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Bankruptcy is back – at least in the hopes and dreams of heavily capitalised investors jockeying over a finite amount of distressed debt. The wave of bankruptcies expected by some has yet to materialise. But, as a range of US companies descend toward default, distressed debt investors are spending long days sniffing out so-called fulcrum securities that could make or break their funds when debt-burdened companies reorganise.
Some 15 US distressed debt funds raised a total of $33bn in 2007, four times the amount in 2006, according to Private Equity Intelligence. If the 34 funds raising capital this year hit their targets (perhaps a stretch), the pool of vulture capital will balloon by another $47bn. Distressed debt investors seeking to win control of a bankrupt business, in what is called a loan-to-own scenario, can choose from several courses of action. One entails identifying and buying fulcrum securities from the layer of a firm’s capital structure they believe is most likely to convert into equity once the company is reorganised.
Judging which layers of the capital structure fit the bill involves a fair amount of risk, however. Buy into a tier too high and you might merely recover your investment. Buy just a layer too low and you won’t recover a dime as the company’s bones are picked clean. The fulcrum can fall anywhere between secured bank debt at the top and unsecured, subordinated bonds further down. Judges, as well as other creditors, can have unpredictable effects on the outcome. What is more, most distressed investors use only public information in their analysis in order to avoid restrictions on trading in the target’s securities.
Fulcrum-finding is as much art as science. With a slew of new investors trying their hand against a range of more seasoned firms, a few see-saws may come crashing to the ground.