Distressed Private Equity: The Best Place to Invest When the World is Collapsing?
After the initial panic, the next question becomes: “Which areas might benefit from the crisis?”
We covered restructuring investment banking previously, so now it’s time to look at its second cousin once removed: distressed private equity.
But that description is not entirely accurate.
That child’s name would be “distressed private equity”:
What is Distressed Private Equity?
Definition: In distressed private equity, firms invest in troubled companies’ Debt or Equity to take control of the companies during bankruptcy or restructuring processes, turn the companies around, and eventually sell them or take them public.
Similar to plain-vanilla private equity, distressed PE firms also raise capital from Limited Partners, keep it locked up for long periods, and use it to buy assets or companies.
And, just as in standard PE, the job is part fundraising, part operations, and part investing.
The difference is that distressed PE firms use a much wider variety of strategies to invest, which means that the job may require a much broader skill set.
For example, you need to know a lot more about credit and capital structure, the bankruptcy code and accompanying legal process, and how to make serious operational changes at companies.
Depending on the firm’s strategy, you might even need to know about the public markets and execution risk when trading securities!
Distressed firms and groups might use any of the following five strategies to invest:
- Distressed Debt Trading – This one is similar to what many distressed hedge funds and credit funds do: buy Debt that trades at a considerable discount to par value, such as 30%+, and sell it once the price rises (or, do the opposite and bet against the Debt with a credit default swap).
- Distressed Debt Non-Control – In this one, firms still look for Debt trading at huge discounts, but they buy the Debt to gain influence in the restructuring or bankruptcy process. They’re betting that they can negotiate the terms in their favor such that the market value of the Debt rises significantly.
- Distressed Debt Control – Here, the PE firm buys the “fulcrum security” that will end up being converted into Equity and having a controlling stake in the company post-restructuring. The firm then operates the company, makes improvements, and sells it or takes it public.
- Turnaround – With this one, the PE firm acquires Equity in the company rather than Debt, usually before a bankruptcy process begins, and then attempts to restructure the company and get it out of distress.
- Special Situations – This is a broad strategy that could include any of the ones above (bankruptcy itself is a “special situation”), but which could also refer to investments in spin-offs, asset sales, recapitalizations, acquisitions, or capital raises.
These strategies are not mutually exclusive.
For example, a PE firm that aims to gain control of a company might start by trading small stakes in its Debt for “scouting purposes.”
They want to assess the buyers and sellers, the liquidity, and how the company’s profile changes over time.
If they like what they see, they might increase their position and prepare to gain full control; if not, they might exit the position and look for other opportunities.
In practice, most distressed PE firms and groups look for “good companies with poor Balance Sheets.”
If the company’s entire industry is declining, it will be exceptionally difficult to make that company viable in only a few years.
And if the company is fundamentally flawed because it sells products/services no one wants, it’s also hard to fix in a short time frame.
But if the company is in a decent industry and sells products/services that people are buying, but has made a mistake with a lawsuit, a Debt issuance, or an acquisition integration, those problems are more “fixable.”
The Evolution of a Distressed Deal
To illustrate a typical deal, we’ll walk through the process for a hypothetical company: ABC Carpet, a manufacturer of woven carpets for residences and businesses.
After growing quickly in its early years and reaching $1 billion in revenue, the company tried to expand too quickly and took on a huge amount of Debt to do so.
Then, competitors entered the picture and gained market share as ABC Carpet struggled to service its Debt while continuing its expansion.
The company’s pre-distressed financial profile, where the market value of the Debt equaled its face value, looked like this:
- Equity Value: $400 million
- Enterprise Value: $1 billion
- LTM EBITDA: $150 million
- Cash: $50 million
- Secured Notes: $200 million
- Unsecured Notes: $200 million
- Mezzanine: $150 million
- Preferred Stock: $100 million
Now, the company in danger of violating several covenants on its Debt, and its more junior Debt tranches begin to trade at discounts to par value.
Distressed Debt Trading Strategies
You might start by analyzing this company’s capital structure and checking:
- Which Debt tranches, if any, are potentially mispriced.
- How the market value of each Debt tranche might change if the company enters bankruptcy, sells assets, raises emergency funding, or if it manages to refinance.
In this example, the Unsecured Notes might be trading at 80% of par value, and the Mezzanine has dropped to 60%.
You run the numbers and see that if the company violates its Debt / EBITDA and EBITDA / Interest covenants in its next quarterly results, the value of the Mezzanine will drop substantially, but the Unsecured Notes might only fall to 75%.
On the other hand, if the company reports better-than-expected results and does not violate any covenants, the Unsecured Notes might trade up to 90% of par value.
It seems like an asymmetric risk profile, so your firm buys a small percentage of this company’s Unsecured Notes.
Several scenarios could now play out:
- The company reports better-than-expected results, its Unsecured Notes trade up to 90% of par value, and your firm sells them for a quick 13% gain.
- The company unexpectedly announces a full refinancing, and it repays the Unsecured Notes in full; your firm earns a quick 25% gain.
- The company reports weak earnings, violates its covenants, and the market values of its Equity and Debt all decline.
If scenarios #1 or #2 happen, you’re done with this company.
But if scenario #3 happens, then you could respond in several ways:
- If you believe the company has poor prospects, you could cut your losses and sell your entire position.
- Or, you could double down and keep increasing your position in an attempt to gain “influence” or outright control.
Distressed Debt Non-Control Strategies
In the first case – “influence” – you might look at the capital structure again and re-assess what each piece might be worth.
By this point, everything has dropped to the following market values:
- Equity Value: $300 million
- Secured Notes: $180 million
- Unsecured Notes: $150 million
- Mezzanine: $75 million
- Preferred Stock: $40 million
Additionally, the company’s LTM EBITDA has fallen 20% to $120 million, which puts it in violation of several covenants.
So far, your firm has lost 25% on its position in the Unsecured Notes (retail investors would begin to panic at this stage).
ABC Carpet looks to be heading toward bankruptcy or restructuring, but your firm is still confident in its fundamental business prospects.
So, it decides to increase its stake in the Unsecured Notes and also purchases some of the Secured Notes, ending up with 40% of both tranches, for a total of ~$132 million (ignoring the small initial stake in the Unsecured Notes).
Once again, several scenarios could now play out:
- The company might file for Chapter 11 and raise Debtor-in-Possession (DIP) financing, which is senior to all the pre-petition tranches of Debt. The existing lenders, including your firm, could become the DIP lenders, boosting the chances of a full repayment if the company turns itself around (or, new lenders might come in and repay all or part of the existing Debt).
- The company could file for Chapter 7 bankruptcy or pursue a Section 363 asset sale, shut down operations, and use the liquidation proceeds to repay as much Debt as possible. The Secured Notes will probably be fine, but the Unsecured Noteholders will take a haircut.
- Or, the company might file for Chapter 11 but push for an alternative to a DIP loan, such as a Debt-for-Equity swap, which takes us into the next strategy:
Distressed Debt Control Strategies
In the “control” strategy, the PE firm determines the “fulcrum security,” or the one that will be converted into Equity and likely result in a controlling position following a bankruptcy process.
These cases are often structured as pre-packed bankruptcies (or “pre-packs”), where all parties agree to a restructuring plan before the company declares bankruptcy.
Continuing with the same example from above, maybe the Equity investors and Preferred Stockholders get wiped out completely.
The Mezzanine investors take a 50% haircut, and the Secured and Unsecured Noteholders receive a percentage of Equity in the new company.
Your firm already owns 40% of each tranche, and it decides to up its stake even further as the bankruptcy proceeds, so it ends up owning 60% of ABC Carpet’s Equity post-bankruptcy.
After the process ends, it starts making significant operational changes, such as:
- Shutting down less-profitable product lines and store locations.
- Increasing sales & marketing in the company’s core markets and cutting it everywhere else.
- Reducing management layers in the company and trimming the workforce.
- Selling non-core assets.
If this process goes well, maybe the company’s Enterprise Value returns to a healthy range of $1 billion+ after several years, with an Equity Value of ~$800 million.
Your firm would do very well under those conditions:
- Multiple of Invested Capital = ($800 million * 60%) / Average Price of $165 million for 50-60% of Both Debt Tranches = 2.9x
If this takes place over 3 years, that’s a 43% IRR.
On the other hand, if the company can’t reach “escape velocity,” and its Equity Value stays at around $300 million, your firm will do much worse:
- Multiple of Invested Capital = ($300 million * 60%) / $165 million = 1.1x
That’s a 3% IRR over 3 years.
Returns are more of a step function in distressed investing because security prices rarely move up or down in a gently sloping line.
This strategy is quite different because it starts with the PE firm acquiring a controlling stake in the company’s Equity rather than a minority position in its Debt.
For ABC Carpet, a firm that uses turnaround strategies might complete an initial transaction to acquire 100% of the company’s Equity.
Then, they might start to negotiate with lenders to restructure the Debt and make it easier for the company to service.
At the same time, they would begin to make serious operational changes, such as some of the ones mentioned above.
Sometimes, the PE firm will acquire the company before an expected bankruptcy, and sometimes it will do so during the bankruptcy process.
PE firms rarely use leverage in the initial transaction because most distressed companies cannot support any additional Debt.
But there may be opportunities to add leverage later on, such as with a Dividend Recap, if the company recovers and starts growing once again.
This strategy tends to be the highest-risk and highest-reward one because Common Equity is junior to Debt and Preferred Stock, which is why PE firms rarely attempt it with fundamentally flawed businesses.
Special Situations Strategies
“Special situations” is the broadest category here.
It could include any of the strategies above, but it could also involve investing based on specific events, such as spin-offs, divestitures, or recapitalizations.
And it could also include being a “lender of last resort” to distressed companies.
Think of it as a mix between distressed debt and equity investing, event-driven hedge funds, and specialized lending (e.g., mezzanine or direct lending).
Continuing with the ABC Carpet example, a Special Situations Group (SSG) might approach the deal differently by acting as a new lender.
It might offer the company a new loan so it can refinance all its existing Debt, and it might charge a higher interest rate to compensate for the higher risk.
It might also negotiate with the company and allow some of the interest to accrue to the loan principal (Paid-in-Kind) or receive equity warrants in exchange for a lower interest rate.
The group would perform traditional Debt vs. Equity analysis, such as looking at the credit stats in different scenarios, to make an investment decision.
But since Special Situations can do almost anything, it could also use one of the other strategies and start by buying the company’s existing Debt or Equity.
Distressed Private Equity Valuation and Financial Modeling
Most of the work that you do in restructuring investment banking also applies here, so please see that article for the full coverage.
The key differences compared with standard private equity are:
- Scenarios: You still build in operational scenarios, but event scenarios (e.g., different options in a Chapter 11 deal or a Chapter 7 vs. 363 Asset Sale vs. Chapter 11 deal) are also critical. Many outcomes are dependent on previous branches, so you could end up with a “scenario tree” here.
- Capital Structure and Fulcrum Securities: In standard LBOs, the company’s existing capital structure doesn’t matter much, but in distressed deals, it’s critical because a firm might use the company’s existing Debt to take control of it. Identifying the fulcrum security may sound simple, but if the company has dozens of Debt tranches, it’s not.
- Modeling Operational Changes: You might make changes to a company in a standard LBO, but you probably won’t close half its stores or shut down product lines. But those could easily happen in distressed deals, so you have to include them in the model.
- Due Diligence: Yes, DD on companies is always critical, but in distressed deals, you must also know a lot about the counterparties that hold the existing securities. If you don’t understand why someone else is buying or selling a distressed bond at a specific price, chances are you’re about to lose money.
Before you ask: I do not know of any courses or books that teach these topics from the perspective of an investor running a distressed deal from start to finish.
It’s a highly specialized topic that’s also difficult to explain, which means that there’s little commercial incentive to create these materials… when most people still struggle with INDEX/MATCH functions in Excel.
So, all I can recommend are the same resources cited in the restructuring IB article.
Who Gets Into Distressed Private Equity?
Anyone in restructuring investment banking is a good fit, but other common backgrounds include:
- Restructuring and turnaround consulting.
- Corporate and bankruptcy law.
- Distressed debt desks in sales & trading (for certain strategies).
- Credit-focused groups like Leveraged Finance, direct lending, and mezzanine.
Theoretically, it’s possible to get in from plain-vanilla PE firms and groups, but it’s probably more difficult than the paths above.
It would be exceptionally rare, if not impossible, to break into distressed PE straight out of an undergrad or MBA program.
You need significant deal/investing experience, and you need to know quite a lot more than fresh grads who work on standard sell-side M&A deals.
The Top Distressed Private Equity Firms
There are dozens, if not hundreds, of firms that focus on distressed investing or that have Distressed or Special Situations groups.
Unlike restructuring IB, some of the largest private equity firms and hedge funds in the world also operate in this space: Oaktree, Cerberus, TPG, Centerbridge, Fortress, PIMCO, Apollo, Ares, Brookfield, Bain Capital, and Blackstone (GSO Capital Partners) are all well-known for their distressed strategies.
Since there’s significant overlap between private equity and hedge funds, I’m grouping them here.
Then there are smaller funds that focus on this one area; names include Avenue Capital Group, CarVal Investors, MatlinPatterson, Crestview Partners, Tennenbaum Capital Partners, KPS, Third Avenue, and Highbridge (now owned by JPM).
Many of these firms choose to focus on 1-2 of the five possible distressed strategies.
For example, Oaktree has a distressed debt platform that trades minority stakes in distressed securities.
KPS focuses on control transactions via pre-packaged bankruptcies or Section 363 asset sales, as well as a turnaround operational approach.
And Highbridge often acts as the “lender of last resort” to distressed companies.
Distressed Private Equity Salaries, Bonuses, and Carry
At the junior levels, compensation in distressed private equity is similar to what it is anywhere else, so please see our article on private equity salaries and bonuses for the details.
If you look at compensation reports, such as the ones from Heidrick & Struggles, they often state that compensation for Partners and Principals is highest in distressed funds.
That may be true in some cases, but be careful before taking this at face value:
- The number of professionals in distressed firms and groups is always much lower in these reports, and small sample sizes are less reliable than larger ones.
- Annual performance fluctuates significantly depending on economic conditions.
- Much of this compensation premium comes from carried interest, which takes a long time to vest, may be clawed back, and which can quickly disappear if several later investments in the fund perform poorly.
If you get into the industry, you stay at a fund that performs well, and you advance to a senior level over 10-15 years, you could see higher compensation by that point.
But that comes with a lot of caveats, and compensation will not be much different at the Associate and VP levels.
Distressed Exit Opportunities
You could move into almost any credit-related field: groups at banks such as LevFin or Restructuring, turnaround consulting, mezzanine, direct lending, or standard private equity.
You will not get into corporate/bankruptcy law without a law degree, but you probably don’t want to do that anyway.
You could even move to a credit or distressed hedge fund since there’s so much overlap between PE and HF strategies in this niche.
You probably wouldn’t be able to work as an execution trader, as the skill set there is quite different from the research/analysis one.
Corporate development would be somewhere in the middle; deal experience helps, but few CD transactions are “distressed.”
Distressed Private Equity: Pros and Cons
Summing up everything above, my list of the pros goes like this:
- The work is arguably far more interesting and challenging than what you do in plain-vanilla PE.
- You gain access to a wide range of exit opportunities.
- To succeed, you must be a “jack of all trades” who knows something about operations, credit, the legal code, technical analysis, trading, and more.
- You can work at a huge range of firms, ranging from small shops to the mega-funds, depending on the strategy.
- It is counter-cyclical, but even when the economy is growing, there will always be distressed opportunities because of the wide variety of strategies employed.
And the cons are:
- The hours and stress can also be worse than in standard private equity because many deals are “emergencies.”
- It’s relatively tough to break in, and you usually need directly relevant experience because groups are small and don’t want to train new hires.
- Yes, you gain a broad skill set, but it’s not relevant for every exit opportunity (such as venture capital).
- Compensation at the top levels can be very “lumpy,” and there is a heightened risk if the fund starts or ends at non-optimal times in the business cycle.
- These groups won’t necessarily act as “recession shields” in all cases because they mostly want “good companies with bad Balance Sheets.” If a war, pandemic, or alien invasion kills everyone, distressed investors can’t do much.
The bottom line: Yes, distressed private equity offers some advantages, but like restructuring IB, it’s not a panacea.
You shouldn’t change your entire career plan because a recession or other crisis just started; it doesn’t work like that, and you’re unlikely to break in without a relevant track record.
If you have a serious long-term interest in distressed investing, start by looking at simple deals and case studies.
It’s hard to “practice” because retail investors cannot buy controlling stakes in companies, CDS, etc., but you can write investment recommendations on companies.
Keep doing that, and if you like being a jack of all trades, distressed investing might just be for you.
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