How Does it Work?
Distressed debt refers to the bonds of a company, which is not doing well financially. The company might have already filed for bankruptcy or could be heading towards one. When the company faces a financial crisis, it can choose to sell its bonds to new buyers, in order to attract capital. Thus, it simply means investing in the bonds of a failing company. In such a scenario, the company usually sells its bonds at dirt cheap prices. This is often the last resort to recover from a financial turmoil. Mostly, these buyers are financial entities such as mutual funds, private equity firms, brokerage firms, hedge funds, and specialized debt funds. These entities have their own criteria, which enables them to invest in the right companies. They usually check a company’s background on the basis of following parameters:
- Does it have any legal problems?
- Does it have overextended debts?
- Are there any operational issues?
- Has it been underperforming?
- Does it have potential for recovery in the future?
Returns on investment are usually high, if you invest in the right company. Such buyers are more interested in buying the debts of a company, rather than its equity shares. This is because in an event of liquidation, debt owners are given priority over equity holders, meaning that debts are liquidated before equity. The buyers often get a good return on their investment as the debt liquidates at a much higher price than its initial selling price. If the company survives, then the buyers have a greater stake in the restructuring of the company. Mergers, takeovers, and internal restructuring are some of the ways of resurrecting a failing company. If the company does well after reorganization, the investors can still claim a profit share.
Just like any other investment option, distressed debt investment is also not free of risks. Although, buyers of such debts often make neat profits, they may have to endure huge financial losses in certain cases. If the company does not perform well, even after restructuring, then the investors may not get any return on their bonds. During liquidation, the proceeds may turn out to be pretty expensive, thereby reducing the profit margin drastically. To minimize the risks, you need to thoroughly analyze the financial situation of a company before investing.