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The Turnaround Letter is launching a new series on investing in distressed securities. In this first note, we delve into the question of “what is distressed securities investing”?
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.
Distressed investing usually involves greater risk than turnaround investing, but can also offer higher returns. 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. Yet they still can provide significant upside potential, as gains of 100 to 200% are not uncommon. Distressed equities could potentially provide returns measured in multiples, yet if the company restructures or files for bankruptcy the equity generally becomes worthless.
In future notes in this series, we will explore what provides the attractive opportunities in distressed securities, how to find them and what to do when you find a distressed investing security that looks appealing.