Distressed Private Equity: Where Private Equity & Hedge Fund Converge

1. What is Distressed Private Equity?

1.1. Distressed private equity definition

Distressed private equity invests in a troubled company’s debt or equity, then sells or takes them to the public market to earn higher return. In a nutshell, distressed private equity is a hybrid model between the traditional leveraged buy-out model (a.k.a private equity) and distressed debt trading (a.k.a hedge fund).

As a common market trend, distressed private equity will always rise whenever a crisis, a recession, pandemic or war happen. Intertrust’s survey of 150 private equity firms across North America, EMEA and Asia in Covid-19 shows that 90% of PE managers believe there will be an increase of distressed fund transactions in the next 12 months. 

Although distressed private equity will get more spotlight during recession, this strategy can also be active in traditional PE firms, as there are always some distressed companies that the funds can buy to turn them around. 

1.2. Distressed private equity vs hedge fund

There is significant overlap between hedge funds and private equity firms in the distressed space, but the main difference between hedge funds and distressed private equity lies in two aspects – liquidity and investment restrictions. Distressed PE is more illiquid than hedge funds, and generally bear more restrictions on asset classes that they can invest in.

1.3. Distressed private equity vs traditional private equity

Traditional private equity generally invests in companies with growth potential, whereas distressed private equity invests in a distressed company’s debt or equity during bankruptcy or restructuring processes. However, the general partners of both PE types go through the same process of raising capital from limited partners, sourcing deals, investing in certain companies, managing the portfolio and finding exit options. 

The main difference between distressed PE and conventional PE lies in the “hedge fund” element of distressed PE, which is reflected through common investing strategies of distressed private equity firms as described in the next part.

2. Common Distressed Private Equity Strategies

There are 5 popular strategies distressed private equity firms commonly use to invest:

• Strategy 1: Distressed debt trading
• Strategy 2: Distressed debt non-control
• Strategy 3: Distressed debt control
• Strategy 4: Turnaround
• Strategy 5: Mixed strategies

2.1. Strategy 1: Distressed debt trading

Distressed debt trading, in brief, is trading of a troubling company’s debt. This strategy is more similar to a hedge fund’s one, in which the firm will EITHER buy debt at a discount to par value and expect to sell at a higher price OR bet against the debt with credit default swap (CDS). 

The holding period on this type of investment is typically short and measured in weeks or even days, which makes this strategy the most liquid in the class.

Note: There is no strict rule for when to categorize a debt as distressed, but it generally means that the debt is trading at a significant discount to its par value. This can range from a 20% discount to as much as an 80% discount.

2.2. Strategy 2: Distressed debt non-control

In this strategy, firms also invest in debt to gain more power during transformation or bankruptcy processes of troubled companies. The terms are usually negotiated so that the market value of the debt rises significantly. The return of this strategy is the difference between the selling price and the buying price of that debt.

This is a generally complex procedure that necessitates a longer holding period as well as a larger, more concentrated position.

2.3. Strategy 3: Distressed debt control

In distressed debt control strategy, the ultimate goal of buying debt is to convert into Equity and have a controlling stake of troubled companies post-restructuring. By then, PE firms will take control, manage, operate that company, and then sell them or take them to public. 

These cases are often structured as pre-packed bankruptcies (or “pre-packs”), where all parties agree on a restructuring plan before the company declares bankruptcy. With this strategy, the distressed debt position is in many respects the start of a much longer process, as after the fund manager wins control of the target he would typically begin the process of maximizing profitability either through restructuring, merging, or liquidation.

2.4. Strategy 4: Turnaround

Distressed PE firms buy equity rather than debt, restructure the whole company, and turn it into a profitable business. Because most distressed companies cannot take any more debt, PE firms won’t involve leverage in turnaround deals. But it is possible to add leverage later on, such as with a dividend recap, if the company rebounds and resumes growth once again.

This strategy is common among private equity firms. It tends to be the highest-risk and highest-reward one because common equity is junior to debt and preferred stock, which is why PE firms rarely attempt it with fundamentally flawed businesses.

Note: These strategies are not mutually exclusive. A distressed private equity firm that aims to gain control of a company might start by distressed debt trading with a small amount for “scouting purposes.” They want to assess the buyers and sellers, the liquidity, and how the company’s profile changes over time. And if they like what they see, they might increase their position and prepare to gain full control; if not, they might exit the position and look for other opportunities.

2.5. Strategy 5: Mixed strategies

This is also called special situations that can combine two or even more strategies in a deal. For example: a firm can buy debt of a distressed company first, then decide to use distressed debt control strategy to gain controlling stake, and finally be involved in managing and operating that troubled company. 

It can also involve investing based on specific events, such as spin-offs, divestitures, or recapitalizations, and even being a “lender of last resort” to distressed companies.

3. Distressed Private Equity Salaries and Bonus

Compared with traditional private equity, salaries in distressed PE firms are similar. Depending on their performance, an analyst can earn between $100K and $150K, associate from $150K – $400K, vice president from $500K – $800K, principle from $700K – $2M. As a managing director, you can earn up to $2M.

Similar to traditional PE firms, the salary is largely hinged on the firm’s performance. If the firm performs well, you are likely to get high pay and vice versa. The performance will fluctuate significantly depending on economic conditions. Distressed PE senior levels also receive carried interests (learn more in private equity salary and bonus article), but the carried interests take a long time to vest and are easily eroded if the fund’s later investments perform poorly. 

You may also see our article on private equity salaries and bonuses for the details.

Distressed Private Equity Salary

4. Distressed Private Equity Exit Opportunities

Exit opportunities for distressed private equity include anything credit-related (leveraged finance group or restructuring group at banks), corporate development, and consulting. Moving to traditional private equity or distressed hedge funds is also a viable option since the skills are much applicable.  

• Credit-related exit opportunities can be restructuring groups at investment banks, turnaround consulting, mezzanine, standard private equity, or direct lending. It’s also possible to move to a credit or distressed hedge fund, since there’s much overlap between distressed PE and HF strategies in this niche.
• Corporate development (CD) is another exit opportunity, though is less common, as deal experience in distressed private equity would come in handy, but few corporate development transactions are actually “distressed.”

Note: Due to different skill sets, it’s quite rare for distressed private equity professionals to exit to credit unrelated fields like venture capital, corporate finance, etc.

5. Top Distressed Private Equity Firms

Following are some of the largest private equity firms which have distressed or special situations groups: Oaktree, Cerberus, TPG, Centerbridge, Fortress, PIMCO, Apollo, Blackstone (GSO Capital Partners).

Apart from large private equity firms, there are also smaller funds that focus specifically on distressed securities and private equity: Avenue Capital Group, Carval Investors, MatlinPatterson, Crestview Partners, Tennenbaum Capital Partners, Third Avenue, Highbridge (now owned by JPM).

6. How to Get Into Distressed Private Equity

6.1. Common pathways into distressed private equity

It is very rare for a fresh graduate or an MBA candidate who doesn’t have any background to get into distressed private equity, as the work is more complicated than that in traditional private equity. 

Some common background to get into distressed private equity are:

• Restructuring investment banking: This is the most popular track in distressed private equity: 2-3 years as an analyst in restructuring IB, and then apply for associate position in distressed private equity. 
• Management consulting, focusing on restructuring and turnaround: this track is popular among firms that use turnaround strategy as they need a person with strong experience with troubled companies. 

• Traditional private equity: It is possible to move to distressed private equity from this background but this path is not as common as the other two.

• Big 4 restructuring group: People with this background are equipped with necessary skill sets, but the working culture can be quite different. Work life balance is much better in Big 4 while things are considerably hectic in distressed private equity. 

• Corporate and bankruptcy law: Distressed investing involves quite a lot of regulations in the term sheet, which gives lawyers certain advantages in the process. 

6.2. Skills distressed private equity look for

As observed in 5 types of strategies, distressed investors can be simply short-term debt traders, but can also choose debt-to-equity exchange, or distressed-to-control. That is why distressed investors need a broader skill set: from bankruptcy specific skills , understanding business plans, to comprehension of the LBO modeling. 

For example: Bankruptcy under Chapter 7 is different from that under Chapter 11. Chapter 7 is for companies that want to liquidate their assets to repay their debts while Chapter 11 will give companies some time to restructure their organizations’ debts, assets and business affairs. Chapter 11 is normally the most expensive and time-consuming bankruptcy case. Therefore, distressed private equity needs people who have skills and experience in bankruptcy as they know what to do next in each scenario.  

However, candidates also look at other skills, including those that traditional private equity requires, such as cash flow analysis, valuation, forecasting and business plan analysis. We wrote several articles about traditional private equity, in which you can find that information.

6.3. Distressed private equity recruitment process

Distressed private equity (PE) recruitment process is similar to that of traditional PE, so you may see our article on the guide to private equity for further details. The process generally starts with resume screening, and then multiple interview rounds with different interviewers, from Analyst to Managing Director.

7. Distressed Private Equity Pros and Cons

7.1. Pros of distressed private equity

• Distressed PE firms provide a wide range of experience and skills mostly applicable to many exit opportunities, although those exit paths can be hard to break into
• Total compensation is high, sometimes higher than traditional PE firms due to the complexity and the stress a distressed PE person might face
• What you do will be more interesting in distressed PE firms compared with a conventional PE since you have to understand a vast array of knowledge including operations, credits, technical analysis, and more 
• There will always be distressed opportunities even in the growing economy thanks to a variety of strategies

7.2. Cons of distressed private equity

• Compared to traditional private equity, work-life balance hardly exists due to the emergency of the deals
• It’s really difficult to get into unless you have relevant experience, because distressed PE is rarely a firm, but a small group which hardly gives job offers to inexperienced professionals
• Broad skill set gained in distressed private equity is relevant to limited exit opportunities (mostly are credit-related)
• There’s still a risk for distressed firms to operate in non-optimal periods. Not to mention, though called distressed, troubled companies with bad credits and balance sheets are not what distressed PE firms aim for buying, making it more difficult to run in their favor in the non-optimal time

8. Bottom Line: Is Distressed Private Equity Right For You?

Some people say that distressed private equity is more interesting than the traditional buyout firm but some do not agree at all. Whatever the opinion is, distressed private equity provides a broad range of skills beyond traditional PE, such as credit trading, legal skills, or turnaround. Thus, broad exit opportunities are also available for professions in distressed private equity. 

If you are interested in distressed investing and want to work after several years, you should start gaining relevant experience as soon as possible. Distressed PE firms favor professionals having relevant experience, and sky-high compensation that distressed PE firms offer will prove  your efforts pay off.