Financial distress arises when a company has too much debt and too little cash flow. The company must seek to reduce this debt burden by either restructuring its balance sheet or by liquidating the assets used as collateral. Distressed debt is any payable that has been issued by such a company. The asset class includes bank debt, fixed and floating rate public debt, convertible bonds and private debt including trade claims. Investors in the asset class take advantage of the significant fall in price of these claims in the event of financial distress. They employ an event-driven strategy by purchasing debt at deep discounts, between 20 and 80 cents on the dollar, and either holding it passively throughout or, more commonly, becoming actively involved in restructurings or other events that bring significant recovery in its credit standing. If successful, the subsequent price recovery can provide considerable investment returns.
The Asian financial crisis of 1997 caused widespread corporate distress and bankruptcies across the region. Healthy and viable companies saw their foreign debt burden explode as their cash flow currency devalued sharply against the dollar. This widespread distress brought numerous opportunities to investors able to understand the special complexities of this Asian asset class.
There are a number of general characteristics shared by all types of distressed debt that make it inherently risky but a source of high returns for those that are well informed and able to employ appropriate strategies.
- Under researched and poorly understood - analysts tend not to produce research on the distressed company. Furthermore, the pace and volatility of financial change means that information becomes highly unreliable and "real-time" information is only available to those who have the techniques and local contacts necessary to obtain it.
- Illiquid with low price transparency - most investors are unable or unwilling to invest in illiquids. Competition for distressed debt is low and prices may discount its true value.
- Low beta correlation to major indices - although economic shocks such as a rise in US interest rates can have an impact, the most important factors in determining the price of distressed debt are primarily related to the progress of workout negotiations and are therefore isolated from market movements.
Downside protection is a primary concern in every distressed debt investment. In the case of secured debt this is provided by the liquidation value of the assets used as security. Unsecured debt requires an analysis of the potential break up value of the company to establish whether it is sufficient to provide protection once secured creditors have been repaid. In all investment cases the fair value of the company as an ongoing concern provides upside potential. Although the downside/upside criteria are common to all, there are two distinct types of distressed debt investment - investment in liquidations and investment in restructurings.
The key aspects in this type of investment are the assets the debt has been secured on and the enforceability of this security. The investor must evaluate the market demand for these underlying assets, their fair value and the projected timeline for the sale process. The investor's IRR targets, given the analysis of the above factors, determine the price it is willing to pay.
When investing in operating companies that are undergoing or about to undergo a restructuring, the investor needs to determine what debt structure will produce maximum returns. However, this debt structure must be sustainable by the realistic projection of the company's operation. Such a restructuring of debt may involve such things as a 'hair cut' (a process which erases a portion of the debt), a part debt-to-equity conversion, an extension in maturity, and alteration of the coupon rate of the remaining debt. The return to the investor in this type of debt investment is a combination of coupon payments and the exit value. Exit can be achieved either by being repaid by the restructured debtor or by selling into the market where demand has risen as a consequence of the restructuring.
The investor must use its negotiating leverage to align the other creditors and the shareholders with its own interests. Achieving a consensus is very difficult, but a restructuring plan that will provide for targeted returns is vital to the investment process. Fundamentally, the investor must analyse the company's projected cash flows to ascertain whether they are sufficient to make debt payments. Once the restructuring is complete, the debt may trade close to its fair value and the distressed investor will look to exit.
In Asia, widespread inefficiency in legal systems complicates the above processes significantly. The events that are fundamental to the price recovery of investments are intertwined with court proceedings. Although perfection of security is recognised in all courts across Asia, in the event of liquidation the process of seizing assets and selling them is very difficult and time consuming. A court order authorising the seizure of assets is often not sufficient to make companies release them, and the returns on the investment diminish as the process is drawn out. In the case of a restructuring, shareholders may exploit legal inefficiency and corruption to delay the restructuring process - with the hope of delaying to the point where creditors resort to agreeing to the company's offer to buy back all of the debt far below its fair value.
There are very few investors who have the patience, local knowledge, experience and information to overcome the difficulties of investing in Asian distressed debt. Returns are therefore potentially very high and consistent. Good distressed investors enjoy annual returns of 15-20% with low volatility due to the nature of the asset class (the non-correlation with indices) and the main dependence of returns on the workout strategy and execution. Distressed debt funds can significantly outperform major indices. Asian Distressed is seen as a core of any Asian portfolio of hedge funds driven by the low volatility, high quality returns and low correlation with other strategies.
Looking forward, an enormous opportunity exists in the area of non-performing loans (NPLs). Governments across Asia are putting pressure on banks to release this debt from their books and remove inefficiency from the banking system. Returns can be significant for distressed debt investors but a strong local presence is needed in order to maximise the opportunities.
There are numerous opportunities still to be found in operating companies that have yet to restructure their debt or have recently gone into some form of rehabilitation. Combined with the $885 billion of NPLs currently in the Asia ex-Japan region, investing in distressed Asian debt will continue to keep Asian distressed debt funds busy for many years to come.