When a company faces financial trouble, sometimes we hear stories of investors walking out with a huge sum of money. That calls distressed debt investing. Investors buy the debt of that troubled company, usually at a discount price. These investors usually expect to get profit once the company gets back in its right direction.
With distressed debt investing, investors can still get their payment when, in the worst scenario, the company goes bankrupt. Sometimes, they also end up becoming the owner of that troubled company.
The Cheap Debt
Distressed debt is generally the debts that are trading at a significant discount. For instance, you can buy a supposed to be $600 bond for only $250.
You may get tempted by the amount of the discount, but that discount comes at the risk of defaulting. There is a possibility of the company goes bankrupt and investors lose their money.
On the contrary, the value of the debt will go up dramatically, once the company successfully makes a turnaround.
Indeed, an investor can make much more money by purchasing equity shares once the company makes a turnaround, but if the company goes bankrupt, the investor will also lose all of his money.
Purchasing a company’s distressed debt also means getting some control of the business. The entities which buy a large sum of distressed debt even can gain an active role in that troubled company.
In addition, investors buying distressed debt can also become the priority to get paid once the company goes bankrupt.
The Risk Management
Every debt purchased by investors has the risk of the borrower defaulting. Thus, every investor who plans to purchase debt has to study the creditworthiness of a borrower to know the possibility to get their money back.
For that reason, debt from less creditworthy organizations usually gains higher returns for its investors. The same high risk also faced by distressed debt investors. There is a big chance for them to walk away from the company with nothing at their hand, once the company goes bankrupt.
Thus, distressed debt investors, especially large hedge funds, usually perform super detail risk analysis with advanced models and test scenarios. They usually also very skilled at spreading the risks. Besides, they usually also partner with other firms to avoid getting overexposed if one of their investment defaults.
Writer: Lisa Ramadhani