Distressed Credit and Due Diligence

Distressed Credit and Due Diligence
Investing in distressed debt (Distressed Credit Investing) represents a specialized niche in the world of private credit and alternative investments, requiring a unique combination of credit analysis, legal expertise, and corporate restructuring skills. Distressed credit includes the purchase of debt instruments of companies experiencing financial difficulties—bonds and loans trading at a significant discount to par (typically below 70 cents on the dollar) or with yields exceeding Treasury yields by 1,000+ bps (OAS > 1,000 bps).
The attractiveness of distressed investing: potential returns of 15–25%+ IRR due to the purchase of assets at a substantial discount and subsequent value recovery through restructuring, operational improvements, or simply normalization of market conditions. The global volume of distressed and special situations AUM is estimated at $350–400B, with the largest managers—Oaktree Capital (Howard Marks), Apollo Global Management, Cerberus, Elliott Management.

Purchasing Distressed Debt: Strategies and Tactics
The Loan-to-Own strategy is the most aggressive form of distressed investing, where the investor acquires the debt of a troubled company with the aim of converting this debt into a controlling equity stake through bankruptcy proceedings (Chapter 11 Bankruptcy) or out-of-court restructuring (Out-of-Court Restructuring).
Process: the investor buys the fulcrum security—a class of debt that, in the restructuring process, will be converted into equity (typically the most junior class of debt expected to receive partial recovery).
Target return: 20–40% IRR with a holding period of 2–4 years.
Key skills: deep understanding of bankruptcy law (Chapters 7 and 11 of the U.S. Bankruptcy Code), ability to negotiate with creditors of different classes, capacity to assess enterprise value of the distressed company under uncertainty.

Trading distressed debt is a more liquid strategy, involving the purchase of distressed bonds and loans on the secondary market at reduced prices and sale after price recovery (without participation in restructuring).
Catalyst-driven approach: purchase at a specific negative event (covenant violation, credit downgrade, sector-wide sell-off) with an expectation of a rebound as the situation normalizes.
Contrarian approach: purchase of an entire sector during market panic, when "baby-and-bathwater" dynamics (indiscriminate selling) create opportunities in quality credits that have unjustifiably depreciated.

Special situations—a hybrid strategy: investing in the debt of companies undergoing specific corporate events (spin-off, M&A, regulatory change, litigation settlement) that create temporary dislocation in debt pricing.

GP Evaluation: Track Record and Team Stability
The choice of manager (General Partner, GP) is the most critical decision when investing in distressed credit funds, since results in this segment are characterized by an extremely wide dispersion between the best and worst managers: top quartile generates net IRR 15–25%, bottom quartile—0–5% or losses.
Track record analysis: performance is evaluated for at least 3 full credit cycles (15+ years) with an emphasis on behavior during stress periods (2008–2009, 2015–2016, 2020); key metrics—net IRR, net MOIC (Multiple on Invested Capital), DPI (Distributions to Paid-In—realized return), loss ratio (share of loss-making investments), workout timeline (average time to restructuring and exit).
Team stability—a critical factor in distressed investing, as success depends on the expertise of specific professionals, not systematic processes.

Evaluate:

• tenure of key investment professionals—CIO, Portfolio Managers, Restructuring Specialists should have worked together for at least 5–7 years;
• attribution analysis—ability to identify which team members generated returns (key-man dependency risk);
• succession planning—succession plan for senior partners;
• compensation structure—compensation should incentivize long-term value creation (long-vesting carry, co-investment requirements, clawback provisions).

Operational due diligence: compliance and risk management infrastructure, independent valuers (Third-Party Valuations), conflicts of interest (managing multiple funds with overlapping strategies), trading infrastructure (Trading Infrastructure—execution and settlement systems).

Portfolio Company Analysis: EBITDA, Leverage Ratios
The analysis of portfolio companies in a distressed context requires adjustment of standard financial metrics.

Adjusted EBITDA—in distressed situations it is especially important to critically assess the “add-backs” included by management in reported EBITDA: one-time restructuring charges, litigation costs, management fees, synergy adjustments (in case of M&A). Aggressive add-backs may inflate EBITDA by 20–40%, distorting real creditworthiness.

Run-rate EBITDA—a normalized figure reflecting the company’s sustainable profitability after completion of restructuring and elimination of one-off factors.

Leverage Ratios:

• Total Debt / EBITDA—total leverage; for mid-sized companies sustainable leverage usually does not exceed 4.0–5.0x; above 6.0x—high risk of default during an economic downturn;
• Senior Debt / EBITDA—senior debt leverage;
• Net Debt / EBITDA = (Total Debt – Cash) / EBITDA—net leverage, considering company cash balances;
• Interest Coverage Ratio = EBITDA / Cash Interest Expense—ability to service interest payments; below 1.5x—a serious risk of default;
• Fixed Charge Coverage Ratio = (EBITDA – CAPEX – Taxes) / (Interest + Scheduled Principal)—the most conservative metric, accounting for all mandatory payments.

Covenant Structure and Exit Scenarios
Covenant structure defines the creditor’s rights and borrower’s restrictions over the life of the loan. In a distressed context, covenants play a critical role: covenant breach provides the creditor with leverage to initiate restructuring, modify loan terms, or obtain additional collateral.

Affirmative Covenants—borrower obligations (providing financial statements, maintaining insurance, complying with law).
Negative Covenants—limitations (limitation on indebtedness—limiting additional debt; limitation on liens—restricting pledge of assets; limitation on restricted payments—limiting dividends and buybacks; limitation on asset sales—limiting asset dispositions).
Financial Covenants—quantitative metrics (Maximum Leverage, Minimum Coverage, Minimum Liquidity), tested quarterly.

Exit Scenario Analysis is the concluding stage of due diligence in distressed investing.
Scenario 1—Rehabilitation: the company overcomes financial difficulties, the debt is refinanced on market terms, the investor receives full repayment plus coupon income; return 10–15% IRR.
Scenario 2—Consensual Restructuring: creditors and borrower agree to revise terms—lower interest rate, term extension, partial write-down (Haircut), debt-for-equity swap; return depends on terms—from –20% to +30%.
Scenario 3—Chapter 11 / Formal Insolvency: judicial restructuring with a Plan of Reorganization; for Loan-to-Own strategy—conversion of debt to equity, return 20–40% IRR if successful exit through business sale or IPO in 2–4 years.
Scenario 4—Liquidation: worst case, sale of assets at liquidation value; recovery 20–50% for Senior Secured, 0–20% for subordinated debt.

Practical recommendations for the UHNWI investor:

• allocation to distressed credit should not exceed 5–10% of the overall portfolio due to high volatility and illiquidity;
• invest via specialized funds with proven track record (Oaktree, Apollo, Ares, GSO/Blackstone Credit) rather than direct investments—expertise in restructuring and bankruptcy is critically important;
• diversify by vintage years—distressed opportunities are cyclical and occur in waves;
• understand the J-curve effect—distressed funds typically show negative returns in the first 1–2 years (deployment and “marking” phase), then generate returns as investments are realized;
• require detailed reporting from the GP on each position, including current valuation (Mark-to-Market or Mark-to-Model), restructuring status, expected timeline, and exit plan.