Distressed funds

Restructuring plans get scrutiny from investors

From Chicago Tribune, provided by LexisNexis)Publication: Chicago Tribune
Dow Jones Newswires

At a time when a historically low default rate is making distressed investments more scarce, investors are becoming more specialized, and litigious, in their quest for returns.
While such investors are accustomed to navigating their way through complex restructurings and bankruptcy court proceedings, some are increasingly inclined to dabble specifically in pending litigation against companies in distress or default, a tactic known as legal arbitrage.
These distressed-debt specialists are looking more than ever for new ways to squeeze as much as they can out of a market parched by a low default rate. One outgrowth has been a burgeoning market for company debt that carries with it rights to potential litigation claims in particularly thorny restructurings, experts say.
Investors accustomed to valuing distressed securities are now arming themselves with teams of restructuring lawyers and other specialists, trying to factor in the economics of litigation risk.
"There are different styles within distressed investing that can range from passive to very active and that vary case by case," said Martin Fridson, publisher of the Distressed Debt Investor research service. "Legal arbitrage is very hands-on and specialized."
Distressed debt generally refers to bonds of companies that have either defaulted or appear to be at a heightened risk of doing so. Bonds that trade at distressed prices can make attractive investments for investors with a strong stomach for risk.
This has tended to make such instruments the territory of hedge funds, vulture investors and private equity, who often amass large stakes in such credits to wield greater influence in restructuring proceedings.
In recent months, however, the distress ratio, as measured as the percentage of high-yield securities trading at spreads of more than 1,000 basis points above Treasuries, has fallen below 1 percent, according to Standard & Poor's. A basis point is 0.01 percent.
As spreads have compressed and defaults have dried up, investors accustomed to trafficking in distressed-debt instruments are finding them in short supply and are being forced to get creative.
One such play has involved cases where fraud has become a key theme in bankruptcy proceedings. Lately, hedge funds have gone into such litigious situations and tried to make a market in affiliated claims.
"You're seeing investors come in with a higher appetite for taking on risk," said Andrew Scruton, a senior managing director at FTI Consulting. "It's becoming a very efficient marketplace. Investors are bringing in more money or more expertise, and the scrutiny into each situation is becoming much more intense."
Scruton said funds have stepped up their research into distressed names, searching filings, press clippings and court dockets for references to fraud or other irregularities. After targeting a particular company, funds will often buy a small piece of that company's debt, which then affords them access to information available to existing holders of that debt.
Issues relating to what information is public versus private can make it tricky for the parties in a transaction to trade with the same level of information, but Scruton said the process continues to grow more efficient.
"There's a lot of market chatter," Scruton said. "Often the sell-side guys at big-name banks might make a market in the debt and alert the funds they know that have an interest in these types of situations."