Wednesday, March 13, 2013

Distressed Debt Analysis

Equities are not the only area in which the principles of value investing apply. Investors of a value mindset can also take part in the debt market. But for most of the public debt that's out there, potential upside is low (how much above par can a company's debt trade? Not much). The situation is different for distressed debt, where securities can trade well below par. An investor who finds mis-priced distressed debt securities can therefore profit to a similar extent as an equity investor.

But distressed debt investing appears much more complicated than equity investing. Not only does one have to understand the business well enough to estimate its earnings power (as the equity investor must do), one must also understand the legal issues and motives of various other stakeholders. To help me understand these and other issues related to investing in debt from a value point of view, I recently read Distressed Debt Analysis by Moyer, which is kind of like a Securities Analysis for debt investors.

The writer compares distressed debt investing to chess, but with several opponents at once. This is because anticipating the actions of the other players is of the utmost importance. Moyer walks the reader through what the players (both large and small, and comprised of all stakeholders from employees to suppliers to debt and equity holders) can and can't do, both pre- and post-bankruptcy. In many cases, the incentives for stakeholders will be such that a court bankruptcy is undesirable. In other cases, certain stakeholders may force lengthy and costly court proceedings. Determining the future course of events (or the probabilities thereof) is crucial to being able to accurately value a distressed security.

Having read the book, I'm not sure distressed debt investing is for me. I'd much rather focus on understanding a business, determining its value, and buying and selling that business when Mr. Market offers favourable pricing. Figuring out whether supplier payables will rank ahead of my securities, or whether other securities holders within the capital structure will force bankruptcy, or what other securities holders will value a company post-bankruptcy sounds entirely too complex for me. But of course, the complexity of this area may also lead to inefficient pricing. The investor who understands this area well may be able to profit as a result.

I wouldn't call this a light read, but I would call it highly informative. Happy reading!

1 comment:

Striver said...

This is one of those areas where I think a lot of opportunities can suddenly arise and that the best way for individual investors to get exposure is probably through a specialised fund where experts can do the work for you.

I haven't got very far in assessing funds in this field though.