The author of this article looks at an area which perhaps isn’t helped by its name. “Distressed” does not have to be distressing. There are some mutterings that the credit cycle in the US and other countries might turn and a decade since the global financial crisis, some changes are overdue. 

What is the case for “distressed investing”? Should family offices be interested in it and are they actually well-suited to embracing this area of the market? To some degree, this asset class is part of that alternative space that sits alongside private equity, private debt, infrastructure and real estate. These are all areas requiring a patient attitude and tolerance for illiquidity. That's a pretty good fit for family offices, as well as institutions such as endowment funds, for example. But the devil is in the details. To discuss the topic is George J Schultze, CEO and founder of his own investment house (established in 1998), Schultze Asset Management. The editors of this news service are pleased to share these insights and invite readers’ responses. The standard editorial disclaimers apply around external contributors’ copy. To reply, email tom.burroughes@wealthbriefing.com or jackie.bennion@clearviewpublishing.com

Historically, investors have profited by exploiting various market inefficiencies, but with advances in technology and the proliferation of index-driven ETFs, those inefficiencies have become increasingly rare. Having said that, the distressed investing universe is still rife with uncertainty, misunderstanding, and a whole host of interesting arbitrage opportunities which offer family offices an interesting diversification alternative.

No matter what ultimately drives a company into bankruptcy, its creditors will be looking to minimize their losses. This gives the distressed investor an opportunity to take advantage of the arbitrage difference in pricing between how lenders valued the firm when new debt was issued versus how the market values it after a distressed event. Sometimes, that difference can amount to hundreds of millions of dollars, or even billions for larger companies.

Often, lenders who backed a company’s issuance of new debt have no desire to own equity in the reorganized firm. The point at which those lenders would happily sell their newly distressed debt is likely to be at a sharp discount from the original price. Moreover, it’s often considerably lower than the price at which the equity market will eventually value that very same business, once the overhang of distress has cleared.

The signs are there, if you know what to look for
There are a number of interesting, yet highly predictable, events that surround most major corporate distress situations, including: missing an interest payment, defaulting on a loan, downgrading of a loan or bond by a ratings agency, breaching loan covenants, delisting public stock from a major exchange, and of course, filing a bankruptcy petition.

These types of events can create sudden drops in the prices of loans and/or bonds. In fact, we’re seeing this phenomenon a lot more these days, because so many of the buyers of original issue loans are collateralized loan obligation (CLO) portfolio managers. These “non-bank” special purpose entities buy pools of loans at new issuance with the goal of spreading out risk among investors, almost like a bank would, and diversifying their exposure among many loans. However, those same CLOs are usually bound by corporate governance structures that restrict them from owning defaulted securities or limit the percentage of poorly rated loans in their portfolios.

This “forced selling” situation presents another opportunity. It’s not uncommon to see a loan that was trading at about 90 cents on the dollar to suddenly drop to well below 70-80 cents. There are times when those same loans might rapidly trade down to 10-20 cents, because there’s such a wide gap between what original issue investors paid to get a diversified interest income stream, compared with where the reorganized firm’s securities will trade after restructuring. We recently witnessed this type of sell off with loans issued by Deluxe Entertainment, a technology company providing services critical to movies and TV shows. In that case, the loans quickly dropped, from nearly par to under 10 cents, within a few months even though the business’ fundamentals hadn’t changed proportionately.

Moreover, once a company lands in bankruptcy, its securities, including stock, bonds and loans, often continue trading which can present even more opportunities. Other events that can be leveraged during a firm’s reorganization are disputes over the size and value of claims, as we see right now with the PG&E bankruptcy. That complex case has presented multiple investment opportunities for nimble distressed securities managers who have the flexibility to invest both long and short. Litigation over creditor claims can create material fundamental change for the underlying business, and can therefore cause the issuers’ securities to move up or down dramatically, regardless of what’s happening in the overall equity markets on that specific day. For PG&E, that has meant some interesting opportunities for short selling the company’s stock since equity investors sometimes become overly enthusiastic about the likelihood of getting a recovery in bankruptcy.

Bankruptcy increases transparency
Bankruptcy is not a swift process with the average time between filing a bankruptcy petition and completion of a reorganization taking about two years in the US.

During bankruptcy reorganizations, the presiding court requires tremendous levels of transparency and disclosure. In addition to current creditors, potential new investors have the opportunity to study these public documents to get a good read on what’s really happening with the distressed firm. Because there’s a greater degree of transparency and disclosure through the required court filings of all corporate debtors, in many cases distressed investors can achieve lower risk than they otherwise would by looking in from the outside at a regular publicly traded [organization].

Let me share with you a real-life example of the benefits of public disclosure from the Owens Corning bankruptcy which occurred a few years ago. This firm is a major manufacturer of building insulation used in the home construction market, and it faced tremendous liabilities due to its prior use of asbestos in its manufacturing process. When it restructured in bankruptcy, I learned by reading its court filings that the company owned five private jets that were worth at least $50 million apiece, something that most public shareholders were probably unaware of. Since the court required the debtor to disclose that it had adequate insurance coverage for each of its assets, it became clear that they had an entire fleet of corporate jets, representing a potential excess asset that could be monetized once it emerged from bankruptcy.
 

Make sure you know what kind of diversification
The final point that family offices should consider is the wide variety of firms and approaches that come with investing in distressed securities. Some are huge behemoths, with very high minimums, which only focus on the biggest of big deals and are structured more like private equity funds, moving slowly and deliberately. There are others which are nimbler and more opportunistic, with the flexibility to invest up and down the capital structure of companies going through distress, regardless of their market capitalization. As a result, they may be better positioned through the duration of a full credit market cycle.

At this point in the cycle, lending is very accommodative since the Fed is very aggressive in terms of making money available to all parts of the economy. Despite low interest rates, there are some companies that are borrowing beyond their means. Junk bond default rates may currently be low but, as the economy begins to turn from a record 11 years of growth, those rates will certainly rise. At that point, we’ll see more of these companies with aggressively over-leveraged balance sheets face heightened risk of distress.

This should present an increasing opportunity to short sell their publicly traded equities along the way, as well as put other distressed tools to work for possible future long investment when appropriate.

Family offices would therefore be well advised to maintain some exposure to this compelling and largely non-correlated asset class. In fact, some of the largest fortunes of all time were made by distressed investing (e.g., the Rockefellers, when they bought most of our country’s oil refineries out of distress) by having sufficient capital ready to put to work, when and if the opportunity presented itself. Moreover, given that distressed investing requires a specific skill set, it’s likely that this specialist value-driven investment approach will not be replaced by passive investing at any time in the near future.

Happy investing!

About the author

George J Schultze is the CEO of Schultze Asset Management, a firm he founded in 1998. An expert on distressed and special situations investing, he is the author of The Art of Vulture Investing: Adventures in Distressed Securities Management (Wiley Finance, 2012).