Quants in Distressed Debt

JM · Post by JM » Wed Mar 07, 2012 3:40 pm

My firm is looking to shift into multi-strategy areas such as distressed debt.

I have limited experience with it. What can/do quants contribute in the space?

Cheng · Post by **Cheng** » Wed Mar 07, 2012 6:53 pm

In distressed basically nothing.

Distressed debt is all about analyzing companies from a fundamental point of view. You have to read loads of balance sheets and annual reports, put all figures in a "model" (maybe with some reasonable adjustments) and make a judgement call whether the company is worth what you see quoted or not (or what the break-up value is).

Experience is a big plus here...

cpptrader · Post by **cpptrader** » Wed Mar 07, 2012 7:17 pm

^^exactly.

On the transactional side, a lot of it is negotiation, and using numbers that are "easy to follow and explain". A lot like M&A, different largely because things aren't as rosy - more issues abound. Those issues are usually balance sheet or forecast related. Generally I've found simplicity to outweigh accuracy, and more generally rounding is popular.

There was some work done mathematically as it pertains to convertibles, risk of default, etc., although I'm not sure if anyone in practice really uses that. I think the most complex math I've seen is black scholes on dilutive warrants...

Kind of a "sky is blue" post, but since you asked, hope it helps.

sidml · Post by **sidml** » Wed Mar 07, 2012 7:56 pm

If you can find a strategy that works, good for you. Do share with us.

Some issues:

1. OTC: traded entirely OTC by appointment at a few market makers. Bid-ask spreads are quite wide. You'll rarely get broker runs with reliable pricing for quant modelling.

2. Legal risk: significant portion of the analysis is understanding the claims of each security and where the assets reside.

3. Transactional process: value creation also frequently depends on negotiations among the different classes of creditors, hence hard to model.

Cheng · Post by **Cheng** » Wed Mar 07, 2012 8:19 pm

And because I saw it recently:

4. Read the docs. Read the f*cking docs !!

A trader bought a loan some time ago. It took the agent 6 months to figure out that the trader wasn't allowed to buy the loan... I think this can only happen in distressed.

doctorwes · Post by **doctorwes** » Thu Mar 08, 2012 12:09 am

Chapter 12 of Seth Klarman's book is a good introduction to investing in distressed securities, though it's a bit dated now, and of course he can't get into many details in just twenty pages.

My impression is that it's tough to pull it off successfully as a passive investor. You have to be prepared to get involved in the creditors' committee to work towards a good outcome, and that requires lots of experience and lots of time. Otherwise, you're free-riding off others' efforts there, and you have to trust that they won't screw it up.

JM · Post by JM » Thu Mar 08, 2012 4:23 pm

Thanks all for the help.

When the downside is evident and the upside is unlikely and asymmetric there's not much point in hedging a portfolio of distressed debt against macro risk. From the case studies I'm reviewing, it looks like needed risk management is dominated by very specific enterprise and legal issues. Cap structure collapses under some DIP-type subordination and rules out opening lines like relative value.

balrog · Post by **balrog** » Mon Mar 12, 2012 3:26 pm

You don't tend to see many quants in distressed / special sits. In terms of risk management, typically you're trying to isolate the risk you're making a bet on, be it credit quality or recovery rates on npls etc. So you will tend to try to hedge out any currency or interest rate risk on your trade / investment.

In theory you could apply quant techniques to assess for example likelihood the equity kickers on a special sits loan will be in the money given historical share price performance assuming your loan works and company restructures - you're basically supplying a structured product as investment to the investee company and thus should be able to embedd lots of fees and optionality to into the structure. I think a quant could be quite useful in such circumstances. Anything where there are reference asset prices which will directly influence the chance of a distressed trade / special sits investment working out, sure some angles a quant could look at to enhance the risk / reward assessment at time of pulling the trigger.

Also for any NPLs where you have highly granular portfolios such as resi mortgages, car loans, personal loans etc, you can apply quant / statistical techniques based on historical portfolio perfomance to determine pricing, to some degree. This is the only place apart from risk management I've seen any quants working in distressed.

deeds · Post by **deeds** » Wed Mar 14, 2012 1:08 pm

I've looked at a number of these investments from a range of fund managers in the course of my work over the last couple of months.

I agree with what's been written here...

- most risks are idiosyncratic, and holders of investments are very active in trying to affect outcomes. These factors seem to move an analysis away from standard quantitative finance assumptions.

- statistical techniques can be used for claims based on aggregated securities.

Two speculative thoughts -

- I wonder if there is any mileage in applying game theory in restructuring or other outcomes requiring negotiation in the context of constraints?

- Quantitative macro analysis may be of some use in understanding structural forces which could affect outcomes.

cpptrader · Post by **cpptrader** » Wed Mar 14, 2012 4:42 pm

- I wonder if there is any mileage in applying game theory in restructuring or other outcomes requiring negotiation in the context of constraints?

In the context of corporate restructuring, I think game theory is in place on at least an informal basis, with a bias towards zero-sum outcomes. In very distressed scenarios, you can run into a traditional prisoners dilemma, where seemingly coordinated bad decisions will just sink an asset leaving the debt otm.

Let me think about the concept more. Negotiation is effectively the entire mechanism on a single situation basis, supplemented by bankruptcy process where applicable. Where is your speculation leading you?