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Sometimes referred to as vulture capital or distressed securities, distressed debt includes the bonds and other forms of securities connected with a business that is undergoing bankruptcy or is likely to do so in the near future. In many cases, the purchase of these instruments is done with the anticipation that the company will emerge from its financial woes and become profitable again. In the interim, the purchase of the debt allows the new shareholders or bondholders to actively participate in the process of reorganizing the company as it attempts to position itself for a return to profitability.
Less commonly, the purchase of distressed debt is a strategy used by corporate raiders. This is often the case when the failing company owns a number of assets that the raiders believe can be sold for substantially more than the money invested in purchasing stocks and bonds issued by the business. Upon gaining control of the company, the raiders can force the sale of any remaining shares, acquire full control, and begin dismantling the business. As part of that dismantling, assets are sold to pay off the company’s debts, with the remaining profit going directly to the raiders.
There is actually a great deal of money to be made by acquiring distressed debt. As with any type of investment process, investors must look closely at a number of factors before attempting to purchase stocks and bonds issued by companies about to fail. This includes understanding what is happening in the marketplace with similar companies, the reasons why the business is failing to turn a profit, and what can reasonably be done to salvage the company and restore it to profitability. Assuming an investor feels that there is a good chance the company can be saved and made profitable once more, the investment in distressed debt can be a wise decision.
There are risks associated with acquiring distressed debt. One of the most obvious is that the projected performance of the company fails to take place. When this is the case, the stocks and bonds may become worth less than the investor initially paid for them, resulting in a loss. If the plan is to acquire the distressed debt, then force the sale of any remaining stocks and bonds to a corporate raider, there is always the chance that the remaining shareholders will balk, effectively causing the plan to stall. At that juncture, the raider must decide whether to hang onto the acquired shares or sell them, often at a loss, to the shareholders who will not sell their investment in the distressed company.