Distressed securities (also known as distressed-debt) are securities or bonds of companies or government entities that are experiencing financial or operational distress, default, or are under bankruptcy. Purchasing or holding such distressed-debt creates significant risk due to the possibility that bankruptcy may render such securities worthless (zero recovery). Distressed securities tend to trade at substantial discounts to their intrinsic or par value and are therefore considered to be below investment grade.. This usually limits the number of potential investors to "large institutional investors—such as hedge funds, private equity firms and investment banks." In 2012 Edward Altman, a leading expert on bankruptcy theory, estimated that there were "more than 200 financial institutions investing between $350-400 billion in the distressed debt market in the U.S. and a substantial number and amount operating in Europe and in other markets."
Distressed securities in the 1990s
An active market developed for distressed securities as the number of large public companies in financial distress increased in the 1980s and early 1990s. In 1992 Altman, who developed the Altman Z-score formula for predicting bankruptcy in 1968, estimated "the market value of the debt securities" of distressed firms as "approximately $20.5 billion, a $42.6 billion in face value."  By 1993 the investment community had become increasingly interested in the potential market for distressed firms' debt. At that time distressed securities "yielded a minimum ten percent over comparable maturity of U.S. Treasury bonds. For example, 16.6% or above are estimated to amount to $71 billion in par value (with several issuers and 600 issues) and about $37 billion in market value. Adding private debt with public registration rights allows private bank debt and trade claims of defaulted and distressed companies to bring the total book value of defaulted and distressed securities to $284 billion, a market value of $177 billion." By 2012
Distressed securities investment strategy
The distressed securities investment strategy exploits the fact that only a few investors are able to enter into the "long low investment grade credit" by holding securities that are below investment grade.
Some investors have deliberately used distressed-debt as an alternative investment, where they buy the debt at a deep discount and aim to realize a high return if the company or country does not go bankrupt or experience defaults. The major buyers of distressed securities are typically large institutional investors, who have access to sophisticated risk management resources such as hedge funds, private equity firms and units of investment banks. Firms that specialize in investing in distressed debt are often referred to as vulture funds.
Investors in distressed securities often try to influence the process by which the issuer restructures its debt, narrows its focus, or implements a plan to turn around its operations. Investors may also invest new capital into a distressed company in the form of debt or equity. According to a 2006 report by Edward Altman, a professor of finance at the Leonard N. Stern School of Business, distressed debt investments earned well above average returns in 2006 and there were more than 170 institutional distressed debt investors. These institutions used "very strong and varied strategies including the traditional passive buy-and-hold and arbitrage plays, direct lending to distressed companies, active-control elements, foreign investing, emerging equity purchases and equity plays during the reorganization of a firm in bankruptcy." The most common distressed securities are bonds and bank debt.
While there is no precise definition, fixed income instruments with a yield to maturity in excess of 1000 basis points over the risk-free rate of return (e.g. Treasuries) are commonly thought of as being distressed. Distressed securities often carry ratings of CCC or below from agencies such as Standard & Poor's, Moody's and Fitch.
By 2006, the increased popularity in distressed debt hedge funds led to an increase in the number of benchmark performance indexes. Highly specialized risk analysts and experts in credit are key to the success of alternative investments such as distressed debt investment. They depend on accurate market data from institutions such as CDX High Yield Index and India-based Gravitas. Gravitas for example, combines risk management software with sophisticated risk analysis using advanced analytics and modeling. They produce customized scenarios that assess the risk impact of market events. Gravitas uses IBM Risk Analytics technology (formerly Algorithmics), which is also used by major banks, to help hedge funds meet regulatory requirements and optimize investment decisions.
When companies enter a period of financial distress, the original holders often sell the debt or equity securities of the issuer to a new set of buyers. Private investment partnerships such as hedge funds have been the largest buyers of distressed securities. By 2006, hedge funds have purchased more than 25% of the high-yield market’s supply to supplement their more traditional defaulted debt purchases. By 2006, "new issues rated CCC to CCC- were at an all time high of $20.1 billion." Other buyers include brokerage firms, mutual funds, private equity firms and specialized debt funds such as collateralized loan obligations.
The United States has the most developed market for distressed securities. The international market, especially in Europe, has become more active in recent years as the amount of leveraged lending has increased, capital standards for banks have become more stringent, the accounting treatment of non-performing loans has been standardized, and insolvency laws have been modernized.[when?]
Typically, the investors in distressed securities must make an assessment not only of the issuer's ability to improve its operations, but also whether or not the restructuring process (which frequently requires court supervision) will benefit one class of securities more than another. See Business valuation: Option pricing approaches.
In June 2013, Goldman Sachs’s Special Situations Group, the proprietary investment unit of the investment bank, purchased Brisbane-based Suncorp Group Limited's loan portfolio for US$863 million. The finance, insurance, and banking corporation is one of Australia's largest banks (by combined lending and deposits) and its largest general insurance group. In the summer of 2013, when European lenders were divesting their loan portfolios, hedge funds and investment banks were buying them in Australia. In 2013, distressed-debt investors seeking investment opportunities in Asia, particularly in Australia, acquired discounted bonds or bank loans of companies facing distressed debt, with the potential of profitable returns if the companies' performance or their debt-linked assets improved. In 2013, Australia was one of the biggest markets for distressed-debt investors in Asia.
According to The Guardian, the principal investment strategy used by Paul Singer (businessman)'s hedge fund Elliott Management Corporation, "is buying distressed debt cheaply and selling it at a profit or suing for full payment." Singer founded his Elliott Associates L.P. in 1977. Elliott Management Corporation oversees Elliott Associates and Elliott International Limited, which together have more than $21 billion in assets under management. Singer has been active in Debt Advisory International (DAI), DC Capital Management, Select Capital Limited and Emerging Market Select Asset Fund Limited. He is associated with e-Century Capital Partners as founder and/or manager, and is described by DAI as a "specialist in structuring debt related transactions in emerging market countries and in supervising debt recovery and work out operations on behalf of corporate and sovereign creditors."
Sovereign states debt instruments
In a 2010 article, Blackman and Mukhi examined a series of litigations employed by distressed funds investors in their law suits against defaulted sovereign states. The business plan involved buying the sovereign debt instruments at a very deep discount based on a very high risk, and then attempting through litigation to enforce the full claim. The strategy is most effective when the sovereign state lacks bankruptcy protection. These investors however are constrained by "the sovereign-immunity rules that national legislatures have enacted and national courts have elaborated" to protect the vulnerable nation states from litigation.
While private debtors have the resource of bankruptcy protection, sovereign states do not. There have been "sporadic calls for a bankruptcy analogue for sovereign states" similar to the bankruptcy process for private debtors, however these calls have lacked momentum.[Notes 1]
One of the most well-known distressed debt deals was first brokered in 1999, when Romania sold $3.2 million of Zambian sovereign debt, which dated back to 1979, to the American financier Michael Sheehan. After continuously pursuing Zambia through the legal system for a payment of $55 million, the face value of the debt, Sheehan was awarded a settlement of $15 million dollars by Justice Smith in 2007. Sheehan became the best-known distressed-debt investor.[Notes 2]
In July of 2014 a U.S. federal judge ruled in favor of NML Capital Ltd., a unit of Michael Sheehan's Elliott Management, against Argentina. The country now owes its creditors more than $1.3 billion. According to Mark Weidemaier, a law professor at the University of North Carolina, the ruling was one of "the most significant litigation victories that a holdout creditor has ever achieved" in the realm of sovereign debt. In a Wall Street Journal article from July of 2014 by Georgetown University Law Center Law Professor, Adam J. Levitin, argued that the relationship between distressed securities investors and the U.S. court system should be revisited. He claimed that while these distressed debt investment funds can choose to "play the game" and "put their head in the mouth of the Leviathan," the US courts should not choose to. Levitin concludes with the limits on what the US law can do.
By humoring the NML litigation, U.S. courts have gotten themselves into a high-stakes game of chicken with a sovereign state. This is a game the U.S. courts cannot and should not win. It’s a basic prudential principle that courts abstain from cases where they lack the ability to administer an appropriate remedy. In this case, the courts cannot administer an appropriate remedy. The U.S. courts may be able to prevent, or at least impede, Argentina’s other bondholders from being paid, but they cannot force Argentina to pay NML on its defaulted bonds.—Levitin 2014
- "When it becomes necessary for a state to declare itself bankrupt, in the same manner as when it becomes necessary for an individual to do so, a fair, open, and avowed bankruptcy is always the measure which is both the least dishonourable to the debtor, and least hurtful to the creditor.| Adam Smith (1776).
- According to articles by journalists Moore and Seager and an article published in The Guardian, a shell company called Donegal International, incorporated and registered in the British Virgin Islands was specially-purposed by U.S. financier Michael Sheehan, to hold the Zambian debt. The deal between Romania and Sheehan was executed by Fisho Mwale, former mayor of Lusaka, Zambia, from 1993 to 1998. Simultaneously Romania was involved in the negotiations with Donegal and a Zambian finance ministry team. Zambia’s economist at that time, David Ndopu, described his optimism that the Zambian team's formalized proposal of a debt-relief deal with Romania whereby Zambia would only pay "12 cents on the dollar, or $3.5 million" would be a success.
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