what they mean. You have to understand the distressed company’s place in its industry and its industry’s place in the overall economy. It doesn’t hurt to have a strong legal background as well so that you can understand the implications of the company’s ongoing litigation in bankruptcy court or otherwise.

Companies coming out of a reorganization are often underpriced by the market. Post-bankruptcy, the actual intrinsic value of the company might not have changed that much, but the market price of its stock may have changed substantially depending on who owns it and what else is going on. 

And filing for Chapter 11 is not the end of the story for a distressed investor. After a company files for bankruptcy, its securities, both publicly traded stock as well as any outstanding loans or bonds, will usually continue trading. In bankruptcy there are a whole host of events that can occur and that distressed investors keep track of. This can be anything from a monthly filing of financial statements to litigation back and forth between creditors or companies. 

One more thing that potential distressed investors should understand is that patience is a prerequisite but in the long run that patience can pay off. 

Is now a good time to consider distressed securities? 

Over the last few years, money has been cheap, and companies have in many instances taken on levels of debt that are simply unsustainable. It’s inevitable that some of these companies are going to be crushed under the weight of their debt service as their cost of debt skyrockets while the availability of new financing disappears. This means that there will likely be many more opportunities for distressed securities investors in the coming months. The trick for distressed investors now will be identifying those companies heading into distress so that they can take short positions. Next, for those companies that still have intrinsic value, to work through their bankruptcies and/or reorganizations in order to recycle capital and help the healthy enterprises emerge on the other side. 

Under what circumstances should investors consider investing in distressed securities?

The best avenue for most investors when it comes to investing in distressed securities is to work with an experienced manager who understands how to invest both long and short, before, during, and after bankruptcy, rather than trying to do it on their own. Distressed investing takes considerably more due diligence than purchasing a mutual fund or an ETF tracking a major index. 

It’s also important to understand that not all distressed securities managers are equal. Some are private equity managers, and some of them are huge firms that only do the biggest of deals and are structured more like private equity funds. They might require a $10 million or $20 million minimum investment. Others have more flexibility and are nimbler and can invest up and down the capital structure of companies going through distress and have the flexibility to invest in companies of all different sizes.

Can individual investors take part in distressed securities opportunities?

Certainly, individuals can invest in distressed securities but are advised to do so with extreme caution. The best advice for potential distressed investors in this environment, really for all investors, is to do your homework and know what you’re buying. There are opportunities out there for those doing the work to find them. 

This interview originally appeared in our TradeTalks newsletter. Sign up here to access exclusive market analysis by a new industry expert each week. We also spotlight must-see TradeTalks videos from the past week.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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