Distress Investing
Subtitled Principles and Technique.
Summary
Whitman and Diz set out the mechanics of investing in the securities of financially troubled companies, covering Chapter 11 reorganisation, out-of-court restructurings, credit agreements, fraudulent conveyance, absolute priority, and the valuation of claims through a bankruptcy process. It is a practitioner text built around the legal architecture rather than a narrative.
Whitman's distinctive position is that the standard academic finance framework is close to useless for this work. He argues that distress investing requires the investor to analyse the specific documents, being the indenture, the credit agreement and the plan of reorganisation, and to understand where in the capital structure value will break. He emphasises what he calls the fulcrum security, the class of claims that will convert into the equity of the reorganised company, and argues that identifying it correctly is the central analytical task. He also stresses that Chapter 11 outcomes are negotiated among creditor classes and are shaped by process, timing and control of the plan, not by valuation alone.
The book includes case material from Kmart and other reorganisations of the period. It is best used as a technical reference by people who already work in credit or special situations, and it is heavy going for a general reader. The bankruptcy code has been amended since publication, notably in ways affecting exclusivity periods and lease treatment, and the market structure has changed with the growth of loan-to-own strategies, liability management transactions and non-pro-rata uptier exchanges, none of which the book addresses.
Key takeaways 7
- The central analytical task in distress investing is identifying the fulcrum security, meaning the claim class that will receive the reorganised equity.
- Distress investing requires reading the actual credit documents, since covenant terms and intercreditor provisions determine outcomes more than enterprise valuation does.
- Chapter 11 outcomes are negotiated among creditor classes, so process control and timing affect recoveries as much as underlying asset value.
- Standard modern finance theory, including efficient markets and the capital asset pricing model, provides no useful guidance for pricing distressed claims.
- Absolute priority is frequently violated in practice through negotiated settlements, which means junior classes can extract value they are not legally entitled to.
- Creditworthiness should be assessed from the resource conversion possibilities of the assets rather than from earnings power alone.
- The costs and duration of a bankruptcy process are a material determinant of recovery and must be modelled explicitly.
Who should read it
Credit and special situations investors who need a technical grounding in bankruptcy mechanics and claim valuation, recognising that the legal detail has moved on.
About Martin J. Whitman
Founder and Chairman, Third Avenue Management; portfolio manager, Third Avenue Value Fund 1990-2012
Four books plus three decades of unusually didactic shareholder letters built out safe-and-cheap and distress investing as a distinct branch of the value tradition.
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