Investing in distressed opportunities

Viewpoints Managing risk

Image: Managing riskBuying distressed is not for the faint of heart.The turmoil that began in the financial services industry in 2007 has continued to spread in 2008 to retail, to consumer products, and to the automotive industry. With the alarming number of bankruptcies as well as companies at the brink of bankruptcy, distressed opportunities abound. According to a recent report on distressed investing, private equity firms are seizing this opportunity and have been active in raising distressed funds.¹ In fact, in the first six months of 2008, distressed funds raised approximately $37 billion globally.²

There are several ways for astute individuals to invest, including purchasing debts of distressed companies, providing financing for companies that lack bank options, potentially employing a loan-to-own strategy, investing in private equity turnarounds, and buying into prepack bankruptcy transactions. Acquiring the equity of and ultimately control over a distressed company may offer higher rewards if a turnaround can be achieved, albeit with potentially higher exposure. An investment in a distressed company is inherently a high-risk transaction, presenting unique risks and rare opportunities.

The level of return on such an investment may hinge upon solving a multitude of a target’s strategic and operational issues. Distressed companies are often associated with funding and liquidity constraints, financial reporting issues, high turnover, and lack of formal controls. Given these complexities, interested players must have the appropriate process, infrastructure, and turnaround talent to evaluate, plan, and manage such investments.

Comprehensive due diligence is critical for those looking to invest in distressed companies. Important factors investors need to consider include liquidity, cash burn, supplier relations and terms, working capital management, customer relationships, headroom on debt covenants, and potentially bankruptcy-specific considerations.

Buying distressed is not for the faint of heart. Experienced distressed investors conduct due diligence that is as much focused on identifying opportunities as it is on risks. Others should beware because distressed investing is not for the novice.

¹PwC, TS insights: Investing in distressed, October 2008.
²Private Equity Intelligence’s Global fundraising update, 2008.