Assets are usually considered "distressed" when
their value is severely depressed for a reason particular
to the issuer and not because of general market conditions.
The most common situation is a commercial loan on which the
issuer has defaulted on payments of interest or principal.
Distressed asset investing generally, and emerging markets
distressed investing in particular, are undertaken by a small
number of firms. Implementing the strategies successfully
requires specific skills and particular economic structures.
For those firms with the appropriate professional skills and
capital base, however, the strategies can be extremely profitable.
Different types of Distressed Asset Investing
Distressed investments can be categorised by the type of
exit foreseen. In other words, what is the strategy for cashing
Event-driven distressed investments. These
are directional investments in distressed and special event
situations in sovereign and corporate securities, for which
some event is on the horizon which will transform the nature
of and increase the value of the assets. The event can be
a restructuring of a company's or country's debt, a liquidation
of a company's assets, or a buyback of outstanding debt by
an issuer or by individuals. Capital gain from the investment
is provided either through re-pricing upon occurrence of the
event, or through the proceeds of a restructuring.
Valuation-driven distressed investments. These
are directional investments made in distressed situations
where a transformative event is not at sight. The exit may
be either through the market (re-pricing due to credit strengthening),
cash flow, or an event (re-pricing upon an event or through
the proceeds of a restructuring).
Some investors may buy distressed assets simply
because the price seems too good to pass up, but this can
be dangerous: what is cheap today may be cheap tomorrow, unless
there is a reason for the value to rise. Valuation-driven
investments should therefore be made only when a clear reason
for triggering an increase in value can be ascertained, even
if the timing of the increase is uncertain.
Distressed investing usually involves the purchase
of debt, but equity analysis is relevant for two reasons.
First, the assets are usually non-performing, and therefore
the theoretical yield is less important than the potential
for capital gains; successful distressed debt investments
will produce equity-like returns. Second, equities are increasingly
being distributed to creditors as part of the package of assets
coming out of debt restructurings; in this way, control of
a company's debt pre-restructuring may later lead to equity
Distressed investing strategies may be combined
with other complementary but uncorrelated investment strategies
in liquid instruments. This can diversify portfolio risk,
create hedging opportunities, and provide useful liquidity.
Distressed investments are rarely possible to sell short,
so any hedges for long positions or outright short positions
must be undertaken in the context of a different, liquid investment
Emerging Markets Distressed Assets
The emerging markets of Asia, Eastern Europe and Latin America
have been a great supply of distressed assets over the past
two decades. Crises and defaults are an essential part of
emerging markets investment. Corporate loans default, trade
at a discount, and are restructured; sovereigns create dismal
economic situations, crash their economies, default on their
commercial debt, learn their lessons, and rebuild.
Emerging markets investment introduces several factors not
present in the developed markets. Investments in both sovereign
debt and in the debt of domestic corporations are affected
by politics, macroeconomic factors, currency valuation and
convertibility stresses, the evolution of tax and legal regimes,
trading and settlement structures, and market liquidity. Specialist
firms develop methods for analysing, pricing, and controlling
those factors, so that to the maximum extent possible they
can focus on the economics of a particular investment.
Distress and Liquidity
The relationship between distress and liquidity is important,
but flexible. Many distressed assets are quite liquid, due
to the size of the issuance, the number of interested market
participants, and the transfer process for the asset. Sovereign
emerging market distressed bonds, for instance, have often
been liquid assets even while in default, with issuances in
the hundreds of millions or billions of dollars, flocks of
interested dealers and end investors from around the globe,
and settlements in standard international bond clearinghouses
such as Euroclear. Other distressed assets can be quite illiquid,
including most defaulted loans of corporates in emerging markets
Liquidity is itself a flexible concept. The liquidity standards
used to analyse developed market equities do not apply to
emerging markets distressed debt. In developed equity markets,
a holding might be considered liquid only if the asset is
traded on a recognised exchange. By contrast, almost all emerging
markets debt products are traded over-the-counter, and an
asset which could be traded at a 1/8 % or 1/4 % bid-offer
spread in normal markets would be considered liquid. In developed
markets, the term illiquid is sometimes reserved for non-marketable
securities like private placements, where transactions are
severely restricted by the terms of the assets. For most illiquid
emerging markets securities, a thin market exists and transactions
are possible, but at wider spreads and over longer periods;
such securities may be considered illiquid if the bid-offer
spread in normal markets is wider than 2 %.
Liquidity is not only a function of the market, but also
of an investor's intentions in holding an asset. When buying
a distressed asset with a view to profiting from a future
event, an investor needs to be both willing and able to hold
the asset long enough for the event to materialise. Even when
an event is in sight, it may not be finalised for 6 to 12
months or more; in valuation-driven distressed investing,
any event is only anticipated even further in the future.
A fund making such long-term investments needs to avoid being
forced out of a position for non-market reasons. To ensure
against being forced to sell assets by investor redemptions,
it needs to match its assets with its liabilities by controlling
outflows of assets under management through the use of lockups
or infrequent redemption windows. To ensure against being
forced to sell assets by counterparties, it needs to control
its use of leverage, because leverage providers can force
funds to sell out of positions when prices fall - at precisely
the worst time.
Transfer and settlement processes can have significant effects
on liquidity. Loan transactions are settled via contract between
the seller and buyer, with transfers occurring on the books
of the debtor or its agent. These contracts are often lengthy
and heavily negotiated, so market participants must either
have the requisite legal and administration skills internally,
or must source and pay for them externally. Documentation
and procedures for debt restructurings can also be very complicated.
This minimum skill requirement provides a significant barrier
to entry, enhancing the illiquidity of the asset class.
Information and Sourcing
Value discovery is particularly difficult in distressed investing,
because of poor information dissemination. Little information
is gleaned efficiently by outsiders, because most assets are
not analysed or promoted by investment banks. Lack of liquidity
means little trading, and little opportunity for investment
banks to use research to generate fee income from a client
base; this deters the banks from devoting scarce research
resources. Little information is made available by insiders,
because there is rarely an insider with interest in the price
rising before or during a restructuring. The information gap
has two important effects: it is an effective barrier to entry,
and it allows for huge pricing inefficiencies.
Distressed investing therefore favours institutions which
have the people, the skills and the infrastructure necessary
to research both the market and the assets. Market research
entails building relationships with potential sellers. Good
contacts with the holders of large portfolios of distressed
debt are critical; to understand what assets are potentially
available on the market and to obtain the best prices.
Asset research entails close review of the issuer. Distressed
debt is valuable if the issuer has the ability to make payments
or service a fair restructuring, and if those in control have
the willingness to take those actions. For corporations, investors
should ideally meet with management, shareholders, and major
creditors, as well as reviewing financial information and
visiting the company, to get a comprehensive picture; factors
to consider include the strength of a business plan, management's
history in the business and the company, and the existence
of visible cash flows. If a restructuring is in process or
foreseeable, key contacts will include a corporation's creditors
sitting on the restructuring committee, or the leaders of
the "London Club" of a sovereign's commercial creditors.
Structural Factors Affecting the Market
Larger institutions holding distressed assets are often forced
to sell at inopportune times or for less than full value.
Commercial banks make loans, some of which turn out to be
mistakes. The manager and group responsible for working out
the loans are usually different from the ones that made the
bad loans initially. There are may incentives for them to
sell: positions are often written off internally, making it
easier for the new team to show an accounting "profit"
upon exit; positions that have moved from performing to impaired
or defaulted on the balance sheet of a bank require a larger
risk capital allocation, thereby becoming increasingly costly
to hold; banks often see an improvement in share price when
exiting from a situation that the market perceives as risky.
Traditional mutual funds are often constrained by mandates
setting minimum ratings of assets held; when assets default
or issuer ratings drop, they become forced sellers, often
exactly at the point of least liquidity.
Among investment funds and other end investors, there is
a scarcity of capital with the required flexibility. Restrictive
mandates limit the flexibility of most investible capital,
be it from investment bank proprietary capital, traditional
dealers or even the growing number of alternative asset managers.
Restructurings often involve transformation of securities,
moving from debt to equity or to some form of hybrid security,
and are surrounded with uncertainty; this drastically reduces
the investor base. Investment banks have yet to allocate significant
amounts of capital to distressed debt (with limited domestic-market
exceptions), due to adverse capital allocation restrictions.
US and European distressed funds have provided capital in
the developed markets, but most are deterred from emerging
markets by the perceived additional risks. Those who are not
deterred, but do not adapt their normal approach to the realities
of the emerging markets, may regret the decision: the rules
of the game in Ohio are not those that apply in Jakarta.
Liquidity is key to most investors, so most emerging markets
capital is not structured to fund longer-term opportunities
where the exit is less predictable. Distressed investments
in emerging markets require a very special kind of capital:
capital that is not benchmarked to any index; that can handle
the debt-to-equity transfer; that can sustain mark-to-market
volatility; and that can remain locked into a situation for
a lengthy period of time.
Example of a Successful Distressed Investment
Thai Oil Company had over $2 billion of debt outstanding
in the late 1990s. After default, the debt was traded in the
market at prices in the region of 30% of face value. The company
bought back almost 50% of its own debt at prices from 50%
up to 96% of face value. It agreed on a debt restructuring,
in which it issued clean debt and gave ½ of its equity
to creditors. Improvements in its business and the decreased
amount of outstanding debt propelled the new debt to trade
at par, and made its once-worthless equity very valuable.
Trading in emerging markets distressed investments can therefore
be extremely profitable for those who understand the value
inherent in restructurings and have a capital structure enabling
them to hold investments through the completion of those restructurings;
can price the risks presented by the lack of clear bankruptcy
laws, legal structures that often favour shareholders, and
the other relevant sovereign risks; have the capacity to provide
liquidity and the knowledge base to dispense it properly;
and can bridge the natural structural mismatch between sellers
and buyers in distressed investing and especially in emerging