What are Distresses Debts?
The term “distressed debt” is used in mergers and acquisitions to describe a situation where the debtor or borrower is having difficulty meeting its obligations. If a borrower is not able to repay all of their debt, they may be forced into bankruptcy, which typically results in the liquidation of their assets. This process can be quite time consuming, so distressed debt has been connected with an M&A strategy. A strategic buyer might purchase assets from the distressed company at a cut rate price in order to get out from under obligations without going through bankruptcy proceedings. This is often seen as a time-consuming process that can end up costing the buyer more than it saves.
Fintalent’s distressed debt consultants describe distressed debt as any obligation to repay money with a low probability of full repayment of principal and interest. This may include accounts receivable, bonds, loans, mortgages or lease payments. The payments are typically delinquent or in default. Lenders might choose to sell the delinquent debts at significant discounts in order to get some sort of return on their investment. This can also be referred to as “distressed debt” or “bad debt”. The process of collecting bad debt is known as distressed asset recovery (DAR).
In finance, a loan that has fallen into default has become distressed debt. The lender may sell the debt to a company or individual that specializes in buying distressed debt or they may try to collect the debt themselves. The latter case is referred to as “distressed debt recovery.” If a lender sells the defaulted loan to an agency, it is usually at a large discount, with the expectation of not receiving any more of their money.
Distressed Debt Recovery: A Key M&A Strategy
Distressed debt recovery is often conducted by specialized units within investment banks, private equity firms and hedge funds. Many financial institutions have specialists on staff whose sole responsibility is distressed debt recovery. While these specialists work on behalf of the lenders, they often act independently.
Distressed debt specialists can often offer debt at discounts of up to 25%. Most buyers of distressed debt will have the opportunity to negotiate a discount on their purchase. However, they are also required to pay some sort of fee for the privilege of buying a loan with a 90+% chance of default.
It is important to note that the distressed debt recovery stage is often a side-effect of an M&A deal. A buyer may have obligations to repay loans in the amount and timeframe that they are trying to acquire. Taking on thousands or millions in additional payment obligations from outside entities would only act as an additional strain on their resources.
In order to circumvent these issues, the buyer will often buy off the original lender. They do this in order to get out from under the obligations while allowing them to take over all of the assets of the distressed debtor. The creditor is often eager to get rid of an obligation with a high probability of default or failure due to their own financial vulnerability.
Distressed Debt Recovery in Financial Management
When distressed debt is purchased, often by private equity firms, special care has to be taken in its management and handling. Purchasing portfolios of delinquent loans can be extremely profitable if managed correctly. However, the profit comes at a price. There is the significant risk of investing in a portfolio of high-risk loans that might all go into default. While these are usually bad loans, there is always the possibility that one “priceless” loan will be repaid fully and on time. If this happens, a lender could lose hundreds of thousands or even millions from their original investment.
This type of situation has become quite common in recent years as commodity prices have declined and interest rates have stayed low for much longer than expected. Many financial institutions have had to take out substantial amounts of funding in order to maintain their existing operations and meet refinancing obligations. Many lenders have been reluctant to grant further loans due to their financial exposure. This has completely saturated the loan market and forced many borrowers, especially smaller companies, to turn to alternative forms of credit.
Most borrowers turn to non-bank lending options such as private equity firms, hedge funds or venture capitalists in order to restructure or pay off their debts. Many investors have taken advantage of these distressed situations and purchased portfolios of delinquent loans at large discounts. These portfolios often include loans that are 90+ days past due and have a substantially high probability of default.
The process involves much more than simply holding onto the debt until it either pays back or goes into default. There is much work involved with managing the distressed portfolio and shuffling it around in order to maximize revenue and returns on investment.
Debt Negotiation and Debt Selling: The Distressed Debt Recovery Process
When a borrower is having trouble keeping up with his or her payments, the lender will generally begin by offering flexible repayment terms. Often this consists of extending the term of the loan or reducing the interest rate in an effort to bring down payments to more manageable levels. If these concessions are not accepted, there is a good chance that the lender will begin to negotiate for debt that has already gone into default. This process is known as “debt negotiation.” Through debt negotiation, lenders can often get a substantial discount on their loans in return for waiving certain obligations and cutting their losses.
In order to negotiate the terms of their debt, many lenders will begin by offering a “haircut.” This is where the lender takes a percentage of the loan in return for waiving some or all of its rights to future payments. The haircut amount is often negotiated at a significant discount that brings it down to something equivalent to approximately 10% or less of the principal balance. Often both sides will agree on this deal and put it into writing.
Lenders will take far more extreme measures if no compromise can be reached through debt negotiation. In this case, they may file bankruptcy proceedings in an effort to guarantee that their losses are minimized. This process is known as “debt rescheduling.
This can often be even more beneficial to a lender than negotiating a haircut. A lender may have the right to foreclose on the assets of the borrower so they can keep the property, even though they are no longer required to make payments on the loan due to bankruptcy.
For example, let’s say that a borrower has just defaulted on his $50,000 loan. The lender is entitled to certain assets and other rights obtained by filing for bankruptcy. The most common asset that is foreclosed upon in these instances is often a prime piece of real estate (e.g., commercial or residential properties). Since many loans are secured by the properties that they were used to buy, the lender may be entitled to keep the property for themselves.
After filing for bankruptcy, a borrower may be required to go through a process known as “deficiency judgment.” This is where a court-appointed representative will attempt to determine whether there is enough left in collateral assets or income in order to make up the difference between the loan and its value. Once these assets have been identified, they will often be seized or liquidated (e.g., foreclosed). The lender will then recoup their losses through these means so that they can avoid further losses in trying to collect on the original loan balance.
