Keeping the Battleship Together – Investing in Companies in Distress
To say that the coronavirus pandemic has impacted the financial sector would be an understatement. From large institutions to individual retail investors, many are experiencing fluctuations in their investment portfolios as a result of Covid-19. However, to the trained eye, a crisis such as this can present investment opportunities, including investments in distressed businesses.
Broadly, investing in businesses in distress involves investing in businesses that are usually over-leveraged and therefore facingsome form of insolvency event unless the balance sheet is restructured. Often these businesses have capital needs and no longer have the support of their lenders. Essentially, these businesses have too much debt and not enough cash flow to service their interest costs. This is because the claims on the business (by equity holders, creditors, employees, suppliers etc.) outweigh the business’ value.
Businesses can find themselves facing financial distress for many reasons and currently the most prevalent and obvious is the impact of the pandemic. However, a changing industry or market, lack of access to funding, reduced profitability and increased competition are all factors that can cause distress.
Investing in businesses in financial distress seems counter-intuitive, but to experienced investors there can be much to gain. This is because, by buying the debt or equity of a business in distress, an investor can realise their investment if the business turns around.
How It Works
The main goal of distressed investing is to secure a debt or equity position in the target company at a discount. The investor receives a return on their investment if the distressed business is successfully turned around. Mergers, takeovers, restructuring and access to capital are just some of the ways in which a business can turn itself around.
David Wallace (Joint-Managing Director at Armillary Private Capital) says the key to distressed investing is to “work out if the company has a core viable business, and whether the existing owners and management are prepared to change the way they operate if/when this is necessary”. This means that essentially, as an investor you’re looking for good companies with poor balance sheets.
Distressed investing is sometimes called vulture investing. Despite what this name suggests, distressed investing doesn’t always have to be predatory. It’s about using the rules in the Companies Act 1993 to create value for all parties involved.
Investors can purchase the debt or the equity of a company (however, this is not mutually exclusive), or provide new capital that is positioned ahead of all other creditors, often known as debtor in possession financing.
Because this area of investing can be complex, inexperienced investors should seek the help and expertise of their financial advisors.