How Distressed Debt Investing Works

investing in distressed debt can be extremely lucrative for people and companies that know what they're doing.Oaktree , one of the top-flight distressed debt managers, has generated impressive returns in its distressed debt funds, earning a 17.1% internal rate of return for its investors since its inception in 1995.

Distressed debt investing combines the best of both worlds-- the cash flow of debt investments with the appreciation potential of stocks. While there is no hard and fast rule for what makes a "distressed" investment, it's generally accepted that distressed debt trades at a huge discount to par value (think $400 for a $1,000 bond, for instance) because the borrower is under financial stress and at risk of default.

The risks are certainly high, but those who manage their risks well have put up incredible returns over history. Distressed debt investors typically seek to make money in one of two ways: investing in turnarounds and participating in lend-to-own situations.

TurnaroundsDistressed debt can be a great way to invest in a turnaround situation because debt is given preference to equity in the event of bankruptcy. That is to say that while a stock's value in bankruptcy is usually zero, debt often retains some of its value in a worst-case scenario, limiting downside risk if a turnaround fails.

Consider this scenario: You believe it's a 50-50 coin flip that a company can turn around its poor operating performance. You have two ways to invest in the company: buy its debt or its stock.

You build a table to carefully consider the probability of a successful turnaround, and your potential returns in each case.

In this example, the equity offers the highest potential return (150%) but comes at the risk of much greater risk of loss -- if the turnaround fails you'll lose everything. The debt, on the other hand, offers a smaller return (100%), but the downside risk is minimized to just 20% of your capital, by your analysis.

In this situation, the debt is clearly the better investment. If you've carefully assessed the probability of success or failure, and the value of the company's debt or equity in the best- and worst-case scenarios, the expected return for debt exceeds the expected return for the equity.

Distressed debt investors thrive on these kinds of investments, which are best described as being "heads I win, tails I don't lose much" situations.

Lend-to-own situationsMany companies fail simply because they are overburdened with debt. Distressed debt investors can make a fortune by buying the debt of overleveraged companies with the goal of taking control of the company.

Consider this example: Let's suppose you think XYZ Corp. is a good company, but it carries way too much debt relative to its earnings power. You believe that if the company were debt free, it could be worth as much as $1 billion. Unfortunately, it carries about $2 billion in debt it cannot afford to pay.

The company's debt trades for about $0.20 on the dollar, as investors are running for the exits as quickly as they can. You start buying up the debt. Within months, you acquire all of its $2 billion in debt for just $400 million.

When XYZ Corp. inevitably goes into bankruptcy, you'll be first in line to collect on your debt. But XYZ Corp. cannot afford to simply pay you off with cash; if it could, it wouldn't be in bankrupcty. The stockholders, being rational investors, don't want to pony up $2 billion in cash to pay off the debt just to retain ownership of a company only worth $1 billion.

The stockholders turn over the keys to you. You now have control of a debt-free company worth $1 billion in exchange for a $400 million investment in its debt.

You were a lend-to-own investor, buying up the company's debt to take control of the business when it couldn't pay you back as scheduled. For your effort, you net a 150% return on your money, turning $400 million into $1 billion.

Of course, both of these examples -- turnarounds and lend-to-own situations -- have been simplified. Investing in distressed debt is inherently difficult and expensive. Debt is generally illiquid, making it difficult to buy in large quantities. And bankruptcy, if that is the end result, is an expensive and time-consuming process. But this is why distressed debt investing can be lucrative -- where there is a lot of work to be done, there is often a lot of money to be made.

The article How Distressed Debt Investing Works originally appeared on Fool.com.

Jordan Wathen has no position in any stocks mentioned. The Motley Fool recommends Oaktree Capital. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.