Analysis of Distressed Financing - Research Paper Example

Distressed Financing Introduction There may be many internal as well as external factors that may cause a company to declare bankruptcy and opt for restructuring as a way to fight bankruptcy. The economic downturns in the recent few years have caused the liquidation of a number of companies across the globe. In case of bankruptcy, a company may have much difficulty to access financing from the traditional sources like loans and investments because the external funding sources like banks and other financial institutions often tighten their credit facilities when providing loan to the distressed companies. Both the individual and institutional investors become more cautious about their investments in a particular company when the company is in the state of bankruptcy because the returns for the shareholders are likely to be affected by the weak financial performances of a business. However, in order to fight bankruptcy a company often opts for strengthening and improving its financial performances through restructuring activities rather than dissolving the business. The restructuring process requires a substantial amount of expenses. The traditional funding sources are not often usable in the situation of bankruptcy. However, a new form of financing known as distressed financing has evolved in the business world which is especially used to fund the restructuring processes of a financially distressed company. Distressed financing enables the companies to collect funds for the business restructuring process in the form of distressed debt financing or distressed equity financing. The distressed debt financing has formed a large part of the corporate bond market and is considered as a main type of company financing. Distressed financing is a term commonly used in corporate financing activities. Generally when a company is being liquidated and is facing bankruptcy, distressed financing is widely used to enable the company to achieve a turnaround from the existing financing distress through financial and business restructuring activities. The corporate turnaround from the financial distress and bankruptcy can be achieved from a number of methods like corporate valuation, working capital management, debt restructuring, equity restructuring etc. Therefore, the term “restructuring” in distress restructuring is used from a financial perspective rather than an organizational perspective. Discussion Distressed securities are financial instruments including debt and equities in a business which is in the bankrupt stage or is near bankruptcy. Bankruptcy is generally caused in a company due to its long term inability to meet the necessary financial obligations. In the case of bankruptcy, the financial instruments of a company face a substantial reduction in their prices, value as well as credibility. Distressed securities may include bank debts, corporate bonds, common shares, preferred shares, goods owed trade claims etc. The distressed securities are securities whose values have been considerably reduced in the capital market because of the weakening financial position of the company. The financial distress of a company may be caused by a number of internal as well as external factors. These may include declines in profitability, changing external business environment, loss of competiveness by the company, regulatory or litigation constraints, lack of access to sufficient funding, local and global economic disruptions etc. Whatever the reason may be, a company facing financial distress is faced with two main business decisions- either the company can restructure the business to improve the performance of the company by filing bankruptcy under Chapter 11 of the Bankruptcy Law or its can liquidate the company by filing for bankruptcy under Chapter 7 of the Bankruptcy law. Most companies and investors are in favour of the restructuring processes because it gives a fair chance to the business, creates scopes for the investors to get back their money and also adds to the economic stability of the country. For implementing a restructuring program in the business, a company would require additional sources of fund. Since the prices of the securities of the company in a bankruptcy state or in some form of financial distress would be lowered, therefore, the individual investors and other traditional investors are not likely to invest in these companies. However, the specific distressed investors like venture capitalists, private equity funds etc. operate with the aim of providing capital to the distressed companies in order to make them capable of making a corporate turnaround, reaping a benefit from the whole investment by using sophisticated investment strategies and adding value to the economy as well. If the financial distress is caused by increased illiquidity and poor use of working capital in various parts of the business, then the company should ideally use restructuring changes and introduce streamlined operating activities to mitigate the situation. This may include small operational changes like incentives to the debtors for early payments, incentives to the creditors for extending the credit periods etc. As per the work of Martin, Harner, Harner and Singer (2014), many companies, financial institutions, hedge funds as well as vulture funds play a countercyclical role in the economy by investing in the distressed securities (Martin, Harner, Harner and Singer, 2014). Vulture funds are specific types of heterogeneous investment funds used for investments in distressed securities. The distressed financing source not only acts as a sufficient funding source for many bankrupt companies but also adds to the overall productivity and efficiency of the company. Distressed financing acts as a main source of capital that can be used by a company to improve its operations and strengthen its financial performance and. This may save a company from becoming liquidated. The distressed financing sources enable a company to provide working capital, maintain capital and operational expenses, build more capacity, ensure liquidity in the business, reduce the number of job losses and increase capacity for employment. Both in case of normal functioning as well as in the case of bankruptcy, a company needs sufficient capital and cash for survival and continuity. A company which is in the stage of bankruptcy is likely to ask the debt holders to waive off the loan defaults, compromise on the existing debts, provide an additional capital amount and exercise suitable remedies among other business favours. This presents the investors with an opportunity to exercise more control on the operations and management of the company and also presents them with the scope of having some say in the corporate affairs of the company. The extent of the inclusion of an investor in distress investment depends on three main factors. These are as follows: The statutory rights of the investors The characteristics of the securities The contractual rights of the debt holders The main investors in distressed debts and securities are institutional investors. The institutional investors who invest in distressed companies include private equity firms, venture capitalists, hedge funds, banks and vulture funds. Some other types of institutional investors like mutual funds and pension funds are not directly involved in investing in distressed securities. Distressed securities of a company include those debts and financial instruments whose market values have decreased considerably from the fair value. As such, the general investor groups are not interested in buying these securities. On the other hand, the large institutional investors are much interested to buy the distressed securities which they can use to enhance profits by using suitable investment strategies and structures. Venture capitalists and hedge funds from the major part of the institutional investor groups which invest in distressed securities. They use the value creating investing strategies while investing in distressed firms. The main objective of these investors for investing in distressed debts is to acquire some degree of control over the management of the company. Also, the main intention for achieving this control level is to enhance the value in the company in the long term. The distressed securities often become much attractive investment options for certain class of investors because of the reduced value of the securities. Many institutional investors, especially hedge funds and vulture funds specifically look at distressed securities as a type of bargain because of the low prices of these securities. Also, since these investors are willing to take more risk in order to earn more return, they often invest in distressed securities which have higher potential to become high priced in the long term. The risk level associated with distressed debt financing is high because when any company files for bankruptcy under Chapter 7 of the Bankruptcy Law, there may be high chances of the company being completely dissolved. However, when there are scopes of restructuring the business, there would be chances of getting a bargain with investing in the distressed securities because the prices of the securities may increase if the company is able to have a successful restructuring process and can make a corporate turnaround in the business. The investors who invest in distressed debts and distressed equities have high knowledge and acumen to understand the future potential of a company which is filing for bankruptcy. The main logic underlying the investments for distressed financing includes the fact that the situation of the company is not as weak as is perceived by the market. Also, if there are chances of the company starting to perform better after a successful restructuring process and if it is estimated that the value of liquidation would be sufficient to cover the initial investment in the business, then the vulture funds, hedge funds and other institutional investing funds often engage in financing these firms by buying the distressed debts and equities of a company which is to file for bankruptcy or has already filed for bankruptcy. As identified from the work for Anson, Fabozzi and Jones (2010), the distressed debt financing option is applicable in the cases when a company files for bankruptcy under Chapter 11 because filing for bankruptcy under Chapter 11 allows the company to continue its operations and create a plan for business reconstruction with the creditors in order to revive the company (Anson, Fabozzi and Jones, 2010). This is in contrasts to the Chapter 7 of bankruptcy according to which a company should become insolvent if it has enough money to pay the debt holders through the liquidation of the company. The distressed companies follow the distress and recovery cycle in their corporate restructuring processes (Figure 1). Figure 1- The distress and recovery cycle at micro level Source: (Anson, Fabozzi and Jones, 2010). According to the work of Goldschmid (2005), distressed equity financing is less commonly used as a type for distressed financing because due to bankruptcy, often the common shares of equity stocks of the company become valueless for the investors (Goldschmid, 2005). Therefore, the investors who invest in distress financing opt for more senior financial instruments in distressed financing options like trade claims, bank loans and corporate bonds. However, there is very less certainty involved in distressed investing activities. Most of the distressed investors invest on the basis for probabilities. Distressed investing forms a major part of the investments made by the venture capitalists. The venture capitalists or private equity firms generally make the distressed investments through the use of hedge funds and other high end investment strategies. The distressed debt financing process may be done by a number of avenues. The hedge funds typically employ different investment techniques to ensure that the investment bank or the venture capitalist gains sufficiently by investing in the distressed securities. Distressed investing is a special category of investment used by private equity firms and venture capital firms. Distress firm buyouts and traditional leverage buyouts for companies are main functions of the venture capitalists. The distressed buyouts act as main components for the flow of funds in the distressed investment processes. Distressed investments are done with the main aim of gaining control over the financially distressed company or any particular business unit of the distressed company. The main strategy of hedge funds in investing in the distressed securities or companies is to trade these securities for the distressed companies in the capital markets so that a trade profit can be attained quickly by selling off these securities. The venture capitalists generally ensure the flow of funds in distressed investing through a unique business unit known as the Corporate Venture Capital Unit. As identified from the work of Harner (2014), the venture capitalists generally invest in two types of distressed companies One of these includes those distressed companies which are making operating profits and the other type includes those distressed companies which are making operational losses (Harner, 2014). The distressed companies which have an operating profit experience negative cash flow sensitivity. Therefore, when distressed debt investments are done for financing the company, capital is pushed into the company to ensure that the negative cash flow sensitivity of the distressed company is negated. The restructuring process is used to improve the cash flows of the company as well as to improve the overall financial outlook of the company. If everything goes according to the investment plan and the company starts performing better, the distressed debt investors like the venture capitalists sell their stake in the company and list the IPOs of the company in order to regain their investments. The investment in distressed financing starts with an identification of the distressed firms, followed by an analysis of the future potential of the stocks of the company and the by investing suitably in the debts and securities of the company. The distressed debt financing processes involves a combination of both liquid and illiquid strategies of investment. Branch (2007) discusses in his work that the distressed debt investment opportunities can be categorised into three main categories based on the objectives of the investors (Branch, 2007). These are activist distressed debt investing method; control based distressed debt investing method and discount value distressed debt investing methods. These strategies are summarized in Table 1. Table 1-Distressed Debt Investment Strategies (Source: Branch, 2007) These types of investment vary according to the involvement of the asset managers in increasing the returns. Despite the fact that the securities prices of a distressed company are reduced, there are many prospective buyers for distressed debts and securities in the market. This creates a fair chance for the sellers to achieve a bargain price. Also, the prospective investors get the scope to buy securities at low prices which acts as an opportunity for them, especially in the transactions carried out in an inefficient middle market. Discounted value investments are most suitable for distressed debt investors who do not want to actively participate in the restructuring process. The activities investments are other significant types of distress debt investments that are commonly used by the investors of distressed companies. The control based investment strategy in distressed securities involves investing on the debts of companies which are sufficiently undervalued with respect to the actual liquidation value of the company. Whitman (2009) identifies that this usually occurs if the market perception of the value of a company makes the market value of the company lesser than its actual value or liquidation value (Whitman, 2009). The investments made by the distressed investors can be converted to benefit bearing equity interests through the use of proper business reorganizations and financial restructurings as performed under the bankruptcy process. Therefore, the control based investment funds enter into the investment with the objective of having a degree of control in the distressed company to enable proper restructuring activities in the company. Distressed investing follows the economic cycles as well as the credit cycles in the economy. These cycles consist of periods which generate extraordinary opportunities of investment and returns from these investments. Also, the distressed investing and financing depends largely on both macro as well as micro economic factors. The credit cycle is a main driver of scopes for distressed investing. The investing opportunities in distressed securities can also be caused by certain factors relevant to the company, country or the global economy. Both distress and recovery follow a pattern in the macro level of an economic cycle which is fairly predictable in nature. The micro level opportunities of distressed investment are more dependent on the debtors and the investors profiles. The macroeconomic equity and credit cycles for the United States of America for the period 1988-2010 are given in Figure 2. Figure 2- Macroeconomic equity and credit cycles (1988-2010) (Source: Whitman, 2009) Distressed debts have become an interesting aspect of investment especially fuelled by the significant levels of looming maturities and the periodic cyclical downturns experienced by the cobalt economy. It can be identified from the work of Griffin, Thorpe and Crickenberger (2013), distressed debt investments are emerging as crucial new age investment opportunities which have become widely prevalent in the developed markets like the United States of America and Europe. In comparison, the popularity of distressed investment is limited in the developing countries like Asia, Latin America etc. (Griffin, Thorpe and Crickenberger, 2013). Conclusion Distressed debts are seen as a major liability by companies and individual investors. But, as can be derived from the opinion of Altman (2013), certain specialized institutional and individual investors can gain a lot from taking the risk of distressed debts and managing them with the use of sophisticated investment strategies (Altman, 2013). Through the mitigation and control of the associated risks of distressed financial instruments, the distressed debt investors can earn high rewards for their investments while ensuring that the distressed company is supported to navigate through the financially difficult times. Both distressed financing and distressed investing have become main stream activities in corporate financing. This has occurred especially after the Great Financial Crisis of 2008 when a number of big and small companies went bankrupt or were in the edge of bankruptcy. A lack of liquidity in the capital markets often cause many companies to declare bankruptcy. In these situation, distressed debt financing and investing act as suitable instruments to create beneficial results for both the distressed firm as well as the distressed investors. The investors who invest in distressed firms are increasing in number because of the wider proficiency gained by private equity firms and venture capitals to use sophisticated investment techniques. The special situation investments are expected to gain more prominence in future as a component of distressed debt financing. References Altman, E. I. (2013). The Role of Distressed Debt Market, Hedge Funds and Recent Trends in Bankruptcy on the Outcomes of Chapter 11 Reorganizations. New York: NYU Working Paper. Anson, M. J., Fabozzi, F. J. & Jones, F. J. (2010). The Handbook of Traditional and Alternative Investments. New York: Wiley. Branch, B. (2007). Bankruptcy Investing – How to Profit from Distressed Companies. Mayland: Beard Books. Goldschmid, P. (2005). More Phoenix than Vulture: The Case for Distressed Investor Presence in the Bankruptcy Reorganization Process. Columbia Business Law Review. Vol. 191(1). Griffin, J., Thorpe, M. J. & Crickenberger, I. (2013). Activist Investors, Distressed Companies and Value Uncertainty. ABI Law Review. Vol. 21(2). Harner, M. M. (2014). Activist Investors, Distressed Companies, and Value Uncertainty. American Bankruptcy Institute Law Review. Vol. 167(1). Martin, C. M., Harner, P. E., Harner, M. M. & Singer, A.M. (2014). Distressed Debt Investing in Alternative Investments. New York: Wiley. Whitman, M. J. (2009). Distress Investing – Principles and Technique. New York: Wiley. Wood, A. (2011). The Decline of Unsecured Creditor and Shareholder Recoveries in Large Public Company Bankruptcies. American Bankruptcy Law Journal. Vol. 85(2). Read More