Applying Fundamental Analysis to Distressed Investing Introduction As part of a strategy to diversify their portfolio, investors should consider an allocation to distressed funds. Historically, this asset class has performed extremely well through cycles, generating above average returns while providing a relatively low correlation to the broader markets1. However, distressed investments often experience periods of reduced liquidity, which investors must be willing to accept and which require fund managers to actively manage asset and liability duration in their portfolios. Additionally, distressed investing tends to be highly complex and requires financial and legal knowhow and experience in order to capitalize on the opportunity. Consequently, allocations to distressed situations should be entrusted to individuals and firms that specialize in this type of investing and have demonstrated an ability to invest in the asset class through a broader credit cycle. This paper will provide an overview of the investment process in distressed corporate securities and bank debt2 and the opportunity to generate alpha through an allocation to this asset class. This paper is divided into three parts: Part 1 will provide an overview of distressed investing and review various strategies for investing in this asset class. Part 2 will begin a discussion of the distressed investing process and address both the sourcing of distressed opportunities as well as the financial and legal analysis necessary to make investments in distressed situations. Part 3 will continue the review of the process of distressed investing and examine some of the characteristics inherent in investing in this asset class. Overview of Distressed Investing Distressed investing involves investments in businesses that are experiencing financial distress and are either (i) undergoing a restructuring, reorganization or bankruptcy or (ii) the market perceives a higher probability that they will need to do so in the future. The distress is typically caused by a deterioration of cash flow relative to expectations or an increase in liabilities and the associated concerns regarding liquidity or solvency of the business. A wide variety of factors may lead to the distressed situations including a failure of the management team to execute their business plan, loss of contracts, 1 See “An Overview of Event-Driven Investing: Potential for Alpha and Lower Correlation”, Fidelity Investments, December 2013. Also, of the 12 strategies that make up the Credit Suisse Hedge Fund Indexes, the Distressed strategy had the second highest average annual returns and the highest Sharpe ratio during the period from January 1994 through September 2015. 2 While there are other types of distressed assets, including distressed real estate, structured products, portfolios, sovereigns or municipalities, this paper will deal primarily with investments in single name corporate distressed situations. Applying Fundamental Analysis to Distressed Investing Part 1 of 3 Page 1 Downloaded from www.hvst.com by IP address 192.168.160.10 on 09/23/2021 competitive pressures, cyclical or secular changes to an industry, litigation, the discovery of new liabilities or the increase in pre-existing liabilities (for example, environmental or pension liabilities). Additionally, the risk of distress is exacerbated in situations when the company is heavily leveraged. As a result, the distressed cycle tends to follow periods of easy access to capital, after corporations have taken advantage of looser lending standards to fund buyouts, capital expenditures, acquisitions or dividends. Inevitably, the market realizes that many of these companies were inappropriately capitalized and cannot support their balance sheet. As Warren Buffet said, “only when the tide goes out do you discover who’s been swimming naked.” Irrespective of the reasons for the financial distress, once it occurs (or once the market recognizes the increased risk of it occurring), the company’s fixed income securities, bank debt and other claims will trade down to a level that the market perceives to be the present value of their recovery in a restructuring or reorganization process or to a level that provides a yield commensurate with the increased risk.3 However, there are times when Mr. Market gets it wrong, when fear outweighs greed and the various assets trade at deep discounts to recovery value or provide outsized yields relative to the risk. A distressed investor’s ultimate goal is to identify those situations when Mr. Market errs and to capitalize on what they believe to be an asymmetric risk / reward situation by investing with a margin of safety. Although all asset classes trade below intrinsic value from time to time (and value investors’ goals are always to identify those opportunities), the securities and loans of distressed companies tend to have a higher propensity to be mispriced relative to fundamental value than other investment assets. There are a number of reasons for this: Distressed situations occur because of some aberration relative to expectations: financial forecasts were not realized, liabilities are greater than previously assumed, or industries are experiencing cycles or secular changes. When things go wrong (and there is a lack of understanding as to what occurred and how it will be resolved), fear and panic can guide investment decisions and result in selling. Some investors are precluded by their investment mandate from owning assets that fall below a certain credit rating or other investment criteria forcing them to sell. Recent regulations, including Dodd-Frank and Basel III have put pressure on banks to sell distressed assets as a means of improving their capital adequacy ratios. Investors with highly diversified portfolios may lack the internal resources necessary to analyze the distressed situations and assess the recovery and prefer to “just get out.” Many investors lack either the infrastructure or expertise necessary to engage in restructurings. 3 Debt is typically considered distressed when it trades at an option adjusted spread of at least 1,000 basis points above the risk-free rate. Applying Fundamental Analysis to Distressed Investing Part 1 of 3 Page 2 Downloaded from www.hvst.com by IP address 192.168.160.10 on 09/23/2021 The timeframe to work through a restructuring and the liquidity profile of the assets during the restructuring may cause an asset / liability duration mismatch in the investors’ portfolio forcing them to sell. Some investors may be prohibited from owning post-reorganization securities or lack the ability to provide fresh capital to the company. The result is that there is a strong bias for investors to sell as the market perceives the financial distress and this may result in assets trading below their intrinsic value. Consequently, distressed investors, by nature, must be contrarian and willing to step into situations when the herd is running in the other direction. While investments in distressed situations are typically expressed through secondary trades of the companies’ debt or trade claims at significant discounts to par, distressed investment professionals generally preserve wide latitude to opportunistically invest across the capital structure or to make direct investments into the business. Often in distressed situations, the equity will trade as an inexpensive option on the survival of the business. If the investor deems that the market is wrong about the risk of a restructuring or the recoveries, he or she may be able to buy the equity at values that provide a very asymmetric risk / reward. Additionally, investors may have the opportunity to directly invest in the business. Such investments may include Capital to fund an operational restructuring Capital for the company to bid for its own securities at a discount or to provide a cash element in an exchange offering A debtor in possession loan (DIP) in a bankruptcy Working or growth capital subsequent to a restructuring or reorganization. The injection of capital prior to or during a restructuring or reorganization is typically invested at a super senior level with priority over preexisting debt. In order to exploit the opportunities to provide additional capital, distressed investors will often maintain some dry powder. Distressed Investing Strategies There are two basic strategies for distressed investing: a trading strategy and an active management strategy. As the name implies, a trading strategy involves investing in situations where the investor generates alpha through appreciation of the securities and loans purchased, and then sells those assets in the market. These distressed investors may invest in situations where they believe the market has overestimated the risk of a restructuring and once that risk is mitigated the assets will trade up to intrinsic value. Alternatively, if during a restructuring process the market receives greater clarity on the recovery and timing, assets may appreciate allowing investors the ability to realize profits. The key to a trading strategy is that managers generally are not directly involved in the restructuring process and tend to invest in situations that they believe will remain liquid. Applying Fundamental Analysis to Distressed Investing Part 1 of 3 Page 3 Downloaded from www.hvst.com by IP address 192.168.160.10 on 09/23/2021 An active management strategy, on the other hand, involves investments in situations where the manager believes he or she can create value through managing