What is distressed investing?

Have you ever heard of the “Cigar butt” approach used by Warren Buffet to make his fortune? “You could pick it up, smoke the last puff for free and then throw it away,” he said. Here Cigar is a troubled company and he referred to Distressed investing.

Distressed investing comes under the higher the risk, the higher the return category. What exactly is distressed investing? It means investing in securities (equity, debt, etc) of the financially distressed company who

(i) may not be able to pay the financial obligations within six months, or

(ii) has become insolvent and may file for bankruptcy within a span of few months, or

(iii) is going through the bankruptcy process.

Generally, the investment firms, hedge funds and brokerage firms go for distressed investing. Individual investors can also invest either directly from the stock/Bond market and mutual funds that also include distressed assets in their portfolio. (SEBI has recently allowed mutual funds to trade in distressed assets in India).

But why does an investor invest in such a company whose future looks completely bleak? Well, the higher the risk, the higher the return. The distressed securities especially the debt provide a 10% higher potential rate of return than the risk-free rate of return. For example, if a normal risk-free debt is giving you a 5% rate of return, the distressed debt will give you a 15% rate of return. But this debt that has a CCC credit rating which is very poor comes with a higher risk of default by the borrower company. The investor is extremely optimistic about the company that he expects a good return even in the worst case that is the company going bankrupt.

Let us assume that you bought a bond of Rs. 700 at a discount of Rs. 300 of company X which is currently in financial trouble. So, there are two possibilities:

(i) The company restructure itself with the cooperation of its creditors to avoid bankruptcy. In this case, the price of a bond will probably rise and you can earn a profit selling the bonds at a higher price.

(ii) the second possibility is that the company files for bankruptcy in court. Now there are again 2 cases:

• In the first case, the court will appoint an interim resolution professional who will present a few resolutions for restructuring the company. If the committee of creditors accepts any of the resolutions, the company will be restructured according to that plan and it will be back to resume its operations. In this case, this positive news will increase demand for the bond and the value of bonds will rise, you can sell the bond at a higher price and Can earn profit.

• Second, the committee of creditors didn't accept any resolution and the company will now be liquidated. All the claims of creditors will be resolved by selling the assets of the company to the extent possible. In this case, you still have the possibility of receiving your money back though not profit is earned.

The next question that comes to an investor's mind is whether to buy equity or debt of a distressed company. Investing in equity is riskier than bonds since the equity shareholders are the last recipients of the amount in the worst case i.e., in liquidation. The equity shareholders will receive what is left. Generally, the value of shares become null. This is shown in the following example:

Dewan housing finance Corporation Limited (DHFL) is a house finance company that caters to lower- and middle-income groups in semi-urban and rural parts of India. And 48% of the total shares are held by the general public. This company defaulted the payment of 850 crores on 6 June, 2019 for the first time. And it again defaulted on bond repayments of Rs. 8.07 crores on 23 July 2019. Being unable to pay their financial obligations, the company filed for bankruptcy in December and became the first financial services provider against whom the bankruptcy proceeding has been started.

After a bidding war between the Adani group, Oaktree Capital and Piramal group, the committee of creditors voted in favour of the resolution presented by the Piramal group.

Now the primal group’s resolution says that it will delist the shares of the DHFL and will merge it with the Piramal capital housing finance limited. The group will pay Rs. 150 crores to the lenders of the company. But what about the equity shareholders? The shareholders will get nothing on the day DHFL gets delisted from the Stock Exchange. The values of shares will become nil. The case shows the risk of distressed investing. The investors who invested in shares of this company expecting that the company will provide a higher rate of return loses all their money.

So we can say, Distressed investing is suitable for those who for a higher rate of return is ready to lose all the money he/she has invested.