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While investing in distressed companies can produce enormous gains, not all distressed companies fully recover. Some slip into bankruptcy, yet this might still produce a positive return for some bondholders. However, in some cases the company has little value at all, and is best sold piecemeal, for scrap, in essence. What happens to your investment then? In The Turnaround Letter’s continuing series on investing in distressed securities, we explore this worst-case scenario to help frame the risks.
- As the company’s outlook is nearly hopeless and there is little value remaining, the company will file for Chapter 7, which is for liquidation of the company.
- The assets of the company are sold piecemeal.
- In our example, there is only a partial recovery for the secured bank loans and no recovery for the bondholders and shareholders.
Many of your distressed investments turned out well. But this one just didn’t work and now it’s slipping into the abyss. The industry has turned downward and the company’s turnaround strategy didn’t make any progress. In fact, it is nearly hopeless. This is the worst-case scenario. What does it look like?
Management and the creditors couldn’t find a buyer or agree on pre-bankruptcy debt restructuring. The business is producing a loss at the Ebitda level, and it has few if any products that look promising. Filing for a Chapter 11 bankruptcy doesn’t make much sense because the cash costs are high, banks are unwilling to provide any DIP financing, and there isn’t much value to fight over anyways. The only realistic path is filing for Chapter 7—liquidation.
Like Chapter 11 bankruptcy, a Chapter 7 filing puts the company under the Bankruptcy Court’s formal jurisdiction. The court’s primary focus is to ensure a fair process for allocating value to the claims holders. In this case, the company is sold piecemeal rather than having its operations and debt restructured to emerge as a healthier, low-debt company. After discussions with investment bankers and other liquidation specialists, the value available to creditors will come from these sources:
Example: Proceeds from liquidation ($millions)
Selling the company piecemeal will produce only $100 million in cash proceeds, hardly enough to satisfy the $400 million in debt, along with $50 million in accounts payable. Similar to a Chapter 11 bankruptcy, value is distributed based on creditors’ absolute priority:
If you held the unsecured bonds, your recovery rate is zero. You received one of the 9% interest payments last year, but this year’s payment was missed. As you purchased the bond for 30, and you received 9 cents per bond in total proceeds, you will have a 70% loss. It could have been worse—you could have lost your entire investment.
As we are approaching the end of this distressed investing blog series, we will next explore some other considerations when looking at a distressed security investment.