Distressed debt default rates set to rise, warns GLG’s Galia Velimukhametova

Galia Velimukhametova, manager of the GLG European Distressed Fund, has picked out rising default rates as one of the key themes in the latest thinking around distressed debt investment opportunities.

The term ‘distressed investing’ traditionally relates to the purchase of securities in corporations that are unlikely to meet their debt obligations. In fact, some of the companies concerned may already have filed for bankruptcy while others are widely expected to do so in the not too distant future. As a consequence, the securities often trade at a significant discount to their par value and are considered attractive because substantial profits can be generated through receipt of a higher settlement during the liquidation process, or by accepting an equity stake in the restructured business.

Investing in a business that is close to bankruptcy does not sound like a particularly intuitive strategy. However, as Alumni Award Winner Charles Gradante once observed, “The key to distressed companies is that they all have bad balance sheets, but they could have either good or bad business models”. Consequently, an
important aspect of the distressed philosophy is to recognise that companies with unsustainably weak balance sheets, stemming from financial mismanagement, can actually be operationally sound and potentially profitable businesses.

Although distressed investors are usually able to find attractive investments throughout an economic cycle, periods of ‘peak harvest’ generally coincide with austere economic conditions. This is when a combination of corporate fallibility and financial complexity creates significant opportunity. Indeed, the concept of actively investing during, or shortly after, periods of recession makes a lot of sense as financial asset prices are usually depressed, while risk aversion effectively prevents mainstream investors from getting involved until signs of a broad recovery are evident.

In stressed or distressed scenarios, the valuation of a company’s debt securities can fall disproportionately relative to its degree of financial difficulties because of subjective influences such as fear and stigma. Regulations are also unsupportive as rules prevent institutional investors, such as pension funds, from holding a security once its rating has fallen below specified levels.

Similarly, high-yield funds cannot continue to hold bonds once they are in default. Such investors become ‘forced sellers’ which can create artificial downward pressure on the price of affected securities. Consequently, distressed investors can derive substantial profit from purchasing securities at depressed prices which do not fully reflect the break-up value of the related business, let alone its recovery potential.

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