While there are always some ups and downs in the economy from year to year, unprecedented recent events (the COVID-19 pandemic, inflation, supply chain issues, war in Ukraine) have thrown a monkey wrench into things, and there are plenty of companies whose finances are teetering on the brink today. One of the victims of these changes was the debt and equity markets; 121 large companies filed for bankruptcy in 2021. And while it’s not necessarily good for the players involved in these companies, it gives investors who specialize in distressed debt investing more chances to try to make some gains by investing to turn these companies around.

Understanding Distressed Debt Investing

Just as the name states, distressed debt investing — sometimes referred to as distressed (or distress) investing — is when you invest capital in the existing debt of a company, government or public entity that is financially distressed. When one of those entities is financially distressed, it means it has an unstable capital structure. There are many reasons why a company would find itself in those circumstances, but generally, this means that the company’s debt load is too high and the company is unable to refinance it, or else it can’t meet restrictions on its current debt covenants.

How Distressed Debt Investing Works

Simply put, distressed investing is a strategy in which investors seek out companies that are on the edge financially, or on the verge of bankruptcy. The goal is to profit if these companies have a successful turnaround. Although quite risky, a savvy investor can do well in some situations. Being able to identify opportunities that look promising is one of the key attributes for success in this space.

What Should Investors Look For?

When looking at a potential target for investments, a previously successful company that has run into hard times is a good opportunity. Under the right circumstances, a distressed debt investor can step in and purchase part (or all) of the company’s debt, with the goal of eventually gaining a controlling position, once the ship rights itself. So, all three of the following attributes in a company are viewed positively:

  • A company in financial distress
  • A successful business model
  • An in-demand product or service

In short, what to look for is “a good company with a bad balance sheet.”

The Risks and the Rewards of Distressed Investing

The risks of being a distressed debt investor are high, but then again, there are many risks to be found in standard investing. There is, however, the potential for great rewards by investing in distressed companies, but like virtually every other type of investing, you must know what you’re doing.

There are two types of strategies when it comes to distressed debt investing. Both, of course, contain risks, but their potential for financial reward is certainly possible with both turnarounds and lend-to-own, although they are distinct types of investing that require different levels of commitment. They are the following.

  • Turnarounds: This is a strategy of buying low and hoping the stock rises. A turnaround is more of a quick course of action.
  • Lend-to-own: This is a deeply involved process. Lend-to-own involves acquiring the secured debt of the distressed company, in tandem with a plan to convert the debt to equity — either consensually or by using security enforcement or a formal insolvency procedure.

How To Instigate the Distressed Investing Process

Understand that investing in distressed debt is normally something not undertaken by individual investors, but rather by institutional investors, although there are mutual funds that invest in distressed debt or include it as part of a portfolio. There are different types of debt-like securities, including bonds (both public and private), term loans, preferred stock and convertible securities, which are similar to bonds, but give an option to be able to convert the debt into equity in the event that the stock price rises above the conversion price.

There are three steps in the process to get the ball rolling. These are the following.

  1. Identify the target: Look for a company with debt trading at a larger discount than is justified, considering the potential for a turnaround.
  2. Invest: You must invest enough capital in order to wield some influence on the organization process.
  3. Define your strategy: Go with either a short-term strategy (turnaround) or for the long run (lend-to-own), as described above.

Virtual Data Rooms Are Here To Help

Today, as more and more transactions are handled online and as all parties involved in distressed debt investing communicate remotely, a type of virtual “deal room” is required, one that reduces both the time and the expense consumed in completing the transaction. These online “rooms, ” known as Virtual Data Rooms (VDRs) are online locations, where companies can store, share and access sensitive and confidential data. Using a VDR in distressed debt investing situations certainly streamlines and expedites all of these types of transactions.

A sophisticated VDR features secure access, which includes enterprise-level encryption, multiple layers of security and user-friendly admin controls that allow you to seamlessly upload and download documents, protected by version control, and that allow only certain parties access to certain documents.

The CapLinked Solution

CapLinked, an industry leader in the VDR space, provides VDRs that feature high-level admin controls, document and version management, multiple layers of security and 24/7 customer support. Its user-friendly interface and ability to work on virtually every type of computer or internet-connected device makes CapLinked the best VDR choice for anyone dealing with distressed debt investments, bankruptcy and restructuring. Contact CapLinked today for a free trial of a VDR solution that will help streamline the entire process.

Chris Capelle is a technology expert, writer and instructor. For over 25 years, he has worked in the publishing, advertising and consumer products industries.

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