Understanding financially distressed and bankrupt companies.

Financially distressed and bankrupt securities are analytically complex and often illiquid.

The reorganization process is both tedious and highly uncertain. 

Although the number of variables is high in any type of investing, the issues that must be considered when investing in the securities of financially distressed or bankrupt companies are greater in number and in complexity. 

In addition to comparing price to value as one would for any investment, investors in financially distressed securities must consider, among other things, 

• - the effect of financial distress on business results; 
• - the availability of cash to meet upcoming debt-service requirements; and 
• - likely restructuring alternatives, including a detailed understanding of the different classes of securities and financial claims outstanding and who owns them. 

Similarly, investors in bankrupt securities must develop a thorough understanding of the 

• -  reorganization process in general as well as 
• -  the specifics of each situation being analyzed.

Financially Distressed and Bankrupt Businesses

Companies get into financial trouble for at least one of three reasons: 

• - operating problems, 
• - legal problems, and/or 
• - financial problems. 

A serious business deterioration can cause continuing operating losses and ultimately financial distress.

Unusually severe legal problems caused tremendous financial uncertainty for these companies, leading them ultimately to seek bankruptcy court protection. 

Financial distress sometimes results almost entirely from the burdens of excessive debt; many of the junk-bond issuers of the 1980s shared this experience.

Financial distress is typically characterized by a shortfall of cash to meet operating needs and scheduled debt-service obligations. 

• -  When a company runs short of cash, its near-term liabilities, such as commercial paper or bank debt, may not be refinanceable at maturity. 
• -  Suppliers, fearing that they may not be paid, curtail or cease shipments or demand cash on delivery, exacerbating the debtor’s woes. 
• -  Customers dependent on an ongoing business relationship may stop buying. 
• -  Employees may abandon ship for more secure or less stressful jobs.

Effect of financial distress vary from company to company

Since the effect of financial distress on business results can vary from company to company, investors must exercise considerable caution in analyzing distressed securities. 

The operations of 

• capital-intensive businesses are, over the long run, relatively immune from financial distress, while 
• those that depend on public trust, like financial institutions, or on image, like retailers, may be damaged irreversibly. 

For some businesses the decline in operating results is limited to the period of financial distress. 

• -  After a successful exchange offer, an injection of fresh capital, or a bankruptcy reorganization, these businesses recover to their historic levels of profitability. 
• -  Others, however, remain shadows of their former selves.  

The capital structure of a business also affects the degree to which operations are impacted by financial distress. 

• -  For debtors with most or all of their obligations at a holding company one or more levels removed from the company’s primary assets, the impact of financial distress can be minimal. Overleveraged holding companies, for example, can file for bankruptcy protection while their viable subsidiaries continue to operate unimpaired; Texaco entered bankruptcy while most of its subsidiaries did not file for court protection. 
• -  Companies that incur debt at the operating-subsidiary level may face greater dislocations.

More often bankrupt enterprise continues in business under protection for some to return to financial health

The popular media image of a bankrupt company is a rusting hulk of a factory viewed from beyond a padlocked gate. Although this is sometimes the unfortunate reality, far more often the bankrupt enterprise continues in business under court protection from its creditors. 

Indeed, while there may be a need to rebuild damaged relationships, a company that files for bankruptcy has usually reached rock bottom and in many cases soon begins to recover. 

• -  As soon as new lenders can be assured of their senior creditor position, debtor-in-possession financing becomes available, providing cash to meet payroll, to restock depleted inventories, and to give confidence both to customers and suppliers. 
• - Since postpetition suppliers to the debtor have a senior claim to unsecured prepetition creditors, most suppliers renew shipments. 
• -  As restocked inventories and increased confidence stimulate business and as deferred maintenance and delayed capital expenditures are undertaken, results may begin to improve. 
• - Cash usually starts to build (for a number of reasons). 
• -  When necessary, new management can be attracted by the prospect of a stable and improving business situation and by the lure of low-priced stock or options in the reorganized company. 

While Chapter 11 is not a panacea, bankruptcy can provide a sheltered opportunity for some troubled businesses to return to financial health.