Distressed debt investing valuation services
This is because the liquidity of the security is one of the main considerations when it comes to trading. Otherwise, the illiquidity of a relatively unknown investment makes a short-term exit less likely, regardless of whether the initial investment thesis was correct or not. Trading around distressed securities sees the highest volume in: Companies with Large Public Followings Senior Tranches of Debt with Lower Risk Illiquidity Discount The further down the capital structure one goes, the fewer investors there are with the risk appetite to invest and the higher the likelihood of finding mispricing.
The more liquid an investment, the more likely it is priced near its fair value — as liquidity is the highest at the top of the capital structure. The purchase price of a security should reflect the illiquidity risk of the investment, especially if taking a short-term trading approach. Investors require extra compensation for the risk that market conditions may be illiquid when they hope to sell their holdings.
Typically, the more illiquid an investment, the lower the trading price. While long-term distressed investments can produce outsized returns, these investments require substantial time commitments and an acceptance of downside risk. A control-oriented investment is often a calculated bet that the debtor successfully emerges from a restructuring process.
One piece of the puzzle is investing in debt trading below par, but a sizeable portion of the potential upside is predicated on being able to receive additional post-reorganization recoveries from a successful restructuring process. Typically investments are made in the debt tranches near the top of the priority waterfall , as these securities hold a reasonable chance of recovery in Chapter 11 , especially since these firms seek to actively participate in the reorganization.
Oaktree Distressed Investment Strategy Source: Oaktree Capital Given the magnitude of their controlling stake, active-control investors often receive a seat on the board of directors and are prioritized during negotiations regarding the plan of reorganization POR.
It is often difficult, however, to acquire enough debt securities to hold a majority stake. That said, this particular long-term investing approach has been predominately utilized by distressed private equity firms in recent years. The fulcrum security is the most senior security that, after undergoing restructuring, has the greatest likelihood of conversion into equity ownership e. MW: We will usually try to buy the most senior level of debt which will participate in the reorganization.
The senior secured debt is unlikely to be underpriced and has less leverage in negotiating the POR because they are most likely going to be repaid in full in either cash, new debt, or a mixture of both. Even if the price paid was at a significant discount, the return will be far below equity returns in a successful turnaround because the upside of equity, in theory, is unlimited.
Conversely, riskier forms of debt can easily end up worthless or receive lower recoveries — yet, from a returns perspective, the purchase of debt with lower priority can also be an attractive entry point if those securities could be converted into equity. Distressed-for-Control Loan-to-own and distressed-to-control are frequently used interchangeably.
But one minor distinction to be aware of is that loan-to-own can be used to refer to providing new debt to a company near distress and not purchasing the existing debt of a distressed company. In a loan-to-own situation, the distressed fund offers to structure a new loan for the company before it actually defaults on its existing obligations, usually at very expensive terms.
The lender is aware of the default risk, but even if the borrower defaults, a part of the lending strategy was to be converted into equity ultimately. In either case, the lender receives a high yield, but the potential upside is greater under equity conversion. Specialty Lending — Rescue and Bridge Financing Specialty financing alleviates short-term liquidity shortages, preventing fundamentally sound companies from having to file for bankruptcy protection.
Specialty lending is a category of highly customized capital financing meant to aid companies facing temporary liquidity problems i. Specialty financing is not necessarily distressed credit; it more broadly entails lending to companies facing unanticipated circumstances e. Furthermore, these financing arrangements are typically made out-of-court and before the issue has developed into a serious concern.
Despite the risks, the underwriter usually views the catalyst as short-term and has a positive outlook on the long-term viability of the business. Companies in financial distress have restricted access to the capital markets — this means that distressed funds can often be the only source of capital available as most traditional lenders cannot tolerate the risk. For investment firms, distressed debt investment strategies can be appealing by adding elements of counter-cyclicality to their portfolio.
The anticipation of defaults by lenders causes the downturn, as the capital markets become stringent on lending standards, which causes a deceleration in the money supply and higher interest rates. Causes of Underperformance by Distressed Funds Periods of robust economic growth consist of fewer corporate defaults, causing competition amongst distressed investors to increase and resulting in lower fund returns and indirectly benefiting debtors.
Another external factor that can constrain fund performance is the intervention by the Fed, as seen by their efforts to limit the damage caused by the COVID pandemic. However, to name a few, these are: The difficulty of estimating going-concern value, anchored to future strategic and operational prospects that are extremely uncertain.
Uncertainties that also affect the estimation of liquidation value. The need to break down value for different categories of creditors and shareholders, considering that some of them, in particular new finance providers, may play an essential role in safeguarding the firm as a going concern and supporting its relaunch.
These and other characteristics of distressed firms sometimes bring to the fore, in the literature and in business practice, the need to use approaches and valuation tools unlike those used traditionally. To develop the subject matter, the main methods applicable and my proposal are provided below. The latter emerges with particular relevance in presence of declining and negative operating performance that persists over time, where continuing as a going concern may no longer be expedient.
Focusing on going-concern value and starting with cost or asset methods, it is well known that these are, in general, applicable only to a limited extent to firm valuations owing to some theoretical and practical difficulties. In distressed companies, the underlying logic of such methods i. The most critical problem, however, is the fact that the cost of specific assets i. This is true both for stand-alone value and control value with possible synergies of various kinds and weights.
Market valuation methods also entail a number of critical issues. First is the limited availability of market parameters, given the difficulty of identifying companies that are listed or the subject of capital transactions that are comparable with the distressed firm under valuation.
Despite these and other limitations, market multiples processing is still useful and necessary to test or supplement valuation arising from other methods primarily DCF. Faced with the theoretical and operational difficulties of cost- and market-oriented methods, the solution that seems best suited to distressed firms and to almost all companies is to base valuation on expected results and, therefore, to resort to income approach methods. There are at least three main forms of such methods: DCF, methods based on value creation, and methods derived from the theory of financial options.
DCF and methods based on value creation [4] , if correctly applied, lead to the same result except for a different breakdown of the value components, where the latter could be useful in linking free cash flow and capital value dynamics to accounting values. Thus, this elaboration is particularly useful for designing and implementing a performance management system.
One of the possible versions is based on discrete stochastic processes binomial , which appear more flexible. Starting from this framework, my proposal is to value distressed firms using the traditional DCF model but applied with a probabilistic approach. As with option-based models, this allows the reflection of forecasted cash flow dynamics, the estimation of assets, and debt and equity values in relationships with each other.
Simulations in DCF can be developed according to at least two approaches: scenario and Monte Carlo methods. The first one is illustrated below for the sake of clarity and because it represents the basic framework needed to structure a Monte Carlo-type simulation model. It is assumed, therefore, that the firm is a going concern, but its continuity is under threat and may be preserved only after the approval and subsequent implementation of RP. In the meantime, the firm is also assumed to have obtained new debtor-in-possession financing bridge financing before RP is approved, where necessary, under court protection.
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Intrinsic valuation is challenging as a discounted cash flow valuation DCF in a distressed situation often yields a negative equity value. Nevertheless, if the investor believes the company will successfully re-emerge from insolvency as going concern, a DCF is a crucial step to model through the restructuring process. Note that substantial adjustments have to be made in the model. Just to list a few, the working capital needs have to be propped up due disrupted supplier relationships.
The long-term reputational damage of bankruptcy has to be taken into account softening any future growth prospects. In addition, it is prudent to compute the liquidation value and its probability, as sometimes companies attempt but ultimately fail to restructure, as is the case of Sears Canada for example. Evaluation of debt tranches If the investor determines that the debt of the company is undervalued, the next step is to choose the appropriate level of the capital structure to invest in.
It is crucial to understand the subordination and security of various debt instruments. Security on a loan is only uncontestable if the security was properly perfected. The purchase price of a security should reflect the illiquidity risk of the investment, especially if taking a short-term trading approach.
Investors require extra compensation for the risk that market conditions may be illiquid when they hope to sell their holdings. Typically, the more illiquid an investment, the lower the trading price. While long-term distressed investments can produce outsized returns, these investments require substantial time commitments and an acceptance of downside risk. A control-oriented investment is often a calculated bet that the debtor successfully emerges from a restructuring process.
One piece of the puzzle is investing in debt trading below par, but a sizeable portion of the potential upside is predicated on being able to receive additional post-reorganization recoveries from a successful restructuring process. Typically investments are made in the debt tranches near the top of the priority waterfall , as these securities hold a reasonable chance of recovery in Chapter 11 , especially since these firms seek to actively participate in the reorganization.
Oaktree Distressed Investment Strategy Source: Oaktree Capital Given the magnitude of their controlling stake, active-control investors often receive a seat on the board of directors and are prioritized during negotiations regarding the plan of reorganization POR.
It is often difficult, however, to acquire enough debt securities to hold a majority stake. That said, this particular long-term investing approach has been predominately utilized by distressed private equity firms in recent years. The fulcrum security is the most senior security that, after undergoing restructuring, has the greatest likelihood of conversion into equity ownership e. MW: We will usually try to buy the most senior level of debt which will participate in the reorganization. The senior secured debt is unlikely to be underpriced and has less leverage in negotiating the POR because they are most likely going to be repaid in full in either cash, new debt, or a mixture of both.
Even if the price paid was at a significant discount, the return will be far below equity returns in a successful turnaround because the upside of equity, in theory, is unlimited. Conversely, riskier forms of debt can easily end up worthless or receive lower recoveries — yet, from a returns perspective, the purchase of debt with lower priority can also be an attractive entry point if those securities could be converted into equity.
Distressed-for-Control Loan-to-own and distressed-to-control are frequently used interchangeably. But one minor distinction to be aware of is that loan-to-own can be used to refer to providing new debt to a company near distress and not purchasing the existing debt of a distressed company. In a loan-to-own situation, the distressed fund offers to structure a new loan for the company before it actually defaults on its existing obligations, usually at very expensive terms. The lender is aware of the default risk, but even if the borrower defaults, a part of the lending strategy was to be converted into equity ultimately.
In either case, the lender receives a high yield, but the potential upside is greater under equity conversion. Specialty Lending — Rescue and Bridge Financing Specialty financing alleviates short-term liquidity shortages, preventing fundamentally sound companies from having to file for bankruptcy protection.
Specialty lending is a category of highly customized capital financing meant to aid companies facing temporary liquidity problems i. Specialty financing is not necessarily distressed credit; it more broadly entails lending to companies facing unanticipated circumstances e. Furthermore, these financing arrangements are typically made out-of-court and before the issue has developed into a serious concern. Despite the risks, the underwriter usually views the catalyst as short-term and has a positive outlook on the long-term viability of the business.
Companies in financial distress have restricted access to the capital markets — this means that distressed funds can often be the only source of capital available as most traditional lenders cannot tolerate the risk. For investment firms, distressed debt investment strategies can be appealing by adding elements of counter-cyclicality to their portfolio.
The anticipation of defaults by lenders causes the downturn, as the capital markets become stringent on lending standards, which causes a deceleration in the money supply and higher interest rates. Causes of Underperformance by Distressed Funds Periods of robust economic growth consist of fewer corporate defaults, causing competition amongst distressed investors to increase and resulting in lower fund returns and indirectly benefiting debtors.
Another external factor that can constrain fund performance is the intervention by the Fed, as seen by their efforts to limit the damage caused by the COVID pandemic. In order to stop the free-fall observed at the start of , the Fed responded by: Implementing fiscal and monetary policies that made capital easy to access e.
While the equity markets spiraled downward in the early aughts of the COVID pandemic, bullish sentiment returned within a matter of months. Lenders were also more receptive to out-of-court renegotiations because most understood the COVID pandemic to be a short-term, external disruption.
There was a notable increase in the extension of debt maturities i.
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On the other hand, if the company is simply overleveraged and in need of a balance sheet restructuring but is otherwise healthy, a successful turnaround may be feasible and the investor can use its valuation skills and experience in the insolvency process to generate a return. For example, when computing enterprise value, the market value of debt can be used instead of the book value, as the market value for comparable healthy companies generally equals book value.
Another possibility is to use forward multiples discounted to the present, assuming a successful turnaround of the company. Intrinsic valuation is challenging as a discounted cash flow valuation DCF in a distressed situation often yields a negative equity value.
Nevertheless, if the investor believes the company will successfully re-emerge from insolvency as going concern, a DCF is a crucial step to model through the restructuring process. Note that substantial adjustments have to be made in the model. Just to list a few, the working capital needs have to be propped up due disrupted supplier relationships.
The long-term reputational damage of bankruptcy has to be taken into account softening any future growth prospects. In addition, it is prudent to compute the liquidation value and its probability, as sometimes companies attempt but ultimately fail to restructure, as is the case of Sears Canada for example. Common examples of distressed investing diligence questions are listed below: One of the most influential factors on creditor recoveries is the amount of senior credit and loan facilities e.
Generally speaking, the more existing liens on the debtor and risk-averse senior secured lenders such as corporate lenders there are — the less likely there will be enough value to flow down to unsecured subordinated claims. Distressed Debt Trading In short-term distressed trading, there is no expectation of influencing the financial or operational decision-making of the company.
Distressed trading strategies have the objective of spotting temporary mispricing and capitalizing on these moments of irrational market behavior. Once the potential of default is announced in the market, mass-selling could ensue shortly, causing prices to decline. While steep reductions in pricing are sometimes justified, the odds of mispriced securities expand dramatically during these periods of uncertainty, especially if the sell-off is driven by herd-based mentalities and emotional reactions.
Distressed trading strategies ordinarily work best when involving well-known companies with large followings. This is because the liquidity of the security is one of the main considerations when it comes to trading. Otherwise, the illiquidity of a relatively unknown investment makes a short-term exit less likely, regardless of whether the initial investment thesis was correct or not.
Trading around distressed securities sees the highest volume in: Companies with Large Public Followings Senior Tranches of Debt with Lower Risk Illiquidity Discount The further down the capital structure one goes, the fewer investors there are with the risk appetite to invest and the higher the likelihood of finding mispricing.
The more liquid an investment, the more likely it is priced near its fair value — as liquidity is the highest at the top of the capital structure. The purchase price of a security should reflect the illiquidity risk of the investment, especially if taking a short-term trading approach. Investors require extra compensation for the risk that market conditions may be illiquid when they hope to sell their holdings.
Typically, the more illiquid an investment, the lower the trading price. While long-term distressed investments can produce outsized returns, these investments require substantial time commitments and an acceptance of downside risk. A control-oriented investment is often a calculated bet that the debtor successfully emerges from a restructuring process. One piece of the puzzle is investing in debt trading below par, but a sizeable portion of the potential upside is predicated on being able to receive additional post-reorganization recoveries from a successful restructuring process.
Typically investments are made in the debt tranches near the top of the priority waterfall , as these securities hold a reasonable chance of recovery in Chapter 11 , especially since these firms seek to actively participate in the reorganization. Oaktree Distressed Investment Strategy Source: Oaktree Capital Given the magnitude of their controlling stake, active-control investors often receive a seat on the board of directors and are prioritized during negotiations regarding the plan of reorganization POR.
It is often difficult, however, to acquire enough debt securities to hold a majority stake. That said, this particular long-term investing approach has been predominately utilized by distressed private equity firms in recent years. The fulcrum security is the most senior security that, after undergoing restructuring, has the greatest likelihood of conversion into equity ownership e.
MW: We will usually try to buy the most senior level of debt which will participate in the reorganization. The senior secured debt is unlikely to be underpriced and has less leverage in negotiating the POR because they are most likely going to be repaid in full in either cash, new debt, or a mixture of both. Even if the price paid was at a significant discount, the return will be far below equity returns in a successful turnaround because the upside of equity, in theory, is unlimited.
Conversely, riskier forms of debt can easily end up worthless or receive lower recoveries — yet, from a returns perspective, the purchase of debt with lower priority can also be an attractive entry point if those securities could be converted into equity. Distressed-for-Control Loan-to-own and distressed-to-control are frequently used interchangeably.
But one minor distinction to be aware of is that loan-to-own can be used to refer to providing new debt to a company near distress and not purchasing the existing debt of a distressed company. In a loan-to-own situation, the distressed fund offers to structure a new loan for the company before it actually defaults on its existing obligations, usually at very expensive terms.
The lender is aware of the default risk, but even if the borrower defaults, a part of the lending strategy was to be converted into equity ultimately. In either case, the lender receives a high yield, but the potential upside is greater under equity conversion. Specialty Lending — Rescue and Bridge Financing Specialty financing alleviates short-term liquidity shortages, preventing fundamentally sound companies from having to file for bankruptcy protection.
Specialty lending is a category of highly customized capital financing meant to aid companies facing temporary liquidity problems i. Specialty financing is not necessarily distressed credit; it more broadly entails lending to companies facing unanticipated circumstances e.
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