The highs and lows of purchasing distressed debt

Their aim is either to become one of the firm’s largest stakeholders, or to take the company through to insolvency, and as a secured asset (rather than equity) creditor, potentially make a profit once the price of the assets has been agreed.

In principle, the purchasing of distressed debt offers investors the possibility of spreading their investments across a number of sectors, but whether the markets in the UK will develop enough to provide an amenable platform for this type of investment to flourish, remains to be seen.

Whilst other countries have seen a successfully uptake of distress debt purchasing, the UK has lagged behind, with far fewer companies than expected adopting the model. This lack of activity may have occurred for a number of reasons, including a reluctance by the banks to sell on the debt, constrictions of the financial climate in generating equity to buy the debt – or simply that the ‘supply and demand’ equation has not been met, with the price of the debt being too high for the demand for it.

The model involves investors, or more often, groups of investors, buying up the debt of companies who face an imminent risk of insolvency. The investment can then be managed in two ways – investors retain the secured debt, so that they become stakeholders in the company and can therefore influence how the company is re-structured – something which ordinarily they would not have been afforded the opportunity to do.

Alternatively, they can take the firm through a restructure via in insolvency option. In this scenario, where other shareholders would lose most or all of their investment, as a secured creditor, the distressed debt investors would be one of the first creditors to be repaid, often at a higher rate than their original investment, because of how the asset price is calculated by the appointed Insolvency Practitioner.

Here is a brief overview of the pros and cons of this type of investment:

PROS

  • There can be momentous gains to be made.
  • An adaptable strategy can mean that either a resale or liquidation both become viable options for a good return.
  • Flexible timing – if an investor knows that they want to drive the company towards a restructure, then they can purchase the assets sooner (albeit at a higher price) than investors seeking to liquidate a business. This gives them a greater choice with regards to which firms they choose to invest in.
  • There are some outstanding investments to be had – especially in the current climate, where there is an unwillingness of banks to extend credit facilities to many businesses – this limits their cash flow options and can cause financial instability in what is otherwise a strong business.

CONS

  • It can be difficult to determine when the asset price has reached its lowest point and is therefore the best time to buy.
  • Even a slight overpayment on the price can result in huge losses.
  • The market is hugely unpredictable.
  • It can be hard to get data on distressed debt investment as many of equity firms who currently monopolise this sector don’t post their figures.
  • Many companies will view distress debt investors with hostility, which can make negotiations with them more complex.

It is far from a guaranteed investment – the returns can be high, but so can the risks.

Potentially a company could take the investors to court if they feel that they have breached their remit of investment, and have instead taken a controlling share with a planned mandate of affecting a complete structural reorganisation of the company.

Purchasing the distressed debt of a failing company undoubtedly presents many unique and potentially abundant opportunities for investors who are willing to adopt both a shorter term, higher risk approach via Insolvency, and a longer term strategy of affecting change through restructuring for a future sale or growth.

The general consensus amongst many analysts is that if the purchasing of distressed debt takes off here as well as it has in other countries, it will open up a wealth of investment opportunities that haven’t previously existed in the UK.


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Melanie Hird

As director of Seneca Investments (part of Seneca Partners Limited), Melanie sources and executes deals involving SMEs – managing an investment portfolio and investor relations together with driving the strategy for the businesses. Melanie joined Kroll – global leader in risk mitigation – in 2004 to focus on corporate assignments within the national and international markets.

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As director of Seneca Investments (part of Seneca Partners Limited), Melanie sources and executes deals involving SMEs – managing an investment portfolio and investor relations together with driving the strategy for the businesses. Melanie joined Kroll – global leader in risk mitigation – in 2004 to focus on corporate assignments within the national and international markets.