Regular municipal analysis deals mainly with estimating the probability of default. Distressed investors assume an event of default will occur and are mainly concerned with post-default valuation. They implicitly make the following assumptions: (1) The economic and structural issues affecting the troubled credits are known or discoverable, since distressed bonds can be purchased with the benefit of hindsight; (2) they can restructure the debt to better reflect the actual cash flow value of the underlying assets; and (3) the bonds can be purchased at a dollar price that is meaningfully lower than the value of the underlying assets, even after all workout costs are factored in.
Thus, a successful approach to distressed investing would include the following key ingredients: (1) Accumulate a sufficient ownership interest in the bonds to gain legal and economic control of the workout process; (2) perform due diligence on the underlying assets to identify all risk factors, including project site visits, inspections, and so on; (3) accurately model the value of the underlying assets under various legal outcomes; and, last but not least, (4) formulate an effective exit strategy that maximizes recovery value to the bondholders.
Let’s examine each of these factors in more detail.
As any distressed investor (on the corporate as well as the municipal side) will attest to, it is very difficult—if ...