Distressed Debt Hedge Funds: How to Become a Vulture Capitalist

Ask anyone interested in distressed debt hedge funds for “the pitch,” and they’ll probably mention one of the following:

“It’s like long/short equity or credit, but more interesting!”

“Distressed investing offers equity-like returns with lower risk.”

“Distressed assets offer non-correlated returns, similar to global macro.”

These are nice sales pitches, but the reality is quite different.

Distressed debt investing offers advantages over other hedge fund strategies, but the marketing often oversells the benefits.

Some people can do very well at dedicated distressed funds, but in most cases, you’d be better off pursuing the strategy at a broader credit or event-driven hedge fund:

What Are Distressed Debt Hedge Funds?

Distressed Debt Hedge Funds Definition: Distressed debt hedge funds buy and sell debt that is trading at a steep discount to face value, such as 40%+, and make money by betting on changes in the price of this debt or using it to gain influence in a restructuring or bankruptcy process.

As discussed in the distressed private equity article, there is no universal definition for a “distressed security” or a “distressed company.”

However, various books and textbooks have defined “distressed” as follows:

1. Debt Discounts – If Secured Debt is trading in the low 90% range or below, or Unsecured Debt is trading in the 60-70% range or less, it’s typically distressed. These percentages mean the market is pricing in a high likelihood of creditor losses in a restructuring or bankruptcy.
2. Troubled Company – If the company has a low Cash balance, limited Revolver availability, and a looming debt maturity with no easy way to refinance at similar terms, it is usually distressed.

As an example of the first definition, if a company has issued $1000 of Unsecured Debt, but you can now buy it for only $600, it’s distressed.

The company still pays interest on the full $1000 and must repay it upon maturity, but you can buy the issuance at a steep discount because there’s a significant chance of default (see: book value vs. market value vs. face value).

A sharply declining stock price does not necessarily mean a company is “distressed.”

For example, let’s say a tech startup with no Debt goes public, and its stock price soars from $10 to $200 and then falls to $30.

This company is not distressed; it’s an overhyped tech startup that came crashing down.

Distressed investing relates specifically to Debt and how much a company’s Debt and Equity “should” be worth when various scenarios play out.

The catalysts could be anything from quarterly earnings announcements to covenant breaches to announcements of M&A deals, financings, or strategic reviews.

Distressed debt hedge funds could be classified within either the “credit” or “event-driven” categories, which make up a combined ~22% of all hedge funds:

An Example Distressed Debt Trade

To make this strategy more concrete, we’ll look at a company that initially raised Debt with this financial profile:

The company was levered at 5x Debt / EBITDA, but most of its Debt still traded near its face value or par value, as shown above.

A few years later, the company’s industry declined, and it was slow to cut costs and enter new markets. Its financial profile now looks like this:

Its Debt / EBITDA is now 10x, its EBITDA / Interest has fallen below 1x, the Secured Debt is trading at 90% of its face value, and the Unsecured Debt is down to 60%.

The company has only $100 million of Cash and $150 million of Revolver availability, so it cannot repay the upcoming Secured Debt maturity.

It could refinance, but it will have to accept a significantly higher interest rate on the new issuance – and it can barely afford interest at the current rates.

A distressed debt hedge fund could trade this situation in several ways:

1. Long the Secured Debt and Short the Equity: The fund might do this if it expects the company to announce a full liquidation, but it has determined that the proceeds from its net tangible assets can fully repay the Secured Debt. If they’re right, this will produce a quick 11% gain from the Debt and more from the Equity. This scenario is unlikely since the company’s Equity Value is only $200 million (less than the Secured Debt balance), but you never know…
2. Long Both Debt Issuances and Use CDS to Hedge: If the fund expects the company’s business to turn around in the next earnings announcement, it might buy both the Secured and Unsecured Debt and use credit default swaps to hedge the default risk. If the Secured Debt rises to 98% and the Unsecured Debt rises to 80%, the fund will earn ~9% and ~33%, respectively, minus the hedging costs.
3. Long the Secured Debt and Short the Unsecured Debt (or Use CDS): If the fund expects the Secured lenders to be repaid in full as the Unsecured lenders get wiped out, it might bet on one tranche and against the other. In this scenario, they would earn 11% on the Secured Debt and, if the Unsecured Debt falls to 10% of face value (for example), an 83% return there.

Distressed Debt Hedge Fund Strategies

I’ll refer you to the distressed PE article for more on this one, but there are five basic distressed investment strategies:

1. Distressed Debt Trading – Buy Debt that trades at a big discount to face value, such as 30 – 40%, and sell it once the price rises (or bet against the Debt with credit default swaps).
2. Distressed Debt Non-Control – Buy Debt to gain influence in the restructuring or bankruptcy process and earn a huge gain upon repayment – or get common shares in a debt-for-equity swap and sell the shares at a profit.
3. Distressed Debt Control – Buy the “fulcrum security” that will convert into Equity to gain a controlling stake in the company post-restructuring. This one is more common for distressed PE firms.
4. Turnaround – Acquire Equity before any bankruptcy or restructuring process and turn around the company to make it profitable and cash flow-positive. Again, this is more of a PE strategy.
5. Special Situations – This could include the events above but could also refer to investments in spin-offs, asset sales, recapitalizations, acquisitions, or capital raises.

Most distressed debt hedge funds follow strategies #1 and #2: trading and non-control.

Many hedge funds use strategy #5 (special situations), but they’re usually put in a slightly different category.

Within the “event-driven” category, distressed funds fit in as shown below:

How Are Distressed Debt Hedge Funds Different?

Most dedicated distressed funds offer less liquidity and longer lock-up periods than other hedge funds, and they tend to hold positions for months or years with fairly concentrated portfolios.

They also tend to use less leverage than equity and global macro strategies because it can be difficult to exit their stakes.

If a merger arbitrage fund holds an average of 100 positions, a distressed fund might hold only 10-15 (or even fewer).

You might wonder if these differences result in better performance for distressed funds, and the best answer is “Kind of.”

The distressed strategy outperformed equity and global macro in 2000 – 2019, but not the credit category as a whole:

In terms of risk, distressed funds have fairly standard Betas to stocks and bonds:

Many people correctly point out that 2010 – 2019 was a terrible period for distressed strategies due to zero interest rates and a flood of cheap money.

Outside of events like the oil crash and COVID, there weren’t that many true distressed opportunities because virtually any company could get funding.

So, I would expect distressed performance to improve, especially as companies start to feel the effects of higher rates.

The Top Distressed Debt Hedge Funds

There are single-manager distressed funds in the $500 million – $2 billion AUM range, but these are not necessarily the best funds to target for a few reasons:

1. Cyclicality – Distressed debt investing comes into and goes out of favor quickly, so you could easily go from dozens of opportunities one year to almost nothing the next. It’s a better career bet to aim for diversified funds that do everything from “stressed” credits to event-driven and deep-value strategies.
2. Influence – In many distressed situations, smaller funds are at a disadvantage because they might own 5% of the Debt, while firms like Apollo, Oaktree, or Blackstone own 50%+. They cannot compete for better terms or more influence in this scenario.

With that said, here’s how I would split up the distressed landscape:

Huge Funds That Do Distressed Investing: Apollo, BC Partners, Blackstone, Centerbridge, Fortress, GoldenTree, Oaktree, and Sculptor Capital (FKA: Och-Ziff).

Traditional Distressed Funds That Have Diversified: Anchorage (partially shut down), Brigade, Davidson Kempner, Elliott, Marathon, and Silver Point.

Newer/Smaller Funds with Occasional Distressed Investments: Diameter, Kennedy Lewis, and Nut Tree.

You could add plenty of names to the second and third lists: Angelo Gordon, Appaloosa, Aurelius, Avenue, Baupost, Bayside, Beach Point, Canyon, King Street, Monarch, Mudrick, and Solus Alternative are examples.

A few of these funds specialize in distressed (e.g., Mudrick and Aurelius), while most use broader credit, event, and deep-value strategies and make occasional distressed trades.

How to Recruit for Distressed Debt Hedge Funds

The best background is restructuring investment banking because the skill set is directly relevant.

But you could also move in from Leveraged Finance or an industry group that does frequent debt deals.

DCM would be a tougher sell because you only work with investment-grade bonds.

If you have a non-IB background, such as at a turnaround consulting firm, you might want to aim for operational roles in distressed PE or move to banking first to improve your chances.

You can get into distressed investing at the MBA level, but more so if you’ve already done something relevant pre-MBA, such as credit risk at a large bank, and you move into restructuring IB after the MBA.

If you want to join directly out of an MBA program, you’ll almost certainly need turnaround or distressed experience pre-MBA.

You can also get into distressed investing with a legal background because the job requires you to interpret confusing documents and know the details of the restructuring and bankruptcy processes.

But it’s more common to go from law school to investment banking and then move to a hedge fund.

If you want to get into distressed investing directly out of law school, you’ll probably need:

• A degree from one of the top law schools in the country.
• Two relevant internships in 1L and 2L, such as at a restructuring boutique bank and a PE or credit-related one.

Most distressed funds use an off-cycle recruiting process, so the timing varies, and you’ll have to network proactively to find opportunities.

The large funds that operate in the distressed space use more of a structured, on-cycle approach, which is positive if you’re an IB Analyst at a top bank and negative otherwise.

If you’re recruiting for distressed roles in Europe, language skills (especially Portuguese/Italian/Spanish) help quite a bit because you’ll have to read the original documents and understand the nuances of local bankruptcy law.

Interviews, Case Studies, and Investment Pitches

The differences in credit hedge fund interviews also apply here: Expect many questions about bond math, including the YTM calculation, pricing, recoveries, seniority, and different covenants.

They could also ask you about the bankruptcy and restructuring processes and the options for distressed companies (see the restructuring IB article).

For your investment pitches, you don’t necessarily need to pitch all distressed ideas, but you should aim for “stressed” trades, such as a high-yield bond currently trading at 90% of face value.

The main difference vs. standard credit trades is that the range of outcomes is wider.

For example, you can’t limit yourself to catalysts such as positive or negative earnings or upcoming refinancings.

You must also consider what might happen in a debt-for-equity swap, liquidation, or Chapter 7 vs. 11 bankruptcies.

Your overall approach might look like this:

1. Screen for Stressed or Distressed Issuances – You’ll need Bloomberg or another data source in most cases, but you might be able to use online research to get ideas.
2. Plot Out the Possible Scenarios – And estimate the market value of each Debt tranche and the company’s Equity in the most likely outcomes
3. Create Your Trade – The simplest approach is to long one part of the capital structure and short another, but you could also long or short just one component and use options or CDS to hedge the risk.
4. Find Support – After you have estimated the returns in different scenarios, you should read the company’s credit documents and do some industry/competitive research so you can defend your views in interviews.

This process is time-consuming, so you don’t need to develop many ideas.

You might be fine with just two (2) separate pitches, and they could be based on similar distressed situations.

Careers at Distressed Debt Hedge Funds

The biggest issue with long-term careers is that there aren’t that many viable, dedicated distressed debt hedge funds.

Economy-wide distressed cycles only come along once every 10-15 years, so if your fund does nothing but distressed investing, you’ll be waiting a long time to invest.

Some people argue that higher interest rates and the rise of non-bank lenders will create more distressed opportunities in the future – and they might be right.

But it’s still a highly cyclical investment style with too much capital chasing too few opportunities in most markets.

So, if you want to work in distressed investing, you should aim for a larger, diversified fund that uses a range of credit and event-driven strategies and has relationships with many companies.

The other differences noted in the credit hedge fund article also apply here: You’ll work longer hours because distressed investing is closer to working on deals, and you’ll work in more of a team setting since you need input from so many different parties.

Compensation, as always, has less to do with the strategy and more to do with the AUM, fund performance, your seniority, and the single vs. multi-manager distinction.

Exit Opportunities

The best part of working in distressed debt investing is that you gain a lot of mobility within the credit space.

For example, it’s much easier to go from distressed debt to investment-grade debt than the reverse, and it’s far easier to move from distressed to LevFin than the reverse.

You could also join a generalist credit hedge fund, event-driven fund, special situations fund, or a restructuring investment banking group.

Distressed private equity and turnaround consulting are more of a stretch since they’re operational, but they are plausible if you have the right experience.

You will not be a good candidate for venture capital, growth equity, or corporate finance roles because the skill sets are too different.

Normal industry groups in investment banking and corporate development jobs might also be difficult because you could be perceived as overly specialized.

For Further Learning

To learn more about this field, we recommend the following books and websites:

• Distressed Debt Analysis – The classic Moyer guide. It’s still good, but some concepts have become less relevant since it was written 20+ years ago.
• Creating Value Through Corporate Restructuring (CVCR) – This is a more recent reference that covers real-world case studies.
• Distress Investing – This is good if you’re more advanced and want something written by a top distressed hedge fund investor.
• The Art of Distressed M&A – Another good reference, but more geared toward investment banking.
• Distressed Debt Investing – This site is no longer active, but the archives have many useful case studies.
• Pari Passu and Petition – These are good newsletters related to distressed and restructuring.

Or, you might want to read this article: Distressed Debt Hedge Funds: How to Become a Vulture Capitalist.

Final Thoughts About Distressed Debt Hedge Funds

The biggest benefits of working at a distressed debt hedge fund are:

1. You gain in-depth technical skills.
2. You work on interesting, complex trades.
3. You get a lot of mobility within the credit/distressed/turnaround space.

If you get bored of distressed deals, you could easily move to a credit or event-driven strategy or even switch gears and return to banking or consulting.

The biggest drawbacks are that there aren’t that many dedicated distressed funds, and even if you find one, it’s risky to work on only distressed investments.

It’s arguably the most cyclical of all hedge fund strategies, and if you join at the wrong time, you could end up with limited experience.

But if you find the right fund and work in a more diversified role, distressed investing could be a career highlight – even if the reality doesn’t quite match “the pitch.”