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Distressed Debt Investing Resources to Help Investors Better Understand Their Investment Options in this Asset Class Managed Funds Association | May 2014

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"Distressed Debt Investing: Resources to Help Investors Better Understand Their Investment Options in this Asset Class" is aimed at helping investors better understand their investment options in the distressed debt space. The presentation gives an overview of distressed debt investment and the role these investors play in the bankruptcy process by creating liquidity in the credit markets, lowering the cost of lending, and helping companies that may be close to bankruptcy or in bankruptcy with additional capital.

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Page 1: Distressed Debt Investing: Resources to Help Investors Better Understand Their Investment Options in this Asset Class

Distressed Debt Investing Resources to Help Investors Better Understand

Their Investment Options in this Asset Class

Managed Funds Association | May 2014

Page 2: Distressed Debt Investing: Resources to Help Investors Better Understand Their Investment Options in this Asset Class

Overview

2

Investing in distressed debt instruments provides certain asset managers

with an opportunity to deliver strong, and often less-correlated returns for

investors and play a constructive role in the corporate restructuring process.

This presentation gives an overview of distressed debt investment and the

important role these investors play in the bankruptcy process by creating

liquidity in the credit markets, lowering the cost of lending, and helping

companies that may be close to bankruptcy or in bankruptcy with additional

capital.

Page 3: Distressed Debt Investing: Resources to Help Investors Better Understand Their Investment Options in this Asset Class

Table of Contents

3

What is distressed debt? 4

How does investing in distressed debt work? 5

Who invests in distressed debt? 7

What differentiates distressed debt investors? 10

Distressed debt investor involvement provides a balance of power 11 during bankruptcy and restructuring

Distressed debt investor involvement is associated with a more 12 efficient bankruptcy process

Distressed debt investor involvement is associated with gains in 13 equity and post-bankruptcy company performance

Resources 15

Slide:

Page 4: Distressed Debt Investing: Resources to Help Investors Better Understand Their Investment Options in this Asset Class

1 What is distressed debt?

4

Investing in “distressed debt” is a strategy in which an investor purchases

debt of a financially distressed or insolvent company with the hopes of

realizing a financial return. Distressed investments include public and

private market debt, loans and bonds, vendor and trade claims.

The term “distressed” refers to a material drop in price of the debt instruments

due to an event such as a missed interest payment, the beginning of a

company restructuring or the filing of bankruptcy petition, all of which

suggest a lower probability of the company repaying its debts .

Page 5: Distressed Debt Investing: Resources to Help Investors Better Understand Their Investment Options in this Asset Class

2

5

Distressed debt investing involves the buying of debt instruments issued

by a financially distressed or insolvent company from its early creditors

and debt holders, or on the secondary market.

Debt instruments purchased by an investor may include bonds, notes,

claims, and loans.

Once a financially distressed company enters bankruptcy, the actual

bankruptcy claims may be traded as well, with the nature of each claim

(such as seniority of the claim and the claim holder’s role within the

bankruptcy process) determined by the type of underlying debt

instrument creating the claim.

How does investing in distressed debt work?

Page 6: Distressed Debt Investing: Resources to Help Investors Better Understand Their Investment Options in this Asset Class

6

An investor typically buys the debt instruments at a discount from a

creditor or on the secondary market.

Creditors can include:

• Banks

• Insurance companies

• Mutual funds

• Other bond holders

The earlier creditors may have an incentive to sell their debt holdings

because they may be either prohibited from investing in the securities of

bankrupt companies, they do not have the capacity to deal with the often

long and expensive process of bankruptcy, or they may wish to redeploy

capital to more traditional opportunities.

An example of a creditor’s motivation for selling debt holdings:

An insurance company has bonds in 100 companies and one

company has become distressed. The investment manager for the

insurer may not want to commit the time, money, or resources on

the bankruptcy proceedings for an investment that represents 1%

of the portfolio and sells the debt instrument to a distressed debt

investor at a discount.

How does investing in distressed debt work? (continued)

Page 7: Distressed Debt Investing: Resources to Help Investors Better Understand Their Investment Options in this Asset Class

3

7

The majority of investors involved in distressed debt strategies are part of the

alternative investment industry.

These investors often work alongside the financially distressed company to

execute a successful restructuring or bankruptcy proceeding.

Recent empirical studies* have shown that when a hedge fund is involved as

an investor in a bankruptcy proceeding or restructuring, there is a greater

probability of a successful financial recovery with benefits to creditors,

shareholders, and the company itself.

*A sample of 474 bankruptcy cases from 1996 to 2007 shows hedge fund involvement in 90% of cases, with hedge funds representing

half of all trading volume in distressed debt markets, one third of trading volume in leveraged loans and one quarter of trading volume

in high-yield bonds between 2005 and 2006. Out of the 474 bankruptcy cases studied, hedge funds have been found to become post-

bankruptcy shareholders in 28% of cases involving no bankruptcy financing and 34% of cases that include bankruptcy financing.

Jiang, W., K. Li and W. Wang “Hedge Funds and Chapter 11” The Journal of Finance 67: 513–560 (2012): 513-514.

Who invests in distressed debt?

Page 8: Distressed Debt Investing: Resources to Help Investors Better Understand Their Investment Options in this Asset Class

8

Distressed debt investors purchase claims throughout the capital structure,

including:

Distressed debt investors often become post-bankruptcy shareholders in the

company as their debt is converted into equity in the company.

• Senior bonds

• Subordinated bonds

• Secured/unsecured debt

• Loans/vendor claims

• Common stock

• Preferred stock

Who invests in distressed debt?

(continued)

Page 9: Distressed Debt Investing: Resources to Help Investors Better Understand Their Investment Options in this Asset Class

9

Distressed debt investors are characterized as either passive or active.

• Passive investors simply buy the debt instruments in the hope of realizing a

return through price appreciation determined by the actions of others.

• Active investors buy the debt instruments with the intent of participating in

the restructuring or bankruptcy process, working directly with company

management or other creditors to ensure a successful outcome.

• Active investors may include those who do not seek control of the financially

distressed company, and instead engage the financially distressed company as a

member of the creditor’s committee or another role in the bankruptcy process.

Often, such investors will provide debt financing to operate during the bankruptcy or

inject equity capital in the company after it exits bankruptcy.

• Active investors may also include those that seek control in the financially distressed

company in order to have a greater impact on the restructuring or post-bankruptcy

operations of the company. Active investors seeking control may retain a seat on

the board of directors, replace management with investor personnel or even

purchase the company outright after bankruptcy.

Who invests in distressed debt?

(continued)

Page 10: Distressed Debt Investing: Resources to Help Investors Better Understand Their Investment Options in this Asset Class

4

10

Distressed debt investors possess unique characteristics that allow them to

pursue this investment strategy, including:

• Capacity to purchase large positions in distressed debt and equity.

• Ability to inject fresh capital. Because of flexible mandates these

investors can convert debt to equity and inject fresh capital to recapitalize a

distressed company.

• Capacity to withstand length of time and the cost of restructuring or

bankruptcy proceedings.

• As a major class of investor, distressed debt funds provide a much

needed source of liquidity for earlier creditors who do not have the

capacity or expertise to engage in the bankruptcy process.

• Many times, these investors become shareholders in the post-bankruptcy

company and provide much needed financing to companies during the

bankruptcy process.

What differentiates distressed debt investors?

Page 11: Distressed Debt Investing: Resources to Help Investors Better Understand Their Investment Options in this Asset Class

5 Distressed debt investor involvement

provides a balance of power during the

bankruptcy and restructuring process

11

When distressed debt investors participate in the bankruptcy process, they

typically have a high incentive to ensure the company has a successful

emergence from bankruptcy because they will often own the post-bankruptcy

equity of the company.

Due to these investors’ combination of financial resources, capacity and

expertise, they are able to balance the power between two sets of competing

interests:

1. Creditors who may have a “liquidation bias” of having the distressed

company sold so asset sales can be used to satisfy debt claims.

2. Executives of the distressed company, which often have an incentive to

maintain the status quo and exit the bankruptcy process with minimal

restructuring, oversight and replacement of executives.

Page 12: Distressed Debt Investing: Resources to Help Investors Better Understand Their Investment Options in this Asset Class

6 Distressed debt investor involvement is

associated with a more efficient

bankruptcy process

12

Distressed debt investors’ involvement during the bankruptcy process has been

associated with both a higher degree of debt recovery (both secured and unsecured)

as well as a positive impact on overall company value.

There are several possible explanations for the positive effects of these investors

during the bankruptcy process*:

Overcome Liquidation Bias – they fight the desire to liquidate a distressed

company, leading to a higher probability of emergence from bankruptcy and

corresponding preservation of jobs, tax revenue and stakeholder interests.

Provide Financing – since distressed debt investors often become shareholders in

the post-bankruptcy company, they have a long-term incentive to ensure the financial

stability of the company, and often provide much needed “debtor-in-possession” (DIP)

financing and “exit” financing to the company during the bankruptcy process.

*For empirical evidence on the positive impact of each of the trends above, see Jiang et al., “Hedge

Funds and Chapter 11” The Journal of Finance 67: 513–560 (2012).

Page 13: Distressed Debt Investing: Resources to Help Investors Better Understand Their Investment Options in this Asset Class

7 Distressed debt investor involvement is

associated with gains in equity value

and post-bankruptcy company

performance

13

In a 2012 study, a rise in the price of a distressed company’s stocks and

bonds was documented as a result of the announcement of hedge funds’

involvement in a bankruptcy:

“Hedge fund presence increases the likelihood of a successful reorganization

… higher total debt (including secured and unsecured) recovery and a more

positive stock market response at the time of a bankruptcy filing, suggesting

a positive effect of hedge fund creditors on the firm’s total value.” *

* Jiang, et al., “Hedge Funds and Chapter 11” The Journal of Finance, 67: 513–560 (2012).

Page 14: Distressed Debt Investing: Resources to Help Investors Better Understand Their Investment Options in this Asset Class

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Recent bankruptcy cases further exemplify the positive relationship*

The primary reasons include:

• An increased rate of debt recovery for unsecured and junior claim

holders (because distressed debt investors usually fall into this class of

claim holders)

• Relief of financial constraints (since these investors often offer DIP

financing)

• Higher probability of companies emerging from bankruptcy (because

these investors are often post-bankruptcy shareholders, have an incentive

for the long-term existence of the company)

* Jiang et al., “Hedge Funds and Chapter 11” The Journal of Finance 67: 513–560 (2012).

Distressed debt investors help with

gains in equity value and post-

bankruptcy company performance

(continued)

Page 15: Distressed Debt Investing: Resources to Help Investors Better Understand Their Investment Options in this Asset Class

Resources

15

1. Jiang, W., Li, K. and Wang, W. “Hedge Funds and Chapter 11” The Journal of

Finance, 67: 513–560 (2012).

2. Harner, Michelle H. “The Corporate Governance and Public Policy

Implications of Activist Distressed Debt Investing” Fordham Law Review 77.2

(2008).