Understanding the nuanced differences between distressed debt and distressed operations is crucial for investors who may be considering distressed investing. Both concepts share the commonality of distress but refer to different situations that could be impacting a property or its borrowers/owners.1
While distressed debt investing relies on the recovery of troubled loans, distressed operations investing involves turning around struggling companies. In many situations, properties and their borrowers/owners could be dealing with either one or both of these challenges.
Distressed debt – aka troubled troubled loans
Distressed debt often refers to loans that are non-performing. The non-performing status can be due to various reasons – the borrowers (which could be public or private companies, local or federal governments, and other types of organizations) – might be failing to make timely interest or principal payments. Or, the underlying assets, such as properties, may have decreased in value, making the recovery of the loan uncertain.1
Often, distressed debt emerges as a form of investment when a bank must manage its balance sheet due to an abundance of non-performing loans. These loans are typically sold at a significant discount.
Generally, many Investors interested in distressed debt aim to purchase these troubled loans at a significant discount, betting on the recovery of value in the future.2
Distressed operations – good companies, bad balance sheets
Distressed operations refer to a situation where a fundamentally solid company is facing operational challenges due to having the wrong capital structure. In simpler terms, the company has too much debt, and that debt is hampering its ability to function efficiently and grow.
In these cases, the company might be generating good revenues and maintaining a stable market position, but the burden of heavy debts and high interest payments can lead to cash flow issues.3
The challenge in distressed operations lies not in the core business operations of the company, but in the over-leveraged structure that impedes its performance and growth. To solve this problem, the company might need to undergo a restructuring process, which often involves renegotiating debt terms with lenders, reducing operational costs, or even leading the company through a bankruptcy process for a fresh start.
Typically, investors focusing on distressed operations seek out these companies, hoping to help them overcome their financial challenges and tap into their underlying value.4
Implications for real assets
Both distressed debt and distressed operations scenarios have direct implications on real assets, specifically property.
For properties held as collateral against distressed debt, the risk of foreclosure becomes apparent, particularly if the debt continues to be non-performing. Borrowers and owners, in this scenario, face the risk of losing their properties.
In cases of distressed operations, the properties themselves might be fundamentally sound, but the over-leveraged structure of the borrower or owner may potentially put them at risk. The restructuring process may involve asset sales, potentially including properties, to decrease the debt burden.4
More than semantics
Distinguishing between distressed debt and distressed operations is not just a matter of semantics – it's crucial for understanding the fundamental nature of the financial challenge at hand and informing the appropriate strategies for recovery.
Investing in distressed debt may potentially offer a favorable outcome but commonly also carries a higher degree of risk, mainly related to the borrower's ability to repay the debt. Therefore, it typically requires sophisticated risk management and experience to navigate.3
Market volatility or lack of liquidity could impair an investment’s profitability or result in losses. Factors such as high vacancy, oversupply of the product in the market, increase in interest rates for borrowing loans, bad credit quality of tenants occupying the property, general economic risks such as interest rates, availability of credit, inflation rates, economic uncertainty, changes in laws and general overall deterioration of the market in which the asset sits, all of which could lead to financial difficulties and impact net operating income and can depreciate the value of the property. These factors, in addition to others including increases in the costs in excess of the budgeted costs, the burdens of ownership of real property, environmental liabilities, contingent liabilities on disposition of assets acts of God, pandemics and other national, regional or local emergency conditions, terrorist attacks, and war may affect the level and volatility of asset prices and the liquidity of investment assets.
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