There are three reasons a company might run into financial distress: operating issues, legal issues, and/or financial issues. Issuers can respond to such situations in one of three ways: continue to pay obligations, attempt to convert obligations into less stringent obligations (e.g. get debt holders to accept preferred stock), or default and declare bankruptcy. Investors must understand the implications to their investments as the above scenarios play out. Investors must also understand how other stakeholders will react to such situations, and understand the power that various stakeholders have (for example, one third of a stakeholder groups constitutes a blocking group, and can use this to further that stakeholder group's interests).
Klarman argues that while bankruptcies are often complex and difficult to analyze, investors who know what they are doing usually have tremendous opportunities for returns with very little risk. At the same time, someone who doesn't know what he's doing risks losing his entire investment.
The process of analyzing financially distressed securities starts at the balance sheet. Assets should be valued so that the size of the pie can be estimated. Obligations should then be subtracted from this amount. This task is much more difficult than it appears, however. For a distressed company, asset values are usually a moving target, and getting a handle on their value can be difficult. Furthermore, off-balance sheet liabilities must also be considered.
Finally, Klarman takes the reader through two bankruptcy examples where mispricings occurred which allowed the enterprising value investors the opportunity for excellent returns.