Definition distressed investing

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Investing in distressed securities means purchasing the equity and fixed income securities of companies that are either in bankruptcy or have a meaningful likelihood of filing for bankruptcy in the near future. These companies have claims against them that are greater than the value of their assets. More concretely, distressed companies don't have the cash flow to service their debts.

Critical to the definition of "distressed": these companies are fighting the clock - if operating results don't improve soon or if their debts are not renegotiated, a bankruptcy will likely result. Their survival, in essence, is on the line. How is this different from " turnaround investing "? Generally, investors in distressed securities want a turnaround - that is, they want the company to become operationally and financially stronger which will drive up the value of the formerly distressed equities and bonds.

When we at The Turnaround Letter think about "turnarounds," we think about companies that are not fighting the clock. Rather, turnaround companies in our view have the financial staying power to provide them the time to make major improvements to their operations.

Given the risk, most investors in distressed securities focus on bonds. These securities can provide greater downside protection than equities, as they may have legal claims on valuable assets and may receive new securities or cash in a bankruptcy reorganization. Therein lies the high barrier to entry -- an investor must have the liquidity cash in a bank account to even be qualified to make an offer on the asset.

Why would a group sell an asset at a discount to current market value? Real estate private equity funds are generally closed end, which means there is an investment period where the money goes out, there is a harvest period where the assets are sold, the money comes in and is returned to the investor profits are split between the investor and the private equity firm. As the harvest period of a fund is winding down often there are legacy assets that need to be liquidated.

Management will make a strategic decision to sell assets, gain certainty of execution and close the fund. The other example comes from regulatory compliance. There are a wide variety of financial institutions and various regulatory bodies that oversee banks and financing entities.

For example, banks are only allowed to have certain loan default rates without drawing regulatory scrutiny. If their loan-loss rates get too high, it is more advantageous for the bank to sell at a discount, realize the loss, and eliminate a bad loan from its books then to hold the asset trying for a fair market sale and negatively impact certain regulatory rules.

The networks where these assets are marketed tend to be smaller, more private, and less generally known to individuals and normal retail investors. Rarely are these properties and note marketed to the extent a broker from a major real estate firm would advertise a class A downtown office building that was simply up for sale. Another reason that retail investors have a hard time investing in distressed investing is the vehicle which you purchase these assets might be through the purchase of a loan out of an insurance company, bank, CMBS trust, or other financial institutions.

You may not purchase the physical property, rather the loan itself. The underlying collateral for the loan is commercial real estate but the investor does not hold the fee simple title to the real estate. Most people understand owning a small building but if you change perspective to buying a note secured by property and you lose many investors even though the note is secured by the building. One massive pitfall can be a lender liability lawsuit in which the borrower sues the lender the investor in this case for not handling the loan correctly.

This can be from sending wrongful default letters, improperly instituting foreclosure proceedings, or mismanaging an escrow account. Losses that a novice investor can incur could be multiples of the original investment. If the borrower stops making payments the investor must understand all the legal remedies at their disposal, such as foreclosure. This is a large capital expense due to the time and legal services that an investor must incur. Investors need to be familiar with the foreclosure process, its costs, and factor that into bidding on distressed assets.

Often the mere possibility of having to deal with a foreclosure proceeding will scare off numerous investors, leading to even more attractive discounts for the savvy distressed debt investor. Investors who have experience in managing an office building may not have experience in managing notes, even though the underlying assets are identical, leading to the market inefficiencies existing for distressed real estate investors to take advantage of. Lastly, distressed real estate funds tend to have an edge over the individual distressed real estate investor from a risk point of view.

A fund can purchase numerous distressed properties, diversifying risk across various assets.

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