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A Market Survey
Stuart C. Gilson
uring the past ten years, the number of bank- greatly in value under the weight of high inflation
D ruptcy filings, debt restructurings, and junk and the massive war debt, in the h~pe that Hamil-
ton's program would be completed.
bond defaults by U.S. public companies reached re-
cord levels. One of the most important and enduring What is unique about today's distressed debt
market is its size and scope. There is a market for
legacies of this period has been the development of
virtually every kind of distressed claim: bank loans,
an active secondary market for trading in the finan- debentures, trade payables, private placements, real
cial claims of these companies. The participants in estate mortgages even claims for legal damages
this market include many mainstream institutional and rejected lease contracts. It is only a slight exag-
investors, money managers, and hedge funds, as geration to suggest that anything that is not nailed
well as certain individuals--known as "vultures"-- down will be traded when a firm becomes financially
who specialize in trading distressed claims. distressed. Two and a half years into the Chapter 11
The strategies these investors use are as diverse bankruptcy of R.H. Macy, 728 of the firm's claims
as the claims they trade and the companies they had traded for a total dollar value of $510 million. In
target. Some investors prefer to acquire the debt the recent bankruptcy of Hills Department Stores,
claims of a company while it tries to reorganize more than 2,000 claims exchanged hands.
under Chapter 11 so they can either influence the The market for distressed claims is also quite
terms of the reorganization or wait until the com- large. In 1992, coming off the peak of the most recent
pany's debt is converted into a major equity stake bankruptcy cycle, one estimate placed the total
that can be used to influence company policy. Some amount of U.S. corporate debt that was either dis-
investors prefer to purchase senior claims, others tressed or in default at $159 billion (face value). 2 In
prefer junior claims, and still others spread their 1993, Investment Dealer's Digest identified 27 major
purchases throughout the entire capital structure. investment funds that specialized in buying dis-
Some investors choose to take a passive role, seeking tressed claims, managing total assets of more than
out undervalued claims, "hitching their wagons" to $20 billion. (To put this figure in context, the total
that of a more active vulture investor or holding amount of money under management in U.S. ven-
distressed securities as part of a broadly diversified ture ca P3ital funds in 1993 was approximately $27
portfolio. billion.) Also in 1993, the annual volume of trading
The business of trading in distressed debt is not in distressed bank debt alone approached $10 bil-
new. In the chaos that immediately followed the lion. 4
American Revolution, Treasury Secretary Alexander The level of financial distress in the economy,
Hamilton proposed to restore confidence in the fi- hence the supply of distressed debt, is of course
nancial system by redeeming, at face value, the highly cyclical. As Table I shows, the past few years
bonds the American states had issued to finance the have seen fewer opportunities to invest in distressed
war. On the heels of this proposal, speculators ac- situations, as measured by the number or size of
quired large quantities of the bonds, which had fallen publicly held firms that filed for Chapter 11 (al-
though this group represents only part of the mar-
ket). In part, this trend reflects the final weeding out
Stuart Gilson is an associate professor of business of poorly structured deals from the 1980s. In part, the
administration at Harvard University. downtrend is the result of recent improvements in
© 1995, AIMR®
Table 1. Frequency and Size of Chapter 11 Rlings and Other Corporate Restructuring Transactions by Publicly
Traded Rrms, 1981-94
Number of Transactions Total Value of Transactions ($billions) a
Hostile Hostile
Chapter 11 Tender Leveraged Chapter 11 Tender Leveraged
Year Filings Offers Buyouts Spinoffs Filings Offers Buyouts Spinoffs
1981 74 10 14 2 $6.0 $8.6 $2.7 $1.3
1982 84 8 15 3 11.3 3.4 2.1 0.2
1983 89 9 47 17 15.4 2.5 3.1 3.6
1984 121 9 113 13 7.9 3.3 18.7 1.3
1985 149 12 156 19 6.9 20.3 18.9 1.5
1986 149 17 238 26 15.9 20.6 56.6 4.4
1987 112 16 214 20 49.5 6.1 51.5 3.5
1988 122 28 300 34 49.9 50.0 66.7 12.8
1989 135 15 305 25 78.0 50.0 82.9 8.0
1990 116 5 201 27 85.7 9.0 18.6 5.4
1991 125 3 193 18 86.1 2.8 7.4 4.8
1992 91 1 223 19 55.4 0.5 8.2 5.8
1993 86 1 176 26 17.1 0.0b 10.2 14.4
1994 70 7 159 28 8.3 12.4 8.3 23.4
Total 1,523 141 2,354 277 $493.3 $189.4 $355.8 $90.5
aAll dollar values are converted into constant 1994 dollars using the producer price index. For a Chapter 11 filing, "Total Value of
Transaction" equals the book value of total assets of the filing firm. For a hostile tender offer and for a leveraged buyout, "Total Value of
Transaction" equals the total value of consideration paid by the acquirer (including assumption of debt), excluding fees and expenses. For
a spinoff, "Total Value of Transaction" equals the market value of the common stock of the spun-off entity evaluated at the first
non-when-issued stock price available after the spinoff.
bLess than $0.1 billion.
Sources: The 1995 Bankruptcy Yearbook and Almanac and Securities Data Corporation.
the economy. The supply of distressed debt, how- structuring with their creditors. In the United States,
ever--both within the United States and abroad--is corporate bankruptcy reorganizations take place un-
certain to rise again. Table 1 also shows that the der Chapter 11 of the U.S. Bankruptcy Code. Firms
market for distressed debt has historically provided that liquidate file under Chapter 7. In practice, most
more investment opportunities than other corporate
firms--more than nine in ten--first try to restructure
restructuring transactions that have traditionally at-
tracted the interest of investors, including hostile their debt out of court and only when this fails do
tender offers, LBOs, and spinoffs. they file for bankruptcy. A recent academic study
This article surveys the theory and practice of found that approximately 50 percent of all U.S. pub-
investing in distressed situations. Trading practices lic firms that experienced financial distress in the
in the market for distressed claims have become 1980s successfully dealt with their problems by re-
more sophisticated and institutionalized as the vol- structuring their debt out of court, s
ume of activity has grown. To investors who are An out-of-court restructuring can almost always
unfamiliar with this market, these methods may be accomplished at much lower cost than a court-su-
seem arcane and complex. One goal of this survey is pervised reorganization. Part of this difference re-
to show that the core strategies for realizing value in flects savings in legal and other administrative costs.
distressed situations are relatively straightforward. More importantly, Chapter 11 generally imposes a
Another goal is to describe and analyze the various much heavier burden on the business because of the
risks--most of them highly firm specific and idiosyn- greater demands placed on management's time and
cratic-that one faces when purchasing distressed costly delays engendered by litigation. Consistent
claims. Understanding how to manage these risks is with this cost differential, Gilson et al. found that
key to earning superior returns in this market. I firms that successfully restructure their debt out of
conclude by discussing future opportunities in dis- court experience significant increases in their com-
tressed situation investing. mon stock price (approximately 30 percent, on aver-
age, after adjusting for risk and market movements)
from the time they first experience financial distress
BASIC RESTRUCTURING OPTIONS to when they complete their restructuring. Over a
Investing in distressed situations involves purchas- corresponding interval, firms that try to restructure
ing the financial claims of firms that have filed for out of court but fail experience significant average
legal bankruptcy protection or else are trying to stock price declines (also on the order of 30 percent).
avoid bankruptcy by negotiating an out-of-court re- Chapter 11, however, also provides certain bene-