Distressed Investing and Its Advantages for Hedge Managers.

​Investors have many alternatives to investing in stocks, bonds, and cash investments. Debt investing is an alternative investment vehicle that falls into private and distressed investing (also referred to as distressed debt investing) categories. It involves investing money in a company, public entity, or government debt, organizations usually in financial distress.

While it seems strange to invest in debt, distressed debt investing offers hedge managers advantages. Investors who are interested in this vehicle for generating income look at companies with an unstable capital structure (high debt load or difficulty refinancing) or companies with problems meeting stipulations on current debt agreements.

Another way to determine if a debt is distressed is to see if the debt is traded at a large discount. This percentage can range between a 20 and 80 percent discount. In some cases, an investor might purchase a $500 bond for $200, which indicates that the company borrowing the money might risk defaulting.

However, when looking to invest in distressed debt, investors do not only rely on the percent the debt is discounted factor. Other factors investors consider include whether the company is operating under a successful business model and if the company is offering an in-demand product or service.

After the investor chooses a company to invest in, they approach generating money in one of two ways. The first method is to restructure the company, which is more likely if the investor has a controlling share in the business. This share presents opportunities for the investor to become an equity owner simply because they own a stake in the company.

Another way investors generate income is if the company is in bankruptcy and forced to liquidate assets. In this instance, debt investors get paid from liquidated assets before debt owners.
However, investing this way has caveats as well. For one, the investor might have limited information outside of public records, which places the investor in the position of making uninformed decisions. Further, other debt investors might gradually buy more shares in the company, which makes for increased competition. Finally, restructuring does not bring with it any guarantees that it will become successful.

Even with these caveats, this method of investing has advantages. One immediate benefit is it allows the investor to reap the financial rewards after the company undergoes restructuring and the ability to influence its direction. The second benefit is that if the company is in bankruptcy, the distressed debt investor is guaranteed returns after liquidating its assets. The latter is not the best scenario, but it is one way for investors to provide safeguards against losses.

For the hedge fund manager, distressed debt investing provides the opportunity to get huge returns on their investment. The hedge fund manager takes money pooled from investors and invests it in companies that generate extremely high returns. The money is usually aggressively invested (sometimes risky), so the returns beat the market's performance, presenting substantial earnings potential for the hedge manager himself.

Usually, hedge funds invest in the bond market, but they also can be found in the mutual fund market. In the case of purchasing debt from mutual funds, hedge fund managers can buy huge amounts of debt from mutual funds without influencing market prices while avoiding exchange commissions.

Hedge fund managers invest in distressed businesses as well. In this role, the hedge fund can act as a lender that extends credit to a business while working with it. If the hedge fund takes an active role in the business, this provides the manager more control over decision-making where they play an integral role in dispensing advice to a troubled company.