Investing in troubled economic times can mean creating opportunity out of misfortune. Some call it “vulture” investing, but it gives dying companies a second chance for survival.

ILLUSTRATION BY JONATHAN CARLSON

FORTUNES TURNED SHARPLY in 2001 for venture capitalists, entrepreneurs, and investment bankers, but one group of the School’s alumni began to thrive. Investors in the world of distressed debt are busier than ever, and their numbers have multiplied. While some observers sound a cautionary note and point to a parallel with the VC frenzy of the late nineties, distressed-debt veterans will tell you this is a very different business, with very different challenges and, perhaps most important, very different people.

When companies get into financial trouble and become candidates for bankruptcy, they draw the attention of distressed-debt specialists who scope the market for undervalued debt securities of troubled companies. The current chaos offers a great opportunity by many measures. The number of corporate bankruptcies, the default rate, and the number of “fallen angels”—investment-grade companies that are downgraded to a high-yield rating—are all at cyclical highs.

With talk of opportunity in the face of other people’s woes, it is not surprising that distressed-debt investors are often labeled “vulture investors.” But this ignores the value these specialists bring to the reorganization process, providing a way out for the original investors.

Says Peter Copses, MBA ’86, a partner in the private equity firm Apollo Management in Los Angeles: “The label ‘vulture investor’ suggests you are capitalizing on someone else’s misery. In fact, what is happening is that something that started out as a debt security is being transferred from a traditional fixed-income investor to someone who is willing to hold what has economically become an equity security—and suffer the pain of seeing a company through a tough reorganization.”

Distressed-debt investors also bring a rational perspective to negotiations. “The most difficult negotiations are when original investors are still holding paper and have seen it go from 100 to 20,” says Janice Stanton, MBA ’85, a partner at Connecticut-based Contrarian Capital Management. “There is so much anger, and ultimately it does not advance the process.”

Some observers say too much money is chasing too few opportunities. Stanton’s classmate Marko Dimitrijevic, who runs Everest Capital, a multistrategy hedge fund in Miami that has a strong focus on distressed debt, disagrees. “I believe the enormous explosion on the supply side caused by the fallen angels and some large bankruptcies has more than made up for the increase in demand.” Dominique Mielle, MBA ’98, of Canyon Partners, a multistrategy hedge fund in Los Angeles founded by Drexel alumni, is less sanguine. “That new supply is mostly from very large public cases that are widely scrutinized, which makes it hard to have a real competitive edge,” she says.

Stanton predicts casualties among market participants. “It is not a case of a rising tide lifting all boats,” she says. “A couple of people will make a spectacular amount of money, but some players will just blow up. One of the key skills is to know when not to invest. That will be the big differentiator in the next year or so.”

If in some ways distressed debt has replaced venture as the hot area for investment, the mandate of a venture capitalist stands in stark contrast to that of a distressed-debt investor. Where a venture capitalist is a visionary looking for the next breakthrough technology, a distressed-debt investor is inherently a cynic with a show-me mentality and a religious focus on numbers, cash flow, and legal contract work.

Another obvious difference is that a distressed-debt investor invests in debt, while a venture capitalist invests in equity. The debt investor can hold the company to standards of financial health and performance, but an equity investor owns residual value only after the debt obligations are satisfied. Debt investors also have powers equity investors do not have. “If a company defaults on its debt obligations and management does not do what the lenders want, the lenders can organize and put the company in involuntary bankruptcy,” says Stanton.

Finally, the relationship with management is very different. A venture capitalist has close interaction with management, but in distressed debt the relationship is typically less cordial. “Very often, management itself is responsible for the company’s troubled situation,” Dimitrijevic notes.

Apollo’s Copses puts the impact of corporate fraud in perspective: “Despite all the headlines, the typical distressed situation is more likely to be a case of over-leveraging a business or paying too much for it in the first place, combined with some operational underperformance or a cyclical downturn. If there is a question about management integrity or reliability of financial data, it is very unlikely we would be interested,” he says. Apollo, a private equity firm, generally expects to take a more active approach in its distressed-debt investments than hedge funds, which tend to have a passive strategy. “We look at investing in distressed debt as one of several ways to buy a business,” says Copses.

The last time this niche in the investment management business caught the headlines was in the late eighties and early nineties. It was the tail end of Drexel, the S&Ls were failing, and there were big bankruptcies in retail and steel. Stanton, like Dimitrijevic and Copses, is a veteran of that period. She identifies two key differences between now and then. “Back then the failing businesses were more from so-called smokestack industries, industries that had real fixed assets and made tangible products, compared to the failing telecom and technology businesses we are seeing now. A second difference is that it used to be a much smaller field with only a couple of specialists. Today, there are a lot more players in this business.”

For all of them, every day seems to bring changes and new opportunities. “It is fascinating to watch how industries change over time and how investor perception changes with it,” explains Dimitrijevic. Mielle has a similar passion for the job: “The great thing in our business is that you are not only looking at the industry and the business, but you are also analyzing the capital structure and how it is going to be fixed. There is a huge amount of strategizing involved between the holders of the different parts of the capital structure that you do not see in other types of investing.”

The veterans in this business clearly enjoy the renewed interest in the discipline of value investing. But having been through a couple of investing cycles, they are well aware that some of the current momentum inevitably will fade. They realize that it is a cyclical business and investor memories are short. “There will always be opportunities to make money in distressed debt,” concludes Stanton. “In general, we do best in times of uncertainty, and it just so happens that today is a very uncertain time.”