What is Distressed Debt?
A company is considered to be in a state of financial distress when it cannot meet a majority of its financial obligations. When a company reaches this point, purchasing shares or ownership of that company becomes much cheaper than it would be otherwise. Investors use this opportunity to take over the company at a low price with the intent of improving its financial situation.
There are multiple strategies for achieving a positive return on investment. In an ideal scenario, the firm will reorganize the distressed company into a financially healthy, successful organization whose shares they can then sell at a higher price.
Signals of distressed debt most commonly include low credit scores, loan or covenant defaults, and filing for bankruptcy. Companies at risk of defaulting need investors. One way they attract them is by selling controlling majorities of their ownership stakes, which often make them easy to control. This vulnerable position leaves these companies indebted to whoever purchases them, making them susceptible to vulture capitalism.
See Also: What Are Covenants in Private Equity?
Why Invest in Distressed Debt?
By its nature, investing in distressed debt is a high-risk, high-reward venture. The objective of a successful investment into a financially distressed company is to improve its standing by taking control of the company and getting it back on track. Investors gain significant control in the company, providing them with the authority to make major decisions regarding restructuring or liquidation. Failure is a strong possibility in this field, but in th...