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."
- 1 Distressed securities in the 1990s
- 2 Distressed securities investment strategy
- 3 Risk management
- 4 Key players
- 5 Sovereign states debt instruments
- 6 Sovereign debt in Africa
- 7 Sovereign debt in Latin America
- 8 See also
- 9 Notes
- 10 Citations
- 11 References
- 12 Further reading
- 13 External links
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 lawsuits 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]
Sovereign debt in Africa
According to the African Development Bank Group, at least twenty heavily indebted poor African countries have been threatened with or subjected to legal actions by commercial creditors and hedge funds since 1999. Examples include Sierra Leone by Greganti Secondo and ARCADE, and Côte d'Ivoire and Burkina Faso by Industrie Biscoti. Other RMCs that have been targeted include Angola, Cameroon, Congo, Democratic Republic of the Congo, Ethiopia, Liberia, Madagascar, Mozambique, Niger, Sao Tome and Principe, Tanzania and Uganda.
In 1999, Donegal International purchased $40 million worth of Zambia debt owed to Romania for the "discounted purchase price" of $3.2 million. In 2007, a British high court granted the company "permission to enforce a claim for tens of millions of dollars against the Government of Zambia." OXFAM, the World Bank and Jubilee USA, to name a few aid and development organizations, have spoken out against Donegal's purchase of the Zambian debt. Noted by Brian Finlay in July 2007, "Such egregious practices should be prevented. But more often than not, these cases are the exception rather than the rule."
In 2009, a British court awarded $20 million to hedge funds suing Liberia. Before the hedge funds could collect their money, the Debt Relief (Developing Countries) Act 2010 was passed in the UK parliament in 2010 after Liberian president and 2011 Nobel Peace Prize winner Ellen Johnson Sirleaf appeared on the BBC Newsnight program for the hedge funds to "have a conscience and give this country a break".
That act caps what the hedge funds can collect, they had to settle with Liberia for just over $1 million, and effectively prevents them suing for exorbitant amounts of money in United Kingdom courts. Nick Dearden of the Jubilee Debt Campaign said of the change, "It will mean the poorest countries in the world can no longer be attacked by these reprehensible investment funds who grow fat from the misery of others." The law was made permanent in 2011 but there are still havens for this activity, such as the Channel Islands and The British Virgin Isles.
Another hedge fund, FG Hemisphere of Brooklyn, sued Democratic Republic of Congo for a debt from Yugoslavia in the 1970s which it had picked up for just over $3 million. FG sued in Hong Kong, Australia, and Jersey which was not covered by the UK law against hedge funds involved in sovereign debt. The Chinese government blocked the attempt to sue in Hong Kong but the Jersey court awarded $100 million to FG. FG's owner Peter Grossman was doorstepped by freelance reporter Greg Palast and asked whether he thought it was fair to take $100 million for a debt he had paid $3 million for. He said "Yeah I do actually…I'm not beating up the Congo. I'm collecting on a legitimate claim". A series of attempts were then made in Britain and the United States by organizations such as Jubilee USA Network, Oxfam and the Jubilee Debt Campaign to change the laws so that hedge funds would not be able to collect on their awards. The Jubilee Debt Coalition is now calling on the Jersey government to ban hedge funds collecting there too and Jersey is consulting on making that change. Jubilee's Tim Jones went to Jersey in November 2011 to ask the government to ban hedge funds involved in sovereign debt. He told The Guardian that the Democratic Republic of Congo "desperately needs to be able to use its rich resources to alleviate poverty, not squander them on paying unjust debts".
Hedge Fund FG Hemisphere run by financier Peter Grossman is attempting to enforce an ICC arbitration award for $116 million owed by the Democratic Republic of Congo. The award was originally issued by an arbitral panel of the International Chamber of Commerce (ICC) in favor of Energoinvest DD of Bosnia in the amount of $39 million and then sold to FG Hemisphere. The award was issued by the ICC in respect of unpaid construction contracts pursuant to which Energoinvest supervised construction of high-tension power lines for transmission of power from the Inga–Shaba dam in Congo; the power lines are still in service. Sales of assets by Energoinvest have been criticized by opposition parties in Bosnia as having been "an abuse of power" by the management who defend themselves on the basis that the company had to sell assets in order to pay salaries after it was impoverished and broken up in the break up of the former Yugoslavia.
Sovereign debt in Latin America
In 1983, Peru was in economic distress and had large amounts of external debt. In 1996, the nation restructured its debts. Original loans were exchanged for Brady Bonds, tradable bonds issued in the original amount of the loans.
Elliott Associates, a New York-based hedge fund owned by Paul Singer, purchased $20.7 million worth of defaulted loans made to Peru for a discounted price of $11.4 million. Elliott Associates, holding the only portion of Peru's debt remaining outside the restructure, sued Peru and won a $58 million settlement, a 400% return.
Peru, unable to pay the $58 million, continued to repay creditors that held Brady Bonds. Elliot filed an injunction to prevent Peru from paying off its restructured debt without also paying Elliott. It was argued that Peru violated the "pari passu" clause, which states that no creditor can be given preferential treatment.
In 2001, Argentina defaulted on roughly $81 billion. NML Capital, LTD., a hedge fund that is a subsidiary of Elliott Management Corporation, purchased Argentine debt on a secondary market for a price lower than the original amount. Ninety-two percent of creditors restructured in 2005 and 2010 for roughly $.30 on the dollar. NML Capital rejected the proposal and sued Argentina for the full amount in New York State courts.
The main argument that NML Capital has been using in court is a "pari passu" clause that was in the original contractual agreement. Pari passu is Latin for "on equal footing", which means that if Argentina pays back one creditor, they have to pay back all of the creditors, including those that did not restructure. Since Argentina has already begun to repay the creditors that restructured, Elliot argued that they should be paid back.
In June 2012, Elliot Management supported legislation in New York State Senate and Assembly which would have allowed the fund to pursue post-court judgment. Two poverty alleviation organizations, Jubilee USA Network and American Jewish World Service, came out against the legislation citing the negative impacts that hedge funds have on struggling countries. The legislation did not make it to a vote when the New York State Senate and Assembly ended their session.
On October 2, 2012, NML Capital Ltd., a vulture fund based in the Cayman Islands, which held Argentine debt not included in Argentine debt restructuring, impounded the Libertad, an Argentine Navy training ship in Tema, Ghana. The court in Ghana held that Argentina had waived sovereign immunity when it contracted the sovereign debt being enforced.
Elliot made the pari passu argument and in November 2012, the New York State court ruled in favor of the holdout creditors based on the clause and ordered Argentina to pay $1.3 billion on December 15, the same date they were to pay the creditors that restructured. The appeals court heard oral arguments on February 27. In June 2014, the U.S. Supreme Court rejected Argentina's appeal of the ruling.
The Center for Economic and Policy Research reported on the special meeting of Organization of American States foreign ministry officials, which was held July 3, 2014 in Washington, D.C. to discuss the situation with Argentina and the hedge funds. The meeting passed a resolution expressing:
1. Its support to the Argentine Republic so that it can continue to meet its obligations, pay its debt, honor its financial commitments and through dialogue arrive at a fair, equitable and legal arrangement with 100% of its creditors.
2. That it is essential for the stability and predictability of the international financial architecture to ensure that agreements reached between debtors and creditors in the context of sovereign debt-restructuring processes are respected by allowing that payment flows are distributed to cooperative creditors in accordance with the agreement reached with them in the process of consensual readjusting of the debt.3. Its full support to achieving a solution that seeks to facilitate the broad Argentine sovereign debt-process.
All OAS member states supported the resolution with the exception of the U.S. and Canada.
In July 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 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
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