This paper discusses the range of considerations involved when investing in distressed assets. The term “distressed” is fairly broad when used in this context, as there are a lot of situations where that term would be appropriate. For purposes of trying to nail it down, we can think of distressed as being any situation where someone is trying to secure financing or sell an asset, and are unable to do so through regular channels or at market rates as a result of some additional factor which they would probably prefer not to have to deal with. That still leaves the matter fairly broad, but such the nature of this area. There are any number of factors which might come into play that would make a given transaction more difficult than the ideal case.

Day in and day out distressed situations occur because of some issue with the asset being sold, the project being financed, or the person trying to consummate the transaction. In addition, from time to time distressed situations occur in great numbers as the result of some type of problem that hits an entire industry or market. These can result from asset bubbles caused by over-speculation, general economic downturns that put once-profitable situations in jeopardy, or tightening of lending requirements (both voluntary and regulated) which may not have any direct relationship at all to a given transaction. During such periods it is quite possible to suffer from being in the wrong deal at the wrong time. Distressed situations can even come about during times of economic boom, believe it or not, when projects of one type are “all the rage” and drawing in whatever venture money is available, leaving projects in other industries or investments in other asset classes high and dry.

So distressed assets (DA) are always out there in one form or another. They are a matter of interest because they often have the potential for substantial profitability. There is an old adage in the investment world that you want to “buy when no one wants it and sell when everyone wants it.” This theme has been tapped over and over again for decades (at least) by some of the world’s most successful investors. Warren Buffet, Peter Lynch, George Soros and Wilbur Ross have all built their reputations – and billions of dollars – on using this principle consistently and repeatedly. There is ample proof that it is possible to earn meaningful returns in the DA patch, so it is important to take some time to understand what the factors are that come into play in these situations. That’s what we’ll be doing in this paper.

A few final notes before we get started. First, because there are so many situations which could fall under this heading, we feel it’s best to focus on principles instead of laundry lists of steps. If you understand the principles you’ll be able to spot them in real world situations, and plan your approach based on its specific factors. See Appendix A for a “Rogue’s Gallery” of some of the most common members of the DA tribe. Second, although there are certainly distressed situations to be found in the stock market, we’re not going to discuss any of them here. It would simply be too much for this type of format to deal with; and there are myriad resources already out there for value and deep-value equity investing.

Getting Started

Perhaps the most important first step to successfully getting involved with DA investing is a willingness to ignore conventional wisdom and forget what you think you know about how investments work – at least temporarily. That’s because there are often deals in the DA space which seem to defy logic. In fact, often such surreal situations seem like the rule instead of the exception. You can very easily find yourself wondering if you’ve come across the proverbial “too good to be true” scenario, or alternately lamenting how stupid you must be for wanting something that clearly everyone else thinks is practically worthless.

In other words, to even have a shot at being successful with DA, you’ve got to get your head in the right place. You have to be willing to methodically go through the facts and calculations to see where they lead, and keep at bay the urge to jump ahead to the conclusion before you really know. People who deal in DA frequently say things like “you have to flip a lot of rocks.” Most of the time you’ll determine there’s nothing of much interest after all, and you’ll move on. Always, whatever you find is going to have some dirt on it. But if you can look past these things and continue to look, you can find situations that are very much worth doing; sometimes delivering yields which are substantively greater than those to be had from more conventional investments.

How did this happen?

At least in loose terms, we all have a sense of what constitutes “normal.” In all aspects of our life, when we see something that doesn’t conform to that idea of normal, we have a natural tendency to wonder  why it happened. That’s the case with DA too, and a good way to go about understanding why things go the way they do in these situations is to first review some of the principles we normally expect to be part of a normal investment scenario, and then compare the two.

In a normal investment situation, whether we realize it or not, there are usually two base assumptions underlying how we regard what we are seeing. First, we have been taught that there is a strict relationship between risk and return. Second, we assume that whatever prices we run into out there in the market place are going to accurately reflect whatever the transaction is really worth. That is to say they are going to be “fair.”

In order to understand what is going on in a DA situation, we are going to need to take a closer look at these two assumptions. If they were as iron clad and universal as some purport them to be, then DA situations could not exist except in the rarest of circumstances. Yet the real world data points to the fact that they do exist, and in fairly large numbers at times; as well as the fact that an entire group of investors have made literal fortunes off of them for decades. Theory does not match up with practice, if you will; and since the practical results sort of speak for themselves, that points to the idea that maybe we need to revisit the theory. We’ve got some reconciling to do, which we’ll get started with right now.

What we think we know

The theory goes that if an investor is going to take on a higher level of risk, then he is going to require a greater rate of return. Tough to argue with that, and when we run across high risk situations in the real world they do usually settle at a high price (usually in the form of a small investment in exchange for a large slice of the winnings if everything goes according to plan, or a high interest rate on debt). The bond markets have taken this idea and turned it into a near-science, to figure out what interest rates should be for given levels of perceived risk. This idea is so well ingrained that in the modern day we usually just look at interest rates to give us a gauge of the relative risk levels. If risk starts the process and the result is x interest rate, then we should be able to just turn that around and look at the rates as
an indicator of the risk that must have been assessed when coming up with said rate. Right?

Well, maybe. But only if you are looking at bonds. (There are actually some logic problems with the idea regardless of the asset being discussed, but it probably comes closer to being true in the bond market than anywhere else.) Why would that be, you ask? It has to do with the fact that most of the variables that go into the equation of making a bond what it is are known at the time of issue. We know the face amount, the coupon rate, the term, the interest crediting/payout method, the relationship to market rates, the presumed credit worthiness of the issuer and so forth. There’s no guarantee that the bond won’t default, but assuming everything goes according to plan – and the vast majority of the time, it does – then we know on day-one exactly what this investment is going to do if we hold it until maturity. Contrast that to even the most basic stock valuation, where the current price and all future prices are going to be influenced by the opinions of lots of people trying to guess (excuse me, “forecast”) what future earnings will be. Comparatively speaking the bond situation has almost no unknown variables, and as such, it lends itself well to the type of mechanical processing that determines a fixed relationship between risk and return. But such a relationship is not universally possible.

So let’s put all of this together. An investor who knows he’s taking on more risk logically wants a higher return. But this is sort of a one-way relationship: agreeing to take on more risk certainly doesn’t insure a higher return – or even a chance at a higher return. Moreover, the actual level of risk becomes extremely difficult to quantify when you get outside the realm of mostly-nailed-down variables. If the only two factors were risk and return, then it would be a lot easier to have correlation. But when we introduce an element of uncertainty (in the form of market participants offering their predictions of what the future looks like), then we stop having two variables: we have three. And three factors are much more difficult (some physicists would tell you impossible, but that’s another matter altogether) to deal with. They prevent us from having firm confidence that a potentially high return situation must come with an exposure to high risk, because there is another possible explanation (market sentiment) floating around out there.

OK, you say. That makes sense, but if market sentiment is the other factor then it doesn’t change anything because markets always use whatever information is available to come up with an accurate and complete view of the situation, in the form of a fair price. Fair prices in turn are based on an understanding of the risk/return paradigm, and so we can effectively ignore the notion of sentiment and assume the market got it right. Right? Well, that’s how things work (in theory) in an efficient market, that is to say one that is working as designed and has lots of knowledgeable, profit-minded buyers and sellers coming together regularly to transact like exchanges. But what if the transaction we want to do isn’t like the others being completed? And what if only a handful of the other participants want to look at our widget because the box is scratched up? In other words, what if the individual circumstances of the DA lead to a situation where the market isn’t being efficient for the moment, at least not with respect to the deal we are looking at? Sort of brings the whole house of cards down doesn’t it? We’re back to market sentiment playing a role, which means we are back to being unable to know whether risk
and return line up or not.

Take away: just because there is a potential for a high return in a DA situation, you cannot assume that it has to be a function of high risk. There is another explanation: market sentiment. You will not know until you dig into the details, which one it is.

If you can’t buy into this idea as at least being possible, you probably ought to set this paper to the side and stick with CDs and index funds…

Valuation

So we’ve made the point that risk and return don’t always travel together in lock step, and the point that sometimes markets don’t yield fair values through efficient operation. You either buy that or you don’t, and there’s no need to beat a dead horse. But in order to make this a full discussion we need to spend some more time on the market part of things, because it is only through this path that we can get a comprehensive understanding of valuation. Without some sense of valuation, we can’t (or shouldn’t) move forward as investors, because we would have nothing upon which to base our decisions. There are a lot of aspects of DA that make them different from other types of investments, but the basics of sound investing do not change from one asset class to another. We need to be able to come as close as we can to nailing down what it is we are getting before we make the investment, just as we would with any other investment.

Valuation is one of the most slippery, imprecise aspects of the financial world. Which is really a pretty significant statement if you think about it: what other aspect of dealing making would have as far- reaching an impact as value? That’s not just my opinion, by the way. Valuation is now its own distinct professional discipline, and you can take a look at any guidance you like from the various certifying bodies that train people in the field, to authoritative materials in the law and the tax code, and they all point to the same conclusion: there is no single magic bullet approach to determining what something is worth. In the face of that, it is noted (rightly) that one of the steps you should take in trying to make an assessment of value is to look at the market price. Because a lot of the time the market price will give you a good answer, or at least a close estimate. But sometimes it doesn’t. In the next few paragraphs we’re going to cover three distinct circumstances where the market price (if there even is one) has little hope of helping answer the value question.

Unwilling Sellers

One of the basic assumptions behind the idea of fair market value is that the exchange is taking place between a willing buyer and seller. Fair enough. But if one of the participants is less than willing, then it should be plain to see that this assumption is shot. Specifically, in the spirit of this idea, a seller who is being forced to act, either to get financing (as in “sell” a debt instrument) or sell an asset, is not a willing participant. “Willingness” in this context doesn’t mean they don’t want the financing or the sale at all, it means they don’t want the timing or terms that they are going to have to take as a result of the situation.

If a person wants to wait until the end of a real estate bust to sell his beach house, but he can’t wait that long, he is not a willing participant. If ABC Company is trying to finance a new project and has to do it quickly to avoid losing a contract, then they may be agreeable to terms that they would never consider if the time pressure were not there. A seller who is being influenced by outside forces may transact business at a price point that is different than would be the case if there were no outside forces. The effect of this move in the price point creates the opportunity for a larger yield on the part of the buyer. If the seller has to take less, the buyer gets a discount which can translate into a bigger gain. Simple as that.

Here’s an actual example. In the 80s there was a boom in real estate out in Texas and some surrounding states, brought on by the increase in oil prices. Local economies were flourishing. Everyone wanted in on the action and people were flocking to the area, driving up the price of real estate. Supply and demand 101 stuff. Then oil prices collapsed. So did Texas real estate. So did the lending institutions which held the mortgages, leading to what the papers would later call the “S&L (Savings and Loans) Debacle.” I have a good friend who had front row seats: he was the president of a bank in Texas at the time. Eventually a large portion of the bank’s assets were taken over by the government and re-sold through the liquidation entity that they set up specifically for that purpose, the Resolution Trust Corporation (RTC). People who, in turn, bought assets from RTC went on to re-sell them later at incredible yields. They made the proverbial “killing.” Why? Because the price at which the banks had to dump out was well below the value of the underlying assets. But they had to sell them, because they did not conform to the characteristics required for assets which banks are allowed to own. My friend knew that the assets were worth more than their liquidation value. He knew that the buyers had virtually no risk whatsoever in the deal because the value of the assets was a multiple of what they were selling for out of RTC. He knew that the asset buyers would go on to book huge gains – which they did.He knew all of this, but had no power to stop it because he was compelled to sell as a result of external forces (in this case, compliance with banking regulations). The losses associated with those forced sales consumed the capital of the bank, and they had to shut the doors. Should you have any questions as to whether or not he was a willing participant, I can assure you that he’ll tell you in very certain terms. But the point is, due to a breakdown in the “willing participant hypothesis” the deal took place at a price point which had virtually nothing to do with value. Or risk.

Information in the Marketplace

Market efficiency is also predicated on the notion of a free flow of information which gives the participants the ability to interact in an intelligent and rational manner. Again, no issue with the theory, but one could fairly ask “what happens if the flow of information breaks down?” You’ve already guessed the answer. Market efficiency goes out the window, at least temporarily. In a very real sense, it simply becomes impossible.

When does the flow of information most often break down? Turns out, usually at the worst possible time: in a crisis. Whether the information coming in actually diminishes, or the ability of market participants to analyse it in a timely manner becomes challenged, the impact is the same. Question marks enter the equation. When question marks show up, most people react by doing…nothing. Nothing leads to a very interesting market dynamic: if no one is buying and no one is selling then supply and demand both drop. Which inevitably leads to a decline in price (if not an altogether disappearance). Understand that during the period of time from the market working properly to breaking down altogether, it is likely that nothing actually happened in the real world to change the value of the asset. It already was whatever it was; the market just didn’t know it. Stock market analysts (the good ones, anyway) know very clearly that there is a disconnect between the company itself and what is going on with its traded shares. Long-term the two are understood to be the same, but as a wise old economist once put it, in the long-term we’re all dead. The long-term doesn’t matter if we need to know the value today. In the midst of a crisis, we may have no other alternative available than to look to the market for a take on value, but the longer the crisis goes on, and the worse the crisis gets, the less likely it is that the market price is going to bear any resemblance at all to the true value of the asset or the risk that is supposedly being priced via required interest rates.

All Buyers are Equal, But Some Buyers are More Equal

So we’ve talked about unwilling sellers and we’ve talked about the market’s contribution to value questions in the midst of a crisis. Now we’ll talk about buyers. I know a guy who is in the business of buying liquidated merchandise, especially building materials and fixtures that go into houses. He has a network of contacts all over the country, is widely known in those circles as a guy who has ready cash and can make quick decisions, and handles a lot of volume over the course of a year. He’s got a warehouse to store things in, forklifts to load and unload trucks, people to help move it around, and a place where folks can come to buy what he has picked up. People who renovate houses and own rental property love this guy, because they can get all kinds of useful deals for half of what they’d pay at Home Depot or the local supply house. In turn, he makes a killing, often doubling or tripling his money on a truck load of goods in a month or so. Sounds good, huh?

Well, yes. But it sounds like a lot of work too. Which we’re going to talk about in a minute. But for now, I want to make a very simple point about buyers: not all of them are created equal. In other words, just because there are returns to be had, it doesn’t mean that just anyone can unlock the full value of such deals. Some buyers are far better positioned or equipped (or both) to make lemonade out of distressed asset lemons. In the case of this fellow, a key to being able to book those returns is the infrastructure he has in place. He deals in physical assets; which necessitate a physical operation for handling. He also has done enough of these deals over time that he has a good sense of what things are worth without having to rely on outside sources of data to help him with decision making. So having a source for deals and investment capital is only part of the equation. In many DA situations something is going to have to be done – put a new roof on a building, foreclose junior lien holders to quiet the title,find someone who wants to buy 35,000 pounds of sterilized gauze (think about how many gauze pads that would be…) – to finish the deal and recognize the full potential. Which means that what the deal is ultimately worth is going to vary based on whether or not you are talking to someone who is set up to handle it. As if seller pressure and market breakdowns weren’t enough to confuse the value issue, we also have to consider who the buyer is and what kind of player they are before we can get a sense of how price might further diverge from value. (Side Note: 2 points, by the way, if you caught the literary reference to Animal Farm at the heading of this sub-section)

Bringing this section to a close, as implied at the beginning, the point of all that we have discussed so far stems from the fact that DA situations usually seem a bit surreal when you first find them. In order to keep from making the snap judgement that something is “not worth messing with” or “too good to be true” most people need a rational/intellectual basis for setting programmed response to the side long enough to actually see what’s there. That’s what we’ve been attempting to build. Now invariably, if you are able to get past first impressions, and you do begin a clinical analysis of the facts, you will come across plenty of deals you should say “no” to. And here’s to hoping you discover that during analysis, and not after doing the deal. But the point is that if you never bother to look in the first place, you’ll never find the ones that do have good potential. The information covered thus far was included to help you to answer your own concerns that you might well be wasting your time. Because if you can’t get past that, you aren’t going to be able to operate in this space. At least not without giving yourself an ulcer. Which candidly, may happen anyway.

The Work/Return Paradigm

We have mentioned the often-talked-about relationship between risk and return. In the DA space there’s another relationship you need to understand: the one between returns and work. A full understanding of the impact of work will do two things. First it will help to further the mission of convincing yourself that you are not crazy, by providing a rational basis for why higher returns might be available. Second, it will help to show those returns for exactly what they are: not just a return on capital, but a compensation for effort expended too. DA can often lead to high returns. But often times you earn them the old fashioned way.

To quickly hit the high points, it is useful to ask the somewhat philosophical question of whether or not we actually live in a world where it is reasonable to expect work to be rewarded. For purposes of this exercise we’ll hop in the time machine and go back to when economic analysis was dramatically easier than it is with modern day complexities to have to account for. Let’s give our pal the caveman an ear of corn. Two options: eat it or start his farming empire. A modern ear of corn has something like 300 or so kernels, the majority of which one would assume could become corn plants the following spring. The inputs include nutrients from the soil, sunlight, rain water, the corn seed itself…and someone to put it all together in the right combination so that when nature does its thing, it does so efficiently. Enter the caveman/farmer. He plants the seeds, tends the patch now and again over the course of the summer and comes back in the fall to find a lot more than he started with. Figure 2 ears per plant, 250 plants, ergo 500 ears of corn. One ear plus labour plus natural inputs yields a 500X return the following year. Not bad for a guy who uses a rock for a pillow.

The point is that yes, we do live in a world where labour can yield returns if there is a situation where such work is needed. How much work depends on the circumstances, as does the extra return that we can expect as a result. There are plenty of DA situations where the return is still lavish, even after allocating a hefty portion to pay top dollar for any work that had to take place. But the important element is that without the work, the scope of the yield would not have been there. If our farmer had stuck the whole ear in one hole he certainly would not have ended up with the same yield. The act of separating the kernels and planting them individually set the stage for the larger crop, and the efforts expended once the crop came in, to collect it and protect it, are what made this tale a success story. So we may have to work. Which is a good thing since it leads to higher returns at times, and provides a solid theory as to why the yields are there in the first place, keeping at bay those nagging thoughts that things really shouldn’t be going as they seem to be.

But when we talk about work we have to realize that we are on a slippery slope from mere investing to actually being in a business. Which in turn means that if we are going to talk about being in business, we’re going to have to spend some time looking at scale and repetition. That is, the size operation we need to have, as well as the necessary deal flow, to make sure that the cost of our efforts doesn’t eat up all of our potential profits. If we wanted to be in the freight business we couldn’t spend $100K on a tractor trailer rig and then haul one load a year. Even though the load might be profitable as a stand- alone activity, the profit from one load would not come close to covering our equipment cost. Instead we’d have to figure out how much profit we would make on each load (after fuel, insurance, tolls, etc) and divide it into our equipment costs to figure out how much we’d have to run to break even; and how much more to reap a meaningful profit. Similarly, with DA, while there are some deals that lend themselves to being one-offs, many are going to need to be carried out on a recurring basis to justify the costs associated with creating whatever infrastructure you have to have to unlock the full value.

If a married couple wants to buy a beach condo for their own use by way of a bank REO (“real estate owned” after a loan foreclosure) in order to get it at a discount, then that’s the kind of deal where one is enough. If on the other hand someone wanted to purchase discounted receivables from operating companies (a type of working capital financing known as “factoring”) in order to collect the difference when the accounts finally paid, that’s the type of thing where an ongoing source of deals would need to be found, and a staff to handle the transactions in volume would have to be hired too. As we pointed out earlier, DA encompasses a wide range of deal types, some of which are there for the taking by just about anyone willing to do the work. But others should probably be avoided unless there is a desire to be involved with such transactions repetitively over a period of time. The cost of entry to participate in such situations is simply too high to make it make sense otherwise.

How to Invest

We have now discussed the wide range of principle level concerns that one would be well advised to keep in mind when investing in DA. We’ll now turn our attention to some of the more ground-level concerns that come up when actually doing deals. Investing in DA isn’t so much a different activity than other types of investing, where you throw one set of ideas and maxims out the window in exchange for another set. Rather, it is the same set of rules that always apply, plus an additional sub-set specific to the factors we’ve explored above. As for specific examples, see the Rogue’s Gallery at Appendix A.

Do your homework
Self evident enough. Just be aware that in the DA space you may have to be a bit more creative in finding data, since it is not likely to be a mouse-click away on your favourite financial portal.

All of the basic rules about diversification apply
Irrespective of the type of asset or whether or not it is subject to forces from the DA world, it is rarely wise to have all of you eggs in one basket. Any time a single investment accounts for more than about 10% of your portfolio, you have the very real prospect of losing an entire year’s earnings, if not more, should that investment go south.

Don’t gamble with the bread money
So said my grandfather, the farm boy turned bank executive. Strict divisions between risk capital and non risk capital should be maintained. People who haul money out of their rainy day fund to be able to react quickly to some “once in a lifetime” deal, usually end up regretting it on several levels. If your speculative money is already tied up in other things, and you can’t liquidate those positions, you should at least be open to the possibility of letting the deal pass you by. I have been watching these things for a long time now, and it has been my experience that the deal of a lifetime usually comes along two or three times a year if you are paying attention. Catch the next one, if doing this one means taking on more risk than you should.

Leverage relevant knowledge
To piggy-back on that last point, if you have some type of specialized knowledge about an area or a type of asset, by all means use that to your advantage. Play to your strengths, as the old saying goes, by focusing your dealing-finding efforts in those areas. People who farm or manage timber have an advantage when it comes to rural land. People who own a business in a resort town have better insight into local vacation properties. Those who’ve worked for a bank have a better sense of who can and can’t qualify for conventional financing.

Have staying power
Granted this is easier said than done, but in a lot of DA situations, the simple passage of time will be enough to get to a profitable exit point. The market will essentially do the work for you; you’ve just got to be able to stay in the game long enough to get the next hand of cards. The reality is that many DA situations are created in the first place because someone can’t weather the storm. So by choosing deals of a size and time frame that you can easily handle, you stand to pick up the benefits when the storm finally subsides. I could add additional metaphors, but you probably get it.

Are you a deal guy, or in-the-business?
In any kind of investing, if you find a deal or an opportunity that works, your next logical question is naturally going to be, “Where can I find another one of those?” Or 5 more? Or a hundred more? But as we mentioned before, in the DA space sometimes you have to create an infrastructure to reap the biggest returns. As the availability of DA deal flow increases, the infrastructure requirement almost becomes a certainty. It’s advisable to decide up front if that’s really what you want to do; or if alternately you are looking to do one or two deals because they are available, and then return to following more conventional investment approaches. The time-honoured advice to start with the end in mind is good advice here. You don’t want to accidentally end up in business, nor do you want to fail to put together a business if one is needed. Which leads nicely to our final point…

Consider hiring a manager
If you can find one that deals in the areas you are interested in, and if they have excess deal flow (which would allow them to make use of your capital), maybe you can hire…a manager (cue theme music from The A Team). The idea of tapping into an established infrastructure and knowledge base is not a bad compromise position. Obviously you won’t make as high a return, since the part attributable to the work will end up going to the guy actually doing the work. But the remaining return may still be more than what alternatives can supply, and beyond that there is the benefit of diversifying into assets that may not have any correlation with other holdings. Plus, candidly, part of the appeal of DA investing is that it’s often pretty interesting. Over time you accumulate a lot of good stories. One caution: by “manager” we are describing an experienced and capable operator who does things professionally. Not your nephew who just got out of college and can’t find a job. If you are going to pay the tab, get the benefit of having an expert on the team. If it’s just a way to get out of having to do the dirty work yourself, expect to pay a much higher price than the pay check itself.

Getting Out (aka Exit Strategies)
There are basically 2 theories or approaches that can be followed when determining an exit point. We’ll talk about them both in detail in just a minute. But before we do, keep in mind that although it is usually necessary to get out of the DA investment to fully realize the profits (either through repayment of the debt, or sale of the underlying asset to book the gain), the sell isn’t really where you make money. You make money on the buy side. That is to say, what you pay for the deal in the first place is likely to be the biggest factor in whether or not it ends profitably. Fortunately, the buy side of the transaction is something that you probably have a lot more control over than the actions that will occur at the exit point. The exit is predicated on someone else’s action, either the party you’ve financed or another market participant. The buy is more or less at your discretion.

Now that discretion may come in the form of passing up the deal because the price isn’t right. But paying more than you want to in hopes that you’ll be able to get something to go your way by the time you are ready to leave the building…well, let’s just say that chapter one of a lot of sad tales start out that way. Paying too much causes you to have to overcome an unnecessary negative before you get to profitability, insuring you’ll make less even if you do end up in the black. Sometimes the best deals are the ones you don’t do.

But moving on, we’ll assume you did do the deal, and you will at some point need to get out. Most people follow one of two approaches. We’ll call one of them the “acceptable return approach,” and for lack of a better name, we’ll call the second the “what it’s worth approach.”

The acceptable return approach works like this. I put x into the deal, y time has now passed, and as long as I can get a return of z on my money I’ll be happy. This type of thinking probably comes from the idea of establishing a target return before going into a deal (which in and of itself is not a bad idea), or maybe from having a knowledge of what the return would have been for putting the money into something else (like a CD down at the local bank). A person might buy an asset for $20 and a year later when they get ready to sell it, they will have a conversation with themselves where they say, “If I’d have put it in the bank I would have gotten 5%, so as long as I sell it for more than $21, I win.” In another scenario, our investor may be aware of someone who will pay $25 right now, even though someone else is telling them to hold out for $27 a little later. They will look at the return that $25 represents, and start wondering if they are just being greedy to hold out for more, often concluding that it is better to go ahead and take the deal today since it is comparatively such a big return anyway.

The what it’s worth approach comes at the matter very differently. In essence, this approach takes the position that the entry point is irrelevant. Similarly, no return calculations and comparisons are taking place behind the scenes either. All that matters is what the asset is worth today, and how close the proposed transaction price is to that number. If the widget is worth $100, I may sell it to you for a few bucks less if there is a really good reason, but for all practical purposes the negotiations need to centre on the fact that we’re talking about a $100 widget.

Although there are plenty of people who use the rationale of the first method, it must be pointed out that there are a couple of major problems with that way of thinking. First, it implies a relative values comparison of sorts, and to be meaningful it has to be an apples and apples comparison. Comparing the yield on any kind of risk capital transaction – DA or not, high risk or low – to bank CD rates is certainly not such a comparison. The CD may be an alternative in the pedestrian sense that you could alternatively write the check to the bank instead of the DA deal, but that’s about where the similarity ends. So if you simply must take the comparative approach, you still have to find something with similar characteristics so you’ll have a reasonable basis for weighing one against the other.

But the main problem is encapsulated in the question, “Why in the hell would you sell it for less than it’s worth?” The whole point of a DA investment, if you really think about it, is to take advantage of a discount that is created by the distress, and hold on until the distress goes out of the equation and the asset returns to a more normal market price. If you found the deal, did the transaction, undertook whatever work was necessary, and have now made it through to the light on the other side of the tunnel, why would you sell at less than market? Why would you put another discount into the equation so the next guy that comes along makes the extra pop you left on the table?

Now that doesn’t mean that a discount is always a bad idea. Especially if the deal isn’t “finished” it is often smart to leave a little something in it for the next guy. Likewise, if you need to end your holding period quickly (perhaps you have another good deal ready to go) and you want to move your sale to the front of the line, nothing does that like knocking a couple of points off the price. Hopefully the profit is sufficient that you can afford to do it, and it will still be a big win. But the point is that selling a $100 widget for $80 is silly, irrespective of whether you got in for $70 or $7.

Remember the earlier admonition about making your money on the buy? Well, this is where it comes home to roost. If the market wants to pay you full dollar for the asset, why would you manufacture a lower price just because of some sense of having already earned enough? Mathematically this is about as straightforward as it gets. You won. Take the win. Qualitatively perhaps, there may be some sense of being greedy that comes from booking a large gain. But greed implies taking more than is “fair,” perhaps to the detriment of someone else. How can selling something at or just under the market value be greedy?

This entire discussion may seem a bit overdone, but rest assured that this is something you will have to deal with. Not only will you be making decisions about the price you’d like to get, you will also be getting inquiries from people who want to buy what you have. A favourite tactic of people who source deals from other investors is to begin the discussion by asking what the other person “has in it.” If you answer this question, or if they already know because of some sort of public information (like a foreclosure auction, or something along those lines), you can expect that you are about to receive an offer based on the acceptable return model. Why? Because the other guy knows that he can eventually sell it for what it’s really worth. He may be hoping that you don’t know that, or can at least be distracted from it with the lure of a “reasonable return.” If he can get it from you at a bargain, then he can make money on the deal too. Just keep in mind that any money he can make is money that would have otherwise gone into your pocket. And who invited this guy the party in the first place?

The point is that your exit strategy is how you close the loop on everything you’ve done, and ultimately realize the profits that were the impetus for the actions in the first place. Give it as much thought as the other elements, understand the nuances, and avoid the pitfalls. You know about the implications of a weak link in a chain. It is wise to make sure that your exit strategy isn’t that link. Ideally you don’t want any weak links at all, but having everything fall apart right at the end is the worst kind of failure. If it has to go south, it’s much easier to deal with if you don’t have a lot of time and effort invested along with your capital. Don’t blink when it comes time to get out; else it may undo all of the good you’ve accomplished at all of the other stages.

Conclusion

Distressed Assets are often exactly what they sound like. Volunteering for deals with extra challenges is often a good way to make someone else’s mess your own. So you have to be careful. But despite this possibility, unique stresses affecting the seller, unusual market sentiment or a special advantage that you might have relative to other buyers can set the stage for sizeable gains. DA investing involves the standard set of issues that come into play with any type of investment, plus its own unique elements attributable to the distress. In addition to being interesting and challenging, they also often contain the seeds of high profitability. For this reason they are a topic worth exploring thoroughly.