How do investors make money from bankrupt or restructuring companies?

”How did you go bankrupt?” “Two ways,” Mike Campbell said. “Gradually and then suddenly.” (Ernest Hemingway’s The Sun Also Rises)

When troubled companies go through restructurings, distressed investing comes into play. It’s a niche segment that involves looking for mispriced securities of companies that are in restructuring or in the midst of major change. It’s messy work that rewards players with profits for handling high stakes that scare most others off. It takes hard work, a love for long legal documents, and research to figure out which ones are mispriced. It’s a scary space as it can be complex. However, that’s exactly why it may present opportunities, too.

Bankruptcy wasn’t always seen this way. Up until the middle of the 1800s a man who defaulted on a loan was treated with utter disdain, and often jailed in the local debtors’ prison tower, called the Schuldturm. The term bankrupt derives from the Italian banco rotto, or broken bench of a merchant who didn’t pay. Today the ways of expressing that disdain are less violent (except for the mafia).

Even now, borrowing and bankruptcy is viewed differently depending on the culture. Europe is rather old-fashioned. Using borrowed money for anything is frowned upon. A German seldom uses a credit card - except when traveling abroad. And in cases of bankruptcy there’s still a stigma attached to it that lasts for years.

But in America, borrowing is standard. Those who default on loans can get second and third chances. Even so, interest rates are higher for riskier borrowers. The market sets a cost on the price of borrowing, and sets it by the likelihood of getting the money back. Everything has a cost.

Companies are in the same boat. In many European countries, firms that failed were mostly liquidated. In the U.S., though, failing firms are more often pushed to restructure, rather than disappear altogether.

Bankruptcy Law

If a firm does not pay their creditors the cash that is owed on time, that is default. What happens then is bankruptcy law, which gives relief from payments that cannot be made. The main job of the judge is to help creditors get as much cash back as possible. Hertz is an example. When it went into bankruptcy the judge allowed the creditor-controlled Hertz to sell new shares though shareholders stood to lose everything. It was madness. The SEC eventually stepped in and stopped it.

Companies can file for either Chapter 7 or 11. Chapter 7 shuts down the business. A trustee sells assets and pays creditors and owners. Common shareholders are last in line, and these shares tend to be worthless.

Chapter 11 is the second chance. Its purpose is to preserve a business, and not shut it down. Control of the company stays with the debtor in Chapter 11. That’s the most common chapter for public companies. Chapter 11 can be a great option when a restructuring could save the firm. A recovery plan must be presented, and owners and creditors vote.

When companies file for bankruptcy, the question of how the company goes forward - or if it survives at all - is asked. The questions that decide a troubled firm’s fate:

• Is the cash crunch temporary?
• Is there a recovery plan?
• How much are the assets worth?
• How will the future cash flows stack up against the liquidation value of the assets?

Many people think bankruptcy is the creditor vs. debtor, but that’s not true. Bankruptcy is really a battle between creditors. The secured bondholders are first in line and they steer the process. How much they can recover will decide how they behave.

Now, where’s the opportunity? If the business in bankruptcy has a decent chance of going forward, creditors sometimes swap debt for equity (a recapitalization). That gives them the upside if the business recovers.

That opportunity can emerge in almost any layer of the capital structure. Bonds trading at big discounts that are unlikely to default. Preferred shares. Turnaround bets can be risky but can pay off. Careful analysis and due diligence can reveal what the market has overlooked. No guarantees. Every case is its own. A turnaround in prospects may be brought about with a new turnaround CEO, some hidden asset the market is missing and is not pricing into the shares or a company beaten down by recession whose prospects are turning around as growth comes back. You just never know.

The bottom line

Well, distressed investing, done the right way, can turn a negative into a positive. It’s a way for capital to get recycled, for jobs and companies to be preserved. If you know the process, the risks are lessened. There are even circumstances under which distressed debt converts into equity and that means ownership and control over certain aspects.

To succeed at distressed investing you will need a stout heart, an aggressive streak - and solid fundamental analysis and research skills. There are no hard rules.