Distressed Securities Investing

Hedge funds using the distressed securities strategy invest in companies that are being reorganized, going thorough bankruptcy proceedings or going through some poor performance.  These companies have the lowest credit ratings from such companies as Moody's and Standard & Poor's.  The notes below are a summary of the article "Hedge Fund Investing in Distressed Securities" by T.Casa, M. Rechsteiner and A. Lehmann that was part of CAIA's curriculum.

There are five main sub-strategies:

1. Short
2. Long/short
3. Capital structure arbitrage
4. Value
5. Rescue financing

For stocks, the first has been tackled in a prior article.  A manager can be short by buying the derivative instrument credit default swap (CDS).  To sum up, the manager is obligated to pay a counterparty a fixed amount on the bonds of the distressed company.  In return, if the company has something known as a credit event, the counterparty pays the manager a fixed amount.  The details of the fixed amounts and credit events are listed in the CDS contract.  As the company's situation worsens, the CDS appreciates in price or the hedge fund receives the payment.

Long/short using bonds instead of equities but the premise is still the same.  The manager will establish a position in undervalued bonds and be short in overvalued bonds.

Capital structure arbitrage is similar to long/short except that positions are taken within the same company's securities.  The manager takes a long position in the senior securities such as senior bonds and a short position in junior securities such as stocks.  In the bankruptcy process, senior securities are favored if any assets are recovered.  In theory, the net value of the long and short positions should be positive i.e. the short position should decrease more than the long position.

Value managers take a long position in the company before it announces a reorganization plan to court.  They hope to profit from the rise in prices after the plan is approved by the company's creditors.  They can also take a long position after the plan is approved as other investors will not take the risk at this stage.

In rescue financing, the hedge fund lends money to distressed companies right to prevent bankruptcy filings or establishes a long stock position.

The above five substrategies differ in their approach and timing.  There are five stages in the lifecycle of a distressed company and each substrategy (in parentheses) invests during a certain stage:

1. Pre-default:  the company is restructuring  (rescue financing)
2. Early bankruptcy:  the company tries to restructure its finances;  usually by giving creditors an equity stake for debt reduction or extension  (short, long/short, capital structure arbitrage)
3. Mid-bankruptcy:  balance sheet is stabilized  (short, long/short, capital structure arbitrage)
4. Late bankruptcy:  company is almost recovered  (value)
5. Emergence:  company is recovered  (value)

In 2007, there were $105 billion in estimated assets in distressed securities; up from $30 billion in 2002.  With the market turmoil in 2008, this strategy will grow as there will be more distressed situations to invest in.

Maybe we can examine the bankruptcy process later.  There were many interesting articles in the Wall Street Journal about it during the General Motors and Chrysler crises in 2009.