How to Profit From Investing in Failing Company Debt

Sharpen your talons and prepare to feast on the weak and the dying. You'll need to think like a vulture as we enter the unforgiving world of distressed debt investing. In this world, investors specifically seek out companies that are performing poorly or are on the brink of bankruptcy. Then they buy up the bonds and take control. (See also: Advanced Bond Concepts.)

There are always companies in the market that look terrible but are likely to get back on the right track. The first instinct for the regular investor to invest in a financially distressed company's shares, but, as we'll learn in this article, the debt (bonds) of these firms is often a much more attractive investment. And although buying up large chunks of debt can cost millions of dollars, there are still ways for little guys to cash in, too.

Distressed debt investing entails buying the bonds of firms that have already filed for bankruptcy or are likely to do so. Companies that have taken on too much debt are often prime targets. The aim is to become a creditor of the company by purchasing its bonds at a low price. This gives the buyer considerable power during either a reorganization or liquidation of the company, allowing the buyer to have a large say in what happens to the company.

There are funds—known as "vulture funds"—that specialize purely in distressed debt. The focus for these companies is often on government debt or public debt, rather than that of companies. These funds are very controversial, and are often hated by the governments or public bodies in question.

Many hedge funds also use distressed debt, but in a different manner from other investors. Hedge funds focus on purchasing liquid debt securities that they can sell at a profit in the short run. Conversely, private equity investors are interested in companies that need restructuring or are about to go bankrupt.

It should be noted that such investments form only one component of many hedge funds. These funds have many of other strategies, such as arbitrage, short selling and trading options or derivatives.

Another important point is that, in the event of liquidation, owners of debt have priority over equity holders. For this reason, it is better to invest in the debt of a distressed company than to invest in its stock. (See also: An Overview of Corporate Bankruptcy.)

The philosophy behind distressed investments is therefore simple: There is generally an expectation that the targeted company can and will be restructured successfully or brought back to life through a merger, takeover or some form of managerial re-engineering and rejuvenation. Alternatively, if it comes to bankruptcy, the asset values must substantially exceed the market valuation.

These investments are risky by their very nature. However, like many other intrinsically high-risk investments, they have one big advantage: the lack of correlation with other stock market risks. This lack of correlation means distressed debt is a fine way to diversify.

The basic goal is to buy assets for a price well below their intrinsic or fair values. This is where a scavenger's keen senses come into play. The "vultures" must look carefully and meticulously at distressed companies to detect oversold securities or even specific kinds of accounting problems. (See also: Playing The Sleuth in a Scandal Stock.)

They track industries and corporations that are on the brink of collapse or that have already gone under. If the bonds of a company are trading well below what they really seem to be worth, there may be an opportunity. M&A activity and credit negotiations are also analyzed to find bargains.

Finally, intelligence and information from various sources are combined with top-level legal and financial skills to identify money-making potential. What matters fundamentally is that the assets are undervalued and can be purchased at a large discount. But everyone wants a bargain, so coming out ahead takes skill. It's not a life for the lazy or uneducated. (See also: Value By the Book and Warren Buffett: How He Does It.)

Self-described vulture Martin Whitman first got into distressed-debt investing in the 1970s, because big bond houses such as Lehman Brothers considered it "beneath their dignity" to deal with bankrupt firms.

In 1987, Whitman bought $14 million of debt and stock in Anglo Energy, an oil-service firm that was struggling. He then gained control of the company, put it into bankruptcy and did a debt-for-equity deal with the other creditors. Less than a year later, the company resurfaced from bankruptcy free of debt and Whitman made a sizable gain.

In 1995, a unit of Franklin Mutual Funds assisted in the saving of Canary Wharf, the London office complex built by the Reichmann family, the Canadian real estate developers. After the developer's holding company went bankrupt, lending banks gained control of the project. A group of investors, including Franklin's Mutual Series funds, bought back the development from the banks. Not long afterward, the London property market recovered and in 1999, Canary Wharf listed on the stock exchanges, which provided large returns on Franklin's investment. (See also: Can You Invest Like Carl Icahn?)

It is not particularly easy for private investors to get into distressed debt. The quickest way is to buy into a hedge fund that contains a prudent allocation of distressed debt. However, for most investors, the minimum requirements of hedge funds make it impossible to invest in this manner.

There are a few mutual funds and hedge funds that are accessible to regular investors as well.

If the idea appeals to your more predatory instincts and you are able to access this market, bear in mind that this is a high-risk field. Risky but lucrative is certainly the name of the game. (See also: Finding Profit in Troubled Stocks.)