introduction distressed investing
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Investing in Distressed Situations: A Market SurveyStuart C. GilsonThe practice of investing in distressed companies is popularly known as "vulture" investing. The risks of investing in this market are highly firm specific and idiosyncratic. Invest'ors who are adept at managing these risks, who understand the legal rules that must befollowed in corporate bankruptcy, and who are skilled at identifying or creating value in a distressed situation consistently earn the highest returns in this market.
uring the past ten years, the number of bankruptcy filings, debt restructurings, and junk bond defaults by U.S. public companies reached record levels. One of the most important and enduring legacies of this period has been the development of an active secondary market for trading in the financial claims of these companies. The participants in this market include many mainstream institutional investors, money managers, and hedge funds, as well as certain individuals--known as "vultures"-who specialize in trading distressed claims. The strategies these investors use are as diverse as the claims they trade and the companies they target. Some investors prefer to acquire the debt claims of a company while it tries to reorganize under Chapter 11 so they can either influence the terms of the reorganization or wait until the company's debt is converted into a major equity stake that can be used to influence company policy. Some investors prefer to purchase senior claims, others prefer junior claims, and still others spread their purchases throughout the entire capital structure. Some investors choose to take a passive role, seeking out undervalued claims, "hitching their wagons" to that of a more active vulture investor or holding distressed securities as part of a broadly diversified portfolio. The business of trading in distressed debt is not new. In the chaos that immediately followed the American Revolution, Treasury Secretary Alexander Hamilton proposed to restore confidence in the financial system by redeeming, at face value, the bonds the American states had issued to finance the war. On the heels of this proposal, speculators acquired large quantities of the bonds, which had fallen
Stuart Gilson is an associate professor of business administration at Harvard University.
greatly in value under the weight of high inflation and the massive war debt, in the h~pe that Hamilton's program would be completed. What is unique about today's distressed debt market is its size and scope. There is a market for virtually every kind of distressed claim: bank loans, debentures, trade payables, private placements, real estate mortgages even claims for legal damages and rejected lease contracts. It is only a slight exaggeration to suggest that anything that is not nailed down will be traded when a firm becomes financially distressed. Two and a half years into the Chapter 11 bankruptcy of R.H. Macy, 728 of the firm's claims had traded for a total dollar value of $510 million. In the recent bankruptcy of Hills Department Stores, more than 2,000 claims exchanged hands. The market for distressed claims is also quite large. In 1992, coming off the peak of the most recent bankruptcy cycle, one estimate placed the total amount of U.S. corporate debt that was either distressed or in default at $159 billion (face value). 2 In 1993, Investment Dealer's Digest identified 27 major investment funds that specialized in buying distressed claims, managing total assets of more than $20 billion. (To put this figure in context, the total amount of money under management in U.S. venture ca P3ital funds in 1993 was approximately $27 billion.) Also in 1993, the annual volume of trading in distressed bank debt alone approached $10 billion. 4 The level of financial distress in the economy, hence the supply of distressed debt, is of course highly cyclical. As Table I shows, the past few years have seen fewer opportunities to invest in distressed situations, as measured by the number or size of publicly held firms that filed for Chapter 11 (although this group represents only part of the market). In part, this trend reflects the final weeding out of poorly structured deals from the 1980s. In part, the downtrend is the result of recent improvements in
Financial Analysts Joumal/ November-December 1995 1995, AIMR
Table 1. Frequency and Size of Chapter 11 Rlings and Other Corporate Restructuring Transactions by Publicly Traded Rrms, 1981-94Number of Transactions Chapter 11 Filings 74 84 89 121 149 149 112 122 135 116 125 91 86 70 1,523 Hostile Tender Offers 10 8 9 9 12 17 16 28 15 5 3 1 1 7 141 Leveraged Buyouts 14 15 47 113 156 238 214 300 305 201 193 223 176 159 2,354 Total Value of Transactions ($billions) a Hostile Tender Offers $8.6 3.4 2.5 3.3 20.3 20.6 6.1 50.0 50.0 9.0 2.8 0.5 0.0b 12.4 $189.4
Year 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 Total
Spinoffs 2 3 17 13 19 26 20 34 25 27 18 19 26 28 277
Chapter 11 Filings $6.0 11.3 15.4 7.9 6.9 15.9 49.5 49.9 78.0 85.7 86.1 55.4 17.1 8.3 $493.3
Leveraged Buyouts $2.7 2.1 3.1 18.7 18.9 56.6 51.5 66.7 82.9 18.6 7.4 8.2 10.2 8.3 $355.8
Spinoffs $1.3 0.2 3.6 1.3 1.5 4.4 3.5 12.8 8.0 5.4 4.8 5.8 14.4 23.4 $90.5
aAll dollar values are converted into constant 1994 dollars using the producer price index. For a Chapter 11 filing, "Total Value of Transaction" equals the book value of total assets of the filing firm. For a hostile tender offer and for a leveraged buyout, "Total Value of Transaction" equals the total value of consideration paid by the acquirer (including assumption of debt), excluding fees and expenses. For a spinoff, "Total Value of Transaction" equals the market value of the common stock of the spun-off entity evaluated at the first non-when-issued stock price available after the spinoff. bLess than $0.1 billion. Sources: The 1995 Bankruptcy Yearbook and Almanac and Securities Data Corporation.
the economy. The supply of distressed debt, however--both within the United States and abroad--is certain to rise again. Table 1 also shows that the market for distressed debt has historically provided more investment opportunities than other corporate restructuring transactions that have traditionally attracted the interest of investors, including hostile tender offers, LBOs, and spinoffs. This article surveys the theory and practice of investing in distressed situations. Trading practices in the market for distressed claims have become more sophisticated and institutionalized as the volume of activity has grown. To investors who are unfamiliar with this market, these methods may seem arcane and complex. One goal of this survey is to show that the core strategies for realizing value in distressed situations are relatively straightforward. Another goal is to describe and analyze the various risks--most of them highly firm specific and idiosyncratic-that one faces when purchasing distressed claims. Understanding how to manage these risks is key to earning superior returns in this market. I conclude by discussing future opportunities in distressed situation investing.
BASIC RESTRUCTURING OPTIONSInvesting in distressed situations involves purchasing the financial claims of firms that have filed for legal bankruptcy protection or else are trying to avoid bankruptcy by negotiating an out-of-court re-
structuring with their creditors. In the United States, corporate bankruptcy reorganizations take place under Chapter 11 of the U.S. Bankruptcy Code. Firms that liquidate file under Chapter 7. In practice, most firms--more than nine in ten--first try to restructure their debt out of court and only when this fails do they file for bankruptcy. A recent academic study found that approximately 50 percent of all U.S. public firms that experienced financial distress in the 1980s successfully dealt with their problems by restructuring their debt out of court, s An out-of-court restructuring can almost always be accomplished at much lower cost than a court-supervised reorganization. Part of this difference reflects savings in legal and other administrative costs. More importantly, Chapter 11 generally imposes a much heavier burden on the business because of the greater demands placed on management's time and costly delays engendered by litigation. Consistent with this cost differential, Gilson et al. found that firms that successfully restructure their debt out of court experience significant increases in their common stock price (approximately 30 percent, on average, after adjusting for risk and market movements) from the time they first experience financial distress to when they complete their restructuring. Over a corresponding interval, firms that try to restructure out of court but fail experience significant average stock price declines (also on the order of 30 percent). Chapter 11, however, also provides certain bene-
Financial Analysts Journal / November-December 1995
fits to a distressed firm. While in Chapter 11, the firm does not have to pay or accrue interest on its unsecured debt (and it only accrues interest on its secured debt to the extent the debt is overcollateralized). Chapter 11 also allows the firm to reject unfavorable lease contracts and to borrow new money on favorable terms by granting lenders superpriority over existing lenders ("debtor-in-possession" financing). Moreover, a reorganization plan in Chapter 11 can be passed with the approval of fewer creditors than a restructuring plan negotiated out of court (which generally requires creditors' unanimous consent). From an investor's perspective, Chapter 11 can also be attractive because the firm is required to file more financial information with the court (e.g., monthly cash flow statements) than is generally available in an out-of-court restructuring. Lately, in an attempt to re