Investing in a Bankrupt Company

As soon as a company files for bankruptcy, the value of its debt, as well as equity securities, starts falling close to zero. In a large number of cases, this fall in value is justified as the company bites the dust in the near future, and the value of these securities officially becomes zero. Also, in many cases, certain stakeholder groups lose money even if the company continues to survive in the long run.

However, there are very few cases in which the shareholders make a lot of money while investing in companies on the verge of bankruptcy. This happens because the market often overreacts to the news of a bankruptcy filing, and the securities start selling for pennies on the dollar. When the market corrects itself, and the securities start selling at their actual value, these same securities end up giving a very attractive annualized return on the investment.

The reality is that it takes professional investors to make money from a company on the verge of bankruptcy. Many investors are not aware of the intricacies of making these investments and hence get their hands burned in the process.

In this article, we will have a closer look at some of the factors which are important while deciding whether or not to invest in a company facing bankruptcy.

Know the Judge: The judge is the most important person in the bankruptcy proceedings. To the layman, it might appear that the bankruptcy process is the same for everyone. However, the reality is very different. The same company could file for bankruptcy in two different jurisdictions under two different judges and could end up with very different results.

Some judges are known to be tough on debtor companies. On the other hand, some judges are known to be lenient towards debtor companies. This leniency may arise from the fact that they need to be seen as the savior of many investors and employees, as this would increase their chances of obtaining a prominent public position. Investors who specialize in investing in bankrupt companies are well versed with the entire process. They know the exact nature of the powers which a judge holds over a company. Then they make educated guesses about how the judge is likely to use this power.

Know the Creditors: Apart from the judge, investors who specialize in bankruptcy proceedings are also mindful of who the other creditors are. Any decision regarding the future of the debtor company has to be made in consultation with other creditors. The nature of the creditors' business often dictates their motives. Sometimes the motives of the creditors are complimentary, and hence the bankruptcy process is successful. At other times, the creditor's motives are opposed to each other. This creates a lot of infighting and delay. Professional investors know that delay in re-organization never works to the advantage of anybody since legal and other administrative costs keep adding up and reduce the final enterprise value, which is available to creditors.

Some of the common classes of creditors are as follows:

1. Large institutional investors often take stake early on in a company, and hence their purchase price if often close to the face value of the security. However, they have no shortage of funds and do not mind holding on for long periods of time if that means a higher return. Institutional investors are averse to risky maneuvers since their charters do not permit them to do so.

2. Vulture funds and individual investors are the opposite of this. They usually purchase the bonds at a steep discount when the news of bankruptcy is already out. They are interested in quickly wrapping up the process and moving on to the next target. These funds often take huge risks since they do not have any charters governing them.

3. Trade creditors are the third class of investors. These investors are only interested in recovering their money. They are not in the investment business and do not intend to take a stake in the company. They would even be willing to take a haircut if it means a faster recovery of their outstanding dues.

An educated investor knows exactly who is in control. They keep track of what kind of investors are selling out and at what price. They try to find out information that is not seen by regular investors like whether all the people purchasing the securities are connected to the management of the firm.

Creditors Committee

Professional investors realize that control over the bankruptcy process is important. This is the reason why some of them buy big stakes, which allows them to become a part of the creditors' committee. Once they are on this committee, they have a chance to influence the proceedings instead of being mute spectators. Having control over the outcome reduces the risk to a large extent.

Professional investors are also active participants in the first creditor's meeting. In these meetings, the statements of the officers of the debtor company are being recorded by the Department of Justice. Hence, when creditors ask some questions about the financial situation of the company, they can rest assured that the answers will be accurate and truthful. Professional investors tend to go prepared with pertinent questions at such meetings. These meetings also give them insights that are not available to an average investor.

The bottom line is that investing in companies on the verge of bankruptcy is an art. Nine out of ten investors fail in this endeavor. It takes a highly specialized form of knowledge to be successful in this regard.

Authorship/Referencing - About the Author(s)

The article is Written and Reviewed by Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.