Hedge funds can give massive yields in fairly short periods of time, and viz-versa can lose a lot of money just as quickly. What sort of investments can give such extreme returns? The answer investing in distressed debt. At Reorg all your financial requirements are handled by a team of highly qualified professional staff.
Distressed debt can be roughly defined as the debts of companies that have filed for bankruptcy or are expected to announce for bankruptcy in the near future. Distressed debt are bonds and securities bought from companies that are in insolvency or on the brink of it.
The intriguing question is why a hedge fund, or any investor, would invest in bonds/securities of high default risk. The answer is simple. The higher the level of risk you take, the higher the return. Here we will explore the connection between hedge funds and distressed debt, how mediocre investors can invest in such securities, and whether the high returns support the taken risk.
What Is a Hedge Fund?
Hedge funds are investments using mutual funds that put various strategies to make active money, for their investors.
It is essential to note that hedge funds are generally only reachable to recognized investors as they require less SEC regulations compared to other funds. Hedge funds face less regulation than mutual funds and other investment channels. This aspect of hedge fund industry has set it apart from other mutual funds.
The Potential for Profit
Hedge funds that invest in distressed debt look for entities that could be productively revamped or in some way revived to again become lucrative ventures. Hedge funds can purchase distressed debt mostly in the form of bonds, at a very low percentage of face value. If the once-distressed company comes out from insolvency as a profit-making firm, the hedge fund sells the company’s bonds for a significantly higher price. This potential for high profit even though risky is particularly attractive to hedge funds.
Sources of Distressed Debt for hedge fund
Hedge fund managers and other institutional investors finance in distresses debts via many avenues. Usually investors find distressed debt through the bond market, mutual funds, or the distressed companies itself.
The simplest and easiest way for a hedge fund to gain access to distressed debt is from the bond markets. Majority of mutual funds are excluded from holding securities that have failed to fulfill their debt obligation. After a firm default’s distresses debt are available for hedge fund.
Hedge funds can buy straight from mutual funds. Such transactions are mutually beneficial. In a such transactions, hedge funds can acquire larger quantities, and mutual funds can sell larger quantities. Neither of the two parties has to worry about how such large transactions will affect market prices.
The hedge fund goes directly to the company and offer credit on behalf of the fund. This credit is in the form of bonds or a revolving credit facility. The distressed company is in dire needs of cash to get out of the default situation. When more than one hedge fund offer credit, then nobody gets overexposed to the default risk investing too much money in a single position or market. More often multiple hedge funds and investment banks usually undertake the endeavor together.
Hedge funds get too much involved with the distressed firm. Some firm management, inexperienced with bankruptcy situations take advice from hedge fund who have bought the distressed debt. This way the hedge fund gets more control over their investment, and this improves their chances of success. Hedge funds can alter the terms of repayment to provide the company with more flexibility.
Risks to Hedge Funds
In case of bankruptcy owning the debt of a distressed company is more profitable than owning its equity. The reason being, debt takes priority over equity in its claim on assets if the company is dissolved.
Hedge funds minimize losses by taking small positions in relation to their overall size. Since distressed debt can offer potentially high returns, even relatively small investments can add hundreds of basis points to a fund’s overall return on capital.
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