The subtleties and complexities underpinning the special situations and distressed landscape have contributed to its reputation as a fairly convoluted space for prospective investors. Deciphering the special situations (“special sits”) universe requires an understanding of the range of strategies available to fund managers as well as their risk-return profile, and an alignment on relevant terminology. The diverse strategies that fall under the special situations and distressed umbrella can be implemented across different parts of the capital structure with different aims, complicating direct comparisons and requiring thorough due diligence.
A special situation is an atypical event that compels investors to buy equity, debt, or an asset in the belief that its value will increase. Special situations investments are defined by an element of distress, dislocation or dysfunction that can contribute to a mispricing of the underlying assets. Broadly speaking, there are four principal strategies employed by managers in the special situations space, each with distinct characteristics:
Distressed debt: investors purchase deeply discounted debt with the hopes of favourable price action.
Distressed-for-control: managers purchase fulcrum securities that will end up being converted to equity.
Event-driven: investments motivated by specific price dislocations such as spinoffs or divestitures.
Turnaround: equity investments into troubled companies, usually before a bankruptcy process begins.
Special situations strategies command expertise to execute well, as well as periods of stress for companies or economies at large. Given their elevated risk profile, identifying experienced managers is paramount for investors.
Defining special situations & distressed
Special situations is a broad category which refers to an event or situation which causes a material impact on the value of an asset. The special situations label has become something of a catch-all phrase in recent years, and its application can vary between firms and markets. Some investors apply the term to any situation which are simply non-traditional private equity investments, whereas others use the term to apply to specific scenarios such as buybacks or spin-offs. Special situations may also take the form of a corporate restructuring or corporate transactions such as share repurchases, asset sales, or other catalyst-oriented situations. Generally speaking, special situation strategies are less correlated to traditional market cycles and such opportunities can present themselves in both bull and bear markets. Special situations are therefore often considered all-weather strategies, and in periods of market stress usually seek to create value by flexibly shifting between two sub-strategies: event-driven and distressed debt.
Distressed debt strategies seek to maximise returns driven by capital appreciation of non-performing assets purchased at a steep discount. A distressed debt investor generally purchases the debt of a financially troubled company at a discount against the face value of the debt. The investor seeks to make a profit on its investment by reselling the debt, through recoveries in the restructuring process or by converting the debt into an equity position in the reorganised debtor. The investment selection of distressed assets by a manager is typically based on an in-depth analysis to assess the probability that a turnaround or a catalyst (such as a debt/ equity swap) will help realise attractive returns and to gauge the balance between this upside and the downside of default. Financial distress may be the result of one or more of the following catalysts:
Loss of competitive position
Lack of access to funding markets
Litigation or regulatory difficulties
Changing business climate, whether in an industry, region or specific market
Regional or global economic disruptions (such as the Covid-19 pandemic
Ensuring the performance of these investments often requires a considerable involvement from the fund manager with the borrower to work through a turnaround or restructuring. In some instances, distressed debt managers will aim to exert influence in a bankruptcy process to negotiate more favourable terms. Distressed managers have wide latitude to trade across the capital structure. Such securities may include bonds, debentures, notes, mortgage or other asset-backed instruments, equipment leases, trust certificates and commercial paper. Managers may also acquire positions in equity and equity-related securities, including preferred stock, convertible preferred stock, common stock and warrants. Historically, distressed debt strategies have performed best in the late-expansion through contraction stages, when financial distress generates an expanded opportunity set.
Distressed for control, also known as ‘distressed-to-control’ or ‘loan-to-own’ involves the purchase of troubled company debt with the aim of converting that debt into a controlling equity stake in the restructured business. Distressed for control managers often have a higher risk appetite, accepting credit risk by investing in more junior securities (known as “fulcrum securities” which will be converted into equity post re-organisation) and tend to take on activist approaches. With that control, the distressed for control private equity manager then operates the company with the aim to make improvements before a strategic sale or initial public offering. Distressed for control deals are often structured as pre-packed insolvencies (“pre-packs”), where a restructuring plan is agreed in advance of a company declaring bankruptcy.
Unlike traditional private equity managers who look for strong businesses with strong management teams and apply leverage to grow, distressed for control private equity managers look for strong assets or businesses with poor management teams or strategies, and often seek to quickly de-lever. A distressed for control investor needs the analytical and bankruptcy acumen of a distressed investor, the medium-term business planning and oversight skills of a leveraged buyout investor, and the ability to drive a restructuring process (either in or out of court) while a company is going through a crisis. Thus, the strategy requires not only deep specialist knowledge, but also the ability of the fund manager to invest significant time, energy and resources into the restructuring process.
Event-driven and opportunistic distressed strategies focus on uncovering and exploiting unique catalysts. Event-driven strategies are opportunistic in nature. Managers seek out stressed but performing assets—often obligations of healthy companies—that are under-priced as a result of illiquidity, market disruption or particular nuances related to the issues or issuer. It is also important that a catalyst to unlock value, such as a refinancing, is planned or can be negotiated with the borrower. Positions in these often illiquid assets are built strategically over time. Event-driven strategies seek to identify and creatively exploit these unique opportunities at all stages in the economic cycle. For special situation and distressed investors, bad news is good news.
Opportunistic distressed debt investments are made in situations in which companies are undergoing, or likely to undergo bankruptcies, or other extraordinary situations such as debt restructurings, reorganisations, spinoffs and liquidations. Funds investing in distressed debt often become a major creditor of the underlying company through the purchase of deeply discounted bonds. Similarly, in many circumstances, they are able to exercise a certain degree of control in an underlying company through the acquisition of significantly discounted securities in order to enhance the value of the underlying company. In turn, during and after a company’s reorganisation or restructuring, these funds may be in a position to realise attractive gains through sales of restructured debt obligations, newly-issued securities and/or sales of its currently-held securities. However, as in all situations of distress, risk is elevated.
Turnaround private equity managers acquire controlling equity stakes in failing companies, often before or during formal bankruptcy proceedings. Turnaround specialists start with identifying what they believe are good companies with bad balance sheets. Post acquisition, managers seek to execute financial and operational improvements, typically starting by negotiating with lenders to restructure a company’s debt to create a sustainable capital structure. Given the often precarious state of the acquisition target, leverage is rarely employed by turnaround private equity managers. That said, there may be opportunities to relever the company as it recovers, such as with dividend recapitalisations (“dividend recaps”) to pay out earnings to investors before the company is sold.
Successful turnarounds require extensive expertise to distinguish situations which can merely be salvaged from those which can eventually thrive.
Specialists believe traditional due diligence focused on legal and financial analysis of distressed targets is insufficient to identify winners and losers in the turnaround space. Notably, broader stakeholder buy-in is considered of particular importance in turnaround management, which relies on tolerant suppliers (to extend credit terms to companies in distress) and motivated employees (to undertake the changes necessary to right the company’s course). As the most subordinate type of capital, equity investments are by definition riskier than debt investments, and decidedly so in failing companies. Thus, unlike other types of special situation investments, turnaround strategies are rarely attempted for fundamentally flawed businesses.
Good companies, bad balance sheets
For all special situations strategies, expert due diligence is required to uncover viable distressed targets — these “good companies with bad balance sheets.” In distressed investing, special attention is paid to understanding the capital structure, mapping out restructuring scenarios, modelling the impact of dramatic operational changes, and analysing counterparties. With respect to the capital structure, understanding the intricacies of a firm’s existing capital structure in a distressed scenario can allow managers to extract significant value or control (especially with respect to fulcrum securities). For target companies expected to go through bankruptcy, mapping out event scenarios (or scenario trees where there are interdependencies) becomes critical, as there are important distinctions between different bankruptcy chapters when it comes to supervision, operations and outcomes. Although private equity managers of all strategies model the financial impact of operational changes, in financial duress, immediate operational changes required may be more draconian, such as closing half of a company’s stores, or discontinuing product lines. Building a solid understanding of existing counter-parties, with marked interest in existing debt-holders, is arguably of increased importance in distressed scenarios.
Beyond differences in the opportunity set, distressed private equity presents distinct challenges and opportunities compared with traditional private equity. As such, their risk-return profiles tend to vary considerably. Returns scenarios are often described as stepwise in special situations investing, as distressed prices rarely fluctuate in a gently sloping line. Instead, outcomes are frequently more binary. With companies exhibiting signs of stress (if not serious duress), risks are elevated in distressed investments. Tail risks such as unsuccessful or delayed corporate reorganisations due to adverse legal complications should not be ignored. With these elevated risks, elevated returns can be achieved by managers who know to navigate complex capital structures and processes. In times of turmoil, it would be wise to turn to specialists who know best how to capitalise on complexity.