Companies that go through a challenging time usually have limited options when it comes to raising funds. In some cases, these companies may also go into bankruptcy. Therefore, most investors or creditors don’t trust them with finance. However, these companies can still raise finance through their limited options. One of these includes distressed securities.
What are Distressed Securities?
Distressed securities are financial instruments that companies issue when they are going through financial distress. These securities usually include debt, for example, corporate bonds, bank debts, etc. In some cases, these may also consist of preferred shares. Distressed securities are prevalent among companies that are going through bankruptcy or are close to one.
Due to the higher risks, investors usually refrain from investing in such securities. However, most companies attract investors by providing them with higher rewards. Compared to other securities, distressed securities are less liquid as well. Usually, companies offer investors high discounts to attract them into investing in these securities.
Investors usually consider various factors when choosing to invest in distressed securities. The type of distressed security they get offered also plays a significant role in their decision-making. Some investors may not willingly invest in these securities. Through hedge funds, however, they may get exposed to distressed securities.
What is a Distressed Securities Hedge Fund?
Hedge funds are funds that use investors’ pooled funds to generate profits for them. These funds usually employ derivatives and leverage to achieve this goal. Some hedge funds also use aggressive strategies to maximize the returns they generate for investors. Therefore, distressed securities make a great investment option for these hedge funds.
Hedge funds usually identify companies going through financial distress offering distressed securities. However, these funds prefer companies that they deem can recover from the ongoing circumstances. Due to the pool fund hedge funds have, they can provide significant capital to any company. For that reason, they can also get distressed funds at higher discounts.
Once the companies going through financial distress recover, hedge funds sell their investments. By doing so, they can benefit from the difference between the market value for those securities and the price they paid. This process requires hedge funds to take significant risks. However, the returns they can provide their investors also increase substantially.
What are the risks of Distressed Securities Hedge Funds?
Distressed securities hedge funds undertake significant risks when choosing to invest in those securities. The most prominent risk, in this case, is the underlying company going bankrupt. In that case, the hedge fund risks losing all of its assets invested in the company. However, hedge funds usually mitigate this risk by not investing a large portion of their resources in a single company’s distressed funds.
Distressed securities hedge funds may also prioritize investing in distressed debts over equity. Distressed debt usually offers more protection to investors. However, it does not guarantee profits. In some cases, distressed debt may not provide any additional protection. For hedge funds, the decision to invest in these securities ultimately comes down to their risks and rewards.
Distressed securities are prevalent among companies that are going through financial distress. These companies usually offer securities at a higher discount to attract investors. It is one of the reasons why distressed securities hedge funds prefer these securities. However, there are some risks associated with it, as mentioned above.