The value of distressed assets often hinges on court cases.

When bad things happen to companies, it’s usually bad news for just about everyone involved. When a publicly traded company fails, anyone who has a stake in that entity — be they a shareholder, an investor in the company’s bonds, a supplier, or an employee — faces the prospect of being wiped out. Yet for investors who specialize in distressed assets, corporate bankruptcies, home foreclosures, and other major problems that hurt asset values can be catalysts  for massive profit. Let’s look at distressed assets and whether you can take advantage of the chances for gains that they offer courageous investors.

What are distressed assets?

Distressed assets encompass a broad range of investments, but they generally center on equity and debt investments in corporate or government entities. When these entities experience financial trouble, investors worry they will no longer be able to meet their obligations, and so more risk-averse investors will sell off their holdings for fear of further losses. Prices of these distressed assets reflect pessimism about the prospects for a full recovery, and when the odds appear to be greatly against a particular company, these assets will often trade at just pennies on the dollar.

As you can imagine, investors in distressed assets often end up losing everything when a company fails to recover. But when companies beat the odds, those who invested in their distressed assets can reap huge returns as prices return to more normal levels.

The City of Detroit’s bankruptcy made its bonds distressed assets in the eyes of some investors.

What is the history of distressed-asset investing?

The idea of opportunistically investing in distressed assets go back centuries, but as a recognized investment strategy, distressed-asset investing has only recently distinguished itself from other value-investing concepts. In the past, rules that encouraged liquidation of failing businesses limited the ability of investors to profit from financial difficulties, because once a company entered the liquidation process, the only variables remaining were what its remaining assets would fetch at sale.

As bankruptcy laws have evolved, however, distressed-asset investing has gained in popularity and complexity. In many cases, debt holders of a business in bankruptcy get partial repayment for their stakes in the company, with some senior debt investors receiving cash while others accept equity in the form of stock of the post-bankruptcy business. Even as former shareholders are wiped out, distressed-asset investors can still end up big winners if they invest at attractive prices and the business performs better than expected once it gets back on its feet.

How many distressed-asset investors are there?

Distressed assets have attracted a lot of attention on Wall Street, with dozens of hedge fund companies seeking to profit from the investing strategy. For instance, one fund manager alone — Oaktree Capital Group — opened about 50 distressed-debt funds prior to December 2013, and all but one had produced positive returns as of that date.

Yet the true scope of the distressed asset universe is much greater, because just about any type of asset can become distressed from time to time. For instance, sovereign debt from many countries in Europe has been distressed for several years, with the economic crisis on the continent endangering the stability of the common currency. That has created distressed-asset investing opportunities for those willing to bet on the continued efforts of the European Central Bank and other policymakers, with one U.K. distressed-debt manager estimating the size of the market at between 1.5 trillion and 2.5 trillion euros. Some see similar opportunities coming in hot areas such as China, where concerns about leverage levels have many believing that waiting for a financial crisis and then buying in could produce a repeat of impressive returns seen over the past five years by those who bought in at the depths of the 2008-2009 global financial crisis.

Why invest in distressed assets?

Distressed assets represent an area where it’s difficult for investors to separate reason from emotion. As a business becomes more endangered, its credit quality begins to fall, and many institutional investors have limitations on whether they can continue to hold stocks and bonds once they become distressed assets. With those institutions forced to sell off their holdings, distressed-asset investors can take the other side of the trades at bargain prices, using their greater flexibility to improve the odds of eventual profits from these positions.

For the most part, distressed-asset investing involves taking an extreme contrarian position, and the more extreme that position is, the greater the potential profit if the investors are correct. Because markets in distressed assets are less liquid and efficient than most markets, prices don’t always accurately reflect the risks involved. Rational investors who can look past the fear of business failure can therefore find situations in which the expected gains from success are substantial enough to justify the risk of losses.

The biggest problem here is that it can be hard for individual investors to get exposure to the best securities for distressed-asset investing. Although buying shares of stock is relatively simple, targeting specific bonds for purchase can be more difficult. However, it’s important for distressed-asset investors to identify the bonds they need to buy in order to ensure that they have the most influence in a potential future bankruptcy proceeding. That’s why many investors use hedge funds to obtain distressed-asset exposure rather than trying to do it themselves.

Investors can fare quite well without ever venturing into the realm of distressed assets. Nevertheless, despite its reputation as vulture investing, distressed-asset investing can bring impressive returns to your portfolio if you’re willing to put up with the high volatility that the strategy entails.

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