Account for how a distressed securities strategy works and outline the difficulties, risks and factors involved in carrying it out.

FRM® Part II · Risk Management and Investment Management · Hedge Fund Investment Strategies · FRM2.IM.8.d

The idea

Distressed securities funds buy the debt, and sometimes the equity, of companies in or near bankruptcy at deep discounts. They profit if the restructuring pays more than the purchase price. Value is allocated by the absolute priority rule. Secured creditors are paid first, then unsecured, then subordinated, and finally equity. The fulcrum security is the class where value runs out. It usually receives the equity of the reorganised firm and shapes the plan. Returns depend on enterprise valuation, on administrative and legal costs paid ahead of claims, and on how long the process takes, because delay cuts the annualised return. Difficulties include illiquid and thinly traded positions, legal and procedural uncertainty, information limits, long horizons and the need for active involvement. Hedging is imperfect. The common error is to assume par recovery or to ignore seniority. Exam point: compute recovery by waterfall, class by class.

Formulas

Recovery rate of a creditor class in the waterfall

recovery = min(claim, V − costs − senior claims) ÷ claim

claim: the face value of the class's claims
V: the enterprise value or realised assets
costs: administrative and legal costs paid ahead of all claims
senior claims: claims ranking ahead of this class

A negative remainder means zero recovery. Work class by class; sharing value pro rata across all classes ignores seniority.

Annualised return on a distressed purchase

annualised return = (recovery ÷ price)^(1 ÷ T) − 1

recovery: the expected recovery per 100 of face
price: the purchase price per 100 of face
T: years until the plan pays out

Annual compounding. A longer T sharply lowers the annual return on the same recovery; dividing the total return by T is the slip.

A practice question

From the question bank, with the reason each wrong option is wrong.

What is the central idea of a distressed securities strategy?

Buying securities of troubled companies at deep discounts and profiting if recovery exceeds the price paid. - correct
Buying shares of a target firm after a takeover announcement, and shorting the acquirer.Why not: Describes merger arbitrage, not distressed investing.
Holding a delta-hedged position in convertible bonds of healthy growth firms.Why not: Describes convertible arbitrage, which uses solvent issuers and an equity hedge.
Shorting the debt of highly rated issuers in order to profit from small spread changes.Why not: Distressed funds typically buy troubled debt; the securities involved are low priced, not highly rated.

Distressed investors buy securities of companies in or near default at large discounts and aim to profit from restructuring, reorganisation, liquidation or recovery. Returns depend on valuation and legal process rather than on market direction.

A harder one

A bankrupt company's assets realise USD 120 million. Senior secured claims are USD 70 million, senior unsecured claims USD 80 million and subordinated claims USD 50 million. A fund buys the senior unsecured debt at 45 per 100 of face value. Ignoring time value and costs, closest to what return does the fund earn on completion?

17.5%Why not: Subtracts the price from the recovery (62.5 - 45) in percentage points instead of dividing by the price.
38.9% - correct
33.3%Why not: Shares value pro rata across all USD 200 million of claims (60 recovery), ignoring seniority.
77.8%Why not: Assumes par recovery of 100 per 100 face, ignoring the shortfall in the waterfall.

After the secured claims, 120 - 70 = 50 remains for the unsecured claims of 80, a recovery of 62.5 per 100. The return is 62.5 / 45 - 1 = 38.9%. Subordinated and equity holders receive nothing.

The hardest tier

A fund buys a distressed bond at 40 per 100 of face value, expecting a recovery of 70 from the plan. The plan is expected after 3 years, but legal disputes delay it to 5 years. Using annual compounding, closest to by how many percentage points does the annualised return fall because of the delay?

8.7 - correct
10.0Why not: Annualises the 75% total return simply (25% falls to 15%) instead of compounding.
7.2Why not: Expresses the drop as a share of the original gross return (1.205) instead of in percentage points.
10.7Why not: Counts 6 years for the longer horizon instead of 5.

Total gross return = 70 / 40 = 1.75. Over 3 years: 1.75^(1/3) - 1 = 20.5%; over 5 years: 1.75^(1/5) - 1 = 11.8%. The fall is about 8.7 points. Delay is a core distressed risk because the recovery date is uncertain.

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