Distressed Debt Investing: A High Risk Game | Practical Law

Distressed Debt Investing: A High Risk Game | Practical Law

Distressed debt investment can yield high returns but the risks are also significant. This article reviews the reasons why investment firms buy the debt of companies in distress and outlines hurdles that distressed debt investors must overcome.

Distressed Debt Investing: A High Risk Game

Practical Law Article 9-386-1346 (Approx. 8 pages)

Distressed Debt Investing: A High Risk Game

by Alain Kuyumjian, Practical Law Company
Published on 28 May 2009USA (National/Federal)
Distressed debt investment can yield high returns but the risks are also significant. This article reviews the reasons why investment firms buy the debt of companies in distress and outlines hurdles that distressed debt investors must overcome.
Current market conditions have dramatically changed the credit market landscape. One striking feature of this changed landscape is the distressed debt market. Distressed debt is essentially debt of a financially distressed company that is likely (or perceived to be likely) to default on its debt payment obligations. According to a commonly-used definition, debt securities are distressed if they trade on the secondary market yielding more than 1,000 basis points over benchmark Treasury securities.
A wide variety of players from hedge funds to private equity investors to traditional large financial institutions invest in distressed debt. In a 2009 survey of hedge funds and other institutional investors by Debtwire, over 60% of respondents indicated that investing in distressed debt is their core investment strategy, a staggering number given the high risks involved.

Distressed Debt Investing: Why Bother?

Whether they expect to use their holdings to take on an activist role with the company, convert to equity and sell their equity interest at a profit or hold out until maturity, distressed investors expect that they will reap the benefits of their investment at some point in the life of the company. The quick answer to why firms continue to invest in distressed companies is that the potential returns can be very rewarding. Although distressed investors suffered considerable losses on their bets in 2008, a substantial majority expect returns of over 15% in 2009, and many are forecasting over 20% returns in 2009 (Debtwire).

Negotiation Leverage

Distressed debt investors may buy debt of a company with a view to taking an activist role. By becoming a lender, a distressed investor often gains access to restricted information about the company. This information gives the investor at least two things: the ability to assume an active role in managing their investment and leverage at the negotiating table in the context of a restructuring.
In addition, investors holding sufficient amounts of the company's debt also gain the ability to guide the company's affairs more broadly and force key management decisions to their advantage. Distressed investors can use their holdings to influence any number of matters from corporate governance to a management overhaul and change in long-term strategy (they can seek board representation to achieve these goals).


A loan- to-own strategy is a means for investors to take control of a distressed company, often through bankruptcy proceedings. It involves investing in the distressed company's debt (usually taking security in the company's assets) to have an advantage in eventual bankruptcy proceedings (or to negotiate for the ability to convert to equity prepetition). The investor's debt is then exchanged for equity under a plan of reorganization and existing equity investors and out-of-the-money creditors (often unsecured creditors) get wiped out. Experienced investors bet on where the fulcrum security lies in the company's capital structure to execute this strategy (see Box, Where is the Fulcrum Security?).


A buy-your-own strategy is a means for private equity investors to take advantage of current market conditions to de-lever their portfolio companies (companies in which they own equity) by buying back their debt at a discount. In addition to getting a good deal on the debt and increasing the private equity firm's return on the investment, this increases operating flexibility at the portfolio company because it gives it more wiggle room with regard to debt covenants and ratios with which it must comply since its debt is reduced. See Article, Loan Buybacks: Overcoming the Obstacles and Article, Understanding Loan Buybacks.

Mechanics for Distressed Debt Investing

There are three main ways of investing in distressed debt:
  • Secured lending.
  • Buying debt on the secondary market.
  • Defensive and competitive DIP.

Secured Lending

Secured lending is a direct way of investing in a distressed company. An investor (for example, a hedge fund) agrees to make a secured loan to a company that is overleveraged and is otherwise unable to raise capital, on terms commensurate with the risk assumed.
The investor typically negotiates terms in the loan documents to provide for some type of control and to make it as difficult as possible for third parties to subsequently derail their investment. "The point is to include provisions in the loan documents to enable distressed investors to control the company before and after bankruptcy as much as possible," says Jonathan Landers, head of Milberg LLP's bankruptcy practice. These provisions include tight covenants and onerous prepayment penalty provisions, whose effect is to "tilt control toward the distressed investor," according to Landers.

Buying Debt on the Secondary Market

Another way of investing in distressed debt is by buying it on the secondary market. Because debt is currently trading at record lows, there is an abundant supply of investment opportunities for savvy investors with available cash to deploy. The idea is the same as when the investor lends directly: the investor accumulates debt of the company to gain negotiating leverage and influence management decisions on restructuring options.

Defensive and Offensive DIP

A distressed company needs cash to continue operating after filing for bankruptcy. Incumbent investors or creditors can reinforce their position by providing DIP financing. This is known as a defensive DIP.
However, because current market conditions mean there is not much cash to go around, distressed debt investors may also have an opening at this stage of a company’s life. These financings are known as new money DIPs or offensive DIPs, where financing is provided by newcomers to the company's lending circle who then compete with existing creditors for control (see Box, DIP Financing and Practice Note, DIP Financing: Overview).

Navigating Obstacles

While distressed investing can provide solid returns, there are legal hurdles that may affect the extent to which distressed debt investors are willing to participate in this market.

Restrictive Provisions and Securities Laws

Both the investing firm's formation documents and the distressed company's existing loan documents need close examination to ensure that the investment does not breach any provisions in these documents. A fund's formation documents may, for instance, prohibit it from purchasing the debt of distressed companies or receiving equity securities under a plan of reorganization. In fact, the reason hedge funds are prominent in the distressed debt market is that they can provide liquidity where others (such as pension funds) are barred from doing so because they are often restricted from investing below certain investment grades.
Similarly, loan agreements can contain restrictions on transfers and assignments and loan buybacks, including restrictions on what institutions qualify as permissible transferees. Some of these provisions are drafted to limit the existing creditors' ability to sell their loans to certain types of investment firms.
Finally, purchases of debt securities (but not loans) must comply with federal securities laws, including tender offer rules and insider trading restrictions. Depending on how purchases are structured, this adds another layer of challenges that distressed debt investors must understand and address.

The Push for Transparency and Regulation

Distressed investors rely on sensitive investment strategies to compete in this market, and hedge funds make up a significant portion of the distressed investor community. In re Northwest Airlines Corp., 363 B.R. 704 (Bankr. S.D.N.Y. 2007) stunned this community when the court interpreted Rule 2019 of the Bankruptcy Code to require an ad hoc committee of hedge funds to disclose information on the claims they held, including the amount they purchased, when they purchased them and at what price. This interpretation of the rule was informed by the notion that hedge funds had the ability to manipulate the bankruptcy proceedings to their advantage, turning the purpose of Chapter 11 (distressed company rehabilitation) on its head (see Box, What is Rule 2019?).
The impact of Northwest endures at a time of increased calls for regulation, targeting hedge funds in particular. SEC Chairman Mary Schapiro has indicated that requiring hedge funds to register with the SEC alone would not be sufficient, and left open the possibility of requiring disclosure of, and even restrictions on, what hedge funds can invest in. More recently, hedge funds were publicly vilified for their role in triggering Chrysler LLC's bankruptcy filing because they were accused of holding out for a higher payment on the debt they held (vilification aside, some caution that secured creditors are getting a raw deal in the process and that this may have the unintended impact of chilling distressed lending).
None of this bodes well for hedge funds and their ability (or willingness) to participate in the distressed debt market. But it is too soon to tell how the distressed investor community will react to calls for transparency, and whether public policy choices will require them to temper their tactics.

Investor Wars

Stakeholders often must rely on courts to sanction their reorganization or restructuring plans for distressed companies. Because there are often many stakeholders involved, those who stand to lose (existing equity holders and other creditors) aggressively try to rein in those they view as the schemers in the process (the distressed debt investors). In the bankruptcy context, the claims litigants make are varied and range from equitable subordination to breach of fiduciary duties.
Given the number of stakeholders competing in what many view as a zero-sum game, disgruntled creditors are aggressively seeking to recoup their investment, whether at the negotiating table or in the courtroom. This makes distressed investing a highly-contested and expensive strategy.

Fiduciary Duties

Whether in a distressed context or otherwise, directors always owe fiduciary duties to the company. They also owe fiduciary duties to stockholders or creditors, depending on the company's financial condition. This means directors must tread carefully when considering what financing options a distressed company can pursue, particularly in the case of those directors who are investor appointees. Distressed investors need to understand these duties to ensure their investment tactics do not trigger breaches and give rise to claims from other stakeholders.
Courts recognize that directors have few financing options. "If a company desperately needs financing and is faced with limited and unappealing choices, it is difficult to see what options directors really have," says Douglas Urquhart, a banking and finance partner at Weil, Gotshal & Manges LLP. So courts are reluctant to second-guess board decisions absent clear cases of breach, for example where a decision by the board is tainted by a conflict of interest.
For a solvent corporation, the board of directors must manage the company in the best interests of its stockholders, who have standing to assert direct claims and derivative claims on the company's behalf against directors for breaches of fiduciary duty. On insolvency, directors' fiduciary duties shift to creditors because the interests of stockholders are subordinate to those of creditors. Distressed debt investors then become the beneficiaries of these duties.
However, North American Catholic Educ. Programming Found., Inc. v Gheewalla, 930 A.2d 92 (Del. 2007) confirmed that creditors cannot assert direct claims for a breach of fiduciary duty against directors. This would create a conflict for directors between their duty to maximize the value of the insolvent corporation for the benefit of all constituents and their direct fiduciary duty to individual creditors.
In re Granite Broadcasting Corp., No. 06-12984, (Bankr. S.D.N.Y. 2007) also served as a warning call for distressed investors, suggesting that distressed debtors and their prospective lenders must ensure that the debtor's board of directors has adequate procedures when assessing restructuring or reorganization options. Boards should form an independent committee of directors to evaluate these options, particularly where potential conflicts of interest exist.
For more information on the fiduciary duties of directors in a distressed context, see Practice Note, Fiduciary Duties of Directors of Financially Troubled Corporations.

Too Good to Pass Up?

From an investor's perspective, betting on distressed companies is a complex and litigious strategy, often commercially hostile, and one that involves serious legal and financial risk. While comprehensive data is not available on current trends, one survey indicates that 36% of hedge funds invested in distressed debt in 2008 compared to 48% in 2007 (HedgeWorld & Dykema 2009 Insolvency Outlook Survey). Less than half of the investment managers surveyed expect lending to distressed companies to increase in 2009. But the financial crisis has had ripple effects on all kinds of investing, so these numbers are not surprising.
The stark reality is that financing in current credit markets is scarce. "The basic problem is not legal but financial − there is very little deal money around," says Landers. Companies need to seek out the best available option to shore up their balance sheets and will look to willing lenders and investors to do so. Even as liquidity starts seeping back into the markets, it is not clear that distressed investors and their tactics will disappear any time soon. According to Douglas Warner, a private equity partner at Weil, Gotshal & Manges LLP, the amount of debt maturing in the next couple of years far surpasses likely available credit, which in turn will fuel distressed investment strategies for some time.
Whether distressed debt investing will withstand the financial and legal setbacks it has been dealt depends on how distressed debt investors expect to manage their risks going forward, including the regulatory risks that they anticipate. That the supply of distressed debt money has not dried up entirely, however, is telling. It must be that for those who continue to play this game, the returns are just too tempting to walk away.

Where is the Fulcrum Security?

The fulcrum security is the security most likely to convert to (or receive) equity in a reorganized company after it emerges from Chapter 11 of the Bankruptcy Code. Some investors buy this security as part of a strategy to take ownership of the company. The collateral securing debt is often not sufficient to pay first and second lien lenders, and second-lien debt is likely to be the fulcrum security. This usually means that anything below that in the capital structure (including equity) gets wiped out. While in the past, the fulcrum security was unsecured debt, today it is increasingly secured debt.

DIP Financing

DIP financing allows Chapter 11 debtors to continue their business operations during the course of a bankruptcy case. The Bankruptcy Code encourages lenders to provide DIP financing by granting them superpriority claim status which gives them priority in payment over almost all other existing debt, equity and other claims. The terms of DIP loans are similar to the terms of traditional loan agreements but they carry larger transaction fees, higher interest rates and more burdensome covenants. DIP lenders have greater control over the debtor and the bankruptcy proceedings than a lender under a traditional loan agreement.
As an example, on February 27, 2009, the Bankruptcy Court of the Southern District of New York approved a record $8 billion DIP financing for Lyondell Chemical Company in connection with its Chapter 11 bankruptcy proceeding, the largest DIP financing to date. The financing included a $6.5 billion term loan facility and a $1.54 billion asset-backed revolving facility. The DIP investors included a combination of banks, hedge funds and private equity firms. The financing imposes reorganization milestones with respect to timing on when the company must achieve certain results and negative covenants including limitations on capital expenditures and limitations on indebtedness, liens and investments.
For further information on DIP financing, see Practice Note, DIP Financing: Overview.

What is Rule 2019?

Rule 2019 of the Bankruptcy Code is a procedural requirement that imposes disclosure obligations on committees representing more than one creditor or equity security holder in bankruptcy cases, including cases under Chapter 11. Ad hoc committees are often formed to share the expenses of participating in bankruptcy proceedings, for example by hiring one law firm to represent an unofficial committee of creditors. By acting collectively, these creditors also gain leverage in the proceedings as they bring their collective interests in the company to bear.
These disclosure requirements have existed in bankruptcy reorganization proceedings since the 1930s. But their recent application with regard to committees of distressed investors has created uncertainty because courts have interpreted the rule differently. Two prominent cases are In re Northwest Airlines Corp., 363 B.R. 704 (Bankr. S.D.N.Y. 2007) (holding that Rule 2019 applied to an ad hoc committee of hedge funds and requiring disclosure) and In re Scotia Development LLC, No. 07-20027-C-11, (Bankr. S.D. Tex. 2007) (denying a motion to compel an ad hoc committee to comply with Rule 2019 disclosure requirements).