2.3 Distressed and special situations

Most private credit funds lend to healthy companies and hope to be repaid at par. Distressed investors do the opposite. They buy the debt of companies that are already in trouble, at a price well below par, and profit if the eventual recovery is worth more than they paid. Special situations funds apply similar skills to complex, event-driven deals that don't fit the usual categories.

These strategies behave very differently from direct lending. Returns depend on purchase price, recovery and timing, not on a steady coupon. Analysts need to value a claim in a restructuring. LP-side analysts need to understand why returns are lumpy and why the timing of fund cash flows is hard to predict. Investor relations, product and service provider teams deal with positions that may convert from debt into equity along the way.

Stressed and distressed debt

A company is commonly called stressed when its debt trades at a meaningful discount because investors worry it may not be repaid in full. It's distressed when it's close to default, has defaulted or is in a restructuring or bankruptcy. The lines are drawn differently by different investors.

Distressed debt trades below par (100 cents on the dollar) because the market expects a recovery of less than the full claim. A loan quoted at 60 costs 60 cents per dollar of face value. Distressed investors buy it from:

• lenders that don't want, or aren't allowed, to hold defaulted loans;
• funds that need liquidity or want to reduce a position;
• investors who don't have the time or skills to work through a restructuring.

The distressed investor's job is to judge what the claim will really be worth and how long that will take.

Trading vs. control strategies

Distressed investors commonly follow one of two broad approaches.

	Trading	Control
Aim	Profit from a rise in the debt's price	Influence or control the restructuring
Holding period	Often shorter	Often longer, through the restructuring
Position size	Smaller, spread across many names	Large, often enough to block or lead decisions
Role in the process	Usually passive	Active: joins creditor committees, negotiates terms
Outcome	Sells the debt when the price rises	May end up owning the business

A control investor commonly targets the fulcrum security: the layer of debt that is only partly covered by the company's value, and so is most likely to be converted into the new equity in a restructuring. In PC101 3.1's Northfield example, sold for $260m, the second lien was the fulcrum: the first lien was repaid in full, the second lien recovered 80%, and nothing reached the mezzanine.

Loan-to-own is the extreme form of control investing. The investor buys the fulcrum debt with the aim of converting it into ownership of the company. It's betting that the business is worth more than its purchase price under new ownership and a new capital structure.

How returns depend on price and recovery

PC101 4.1 showed that a lender's loss depends on the recovery rate. For a distressed investor, the key comparison is the recovery against the price paid, not against par. Buying below par only helps if the recovery comes in higher than the price.

The following example is illustrative.

Hollin Bay Capital's opportunistic fund buys $10m face of a defaulted first lien loan at 60, paying $6.0m.

If the recovery is 75 after 2 years, the fund receives $7.5m:

• gain: $7.5m − $6.0m = $1.5m
• multiple: $7.5m ÷ $6.0m = 1.25x
• IRR: 1.25 to the power of ½, minus 1 = about 11.8% a year

If the recovery is 50, the fund receives $5.0m: a $1.0m loss, even though it bought at a 40-point discount to par.

Here is how the result changes with the recovery, still after 2 years:

Recovery	Proceeds	Gain or loss	Multiple	IRR
50	$5.0m	−$1.0m	0.83x	About −8.7%
60	$6.0m	$0	1.00x	0.0%
75	$7.5m	$1.5m	1.25x	About 11.8%
90	$9.0m	$3.0m	1.50x	About 22.5%

Three drivers stand out:

• Recovery. On $10m face, each point of recovery is worth $0.1m, so a 15-point miss turns a $1.5m gain into break-even. Estimating recovery means valuing the business and working out how that value will be shared across the capital structure.
• Purchase price. Buying the same loan at 50 instead of 60, with the same recovery of 75 after 2 years, gives 1.50x and about 22.5% a year. Price discipline matters as much as analysis.
• Time. If the recovery of 75 takes 3 years rather than 2, the multiple is still 1.25x but the IRR falls to about 7.7%. Restructurings often take longer than expected, and legal and advisory costs rise as they go on.

Returns can also come in forms other than cash: new debt, new equity in the restructured company, or a mix. A control investor that takes equity may hold it for years before selling, so the final return depends on how the business performs afterwards.

Risks specific to distressed investing

• Valuation risk. The recovery depends on the value of a troubled business, which is hard to estimate and can keep falling.
• Process risk. Negotiations between creditor groups, the sponsor and the company can shift value between layers. Legal outcomes are uncertain.
• Timing risk. A slower process lowers the IRR even when the recovery is as expected.
• Liquidity risk. Distressed debt can be hard to sell, and a control investor may be restricted from trading once it receives private information.
• Concentration. Control positions are large, so one bad outcome can hurt the whole fund.

PC302 covers workouts and restructurings in detail.

Special situations

Special situations is a broad label for complex, event-driven investing that doesn't fit neatly into direct lending, junior capital or pure distressed debt. Examples include:

• lending to a company going through a major event, such as a spin-off, a large acquisition, a litigation outcome or a regulatory change;
• financing a company that is not yet distressed but can't borrow from its usual lenders, perhaps because of a one-off problem;
• buying assets, portfolios of loans or claims from sellers that need to sell quickly;
• providing structured capital that mixes debt and equity features.

What these have in common is complexity. Special situations investors commonly earn their return from a discount on the purchase price, high pricing on new loans, fees, or equity upside, and they take risks that are specific to each deal. Rescue financing, covered in lesson 2.4, is one type.

Key terms

• Stressed debt: debt trading at a meaningful discount because investors doubt full repayment.
• Distressed debt: debt of a company close to default, in default or in restructuring.
• Par: 100 cents on the dollar, the full face value of a debt claim.
• Trading strategy: buying distressed debt to profit from a rise in its price, usually without seeking control.
• Control strategy: buying large positions to influence or lead a restructuring.
• Fulcrum security: the layer of debt only partly covered by the company's value, most likely to become the new equity.
• Loan-to-own: buying debt with the aim of converting it into ownership of the company.
• Special situations: complex, event-driven investing outside the usual credit categories.

Key takeaways

• Distressed investors buy debt below par and profit only if the recovery beats the price they paid.
• Trading strategies seek price gains; control strategies, including loan-to-own, seek to lead the restructuring, often through the fulcrum security.
• In the worked example, buying at 60 and recovering 75 after 2 years is a $1.5m gain, 1.25x and about 11.8% IRR; a recovery of 50 is a $1.0m loss.
• Recovery, purchase price and time all drive the return, and delays cut the IRR even when the recovery holds.
• Special situations covers complex, event-driven deals, with returns from discounts, pricing, fees or equity upside.