SYNOPSIS: Special Situations and Restructuring

Special situations investing presents a unique opportunity to evaluate a company within conventionally unanticipated scenarios. It includes pre- and post-petition investing as well as various other unique or complex circumstances beyond distressed debt or corporate restructurings. Some other examples of special situations include:

• Turnaround Opportunities: Investing in companies that are experiencing operational challenges or management issues but have the potential for a successful turnaround. This could involve providing new management, strategic direction, or operational improvements to revitalize the company's performance. For example, see JOHN D. FINNERTY, PROJECT FINANCING, ASSET-BASED FINANCIAL ENGINEERING, at 284-287 (John Wiley & Sons, Inc. 2006) (providing an example of a restructuring that permitted the operating company and its creditors to avoid a petition).

• Event-Driven Investments: Investing based on specific corporate events such as mergers, acquisitions, spin-offs, divestitures, or regulatory changes. Special situations investors may seek to capitalize on mispricing or arbitrage opportunities resulting from these events.

• Special Dividend Situations: Investing in companies that are expected to issue special dividends or engage in share buybacks due to excess cash reserves, asset sales, or other one-time events. Special situations investors may seek to profit from these distributions or changes in capital structure.

• Complex Securities and Derivatives: Investing in complex securities or derivative instruments where mispricing or inefficiencies exist. Special situations investors may specialize in areas such as distressed debt securities, structured products, credit default swaps, or other financial instruments.

• Litigation Finance: Providing funding to plaintiffs or law firms involved in litigation or legal disputes in exchange for a share of the potential settlement or judgment. Special situations investors assess the merits and risks of legal claims and provide capital to support litigation expenses.

• Distressed Real Estate: Investing in distressed or undervalued real estate assets, such as foreclosed properties, distressed loans, or underperforming commercial properties. Special situations investors may seek to reposition, redevelop, or restructure these assets to unlock value.

• Emerging Markets Opportunities: Investing in special situations in emerging markets or frontier markets where unique challenges and opportunities exist. This could include distressed debt, privatizations, infrastructure projects, or regulatory changes that create investment opportunities.

• Natural Disasters and Catastrophe Bonds: Investing in insurance-linked securities or catastrophe bonds that provide coverage against natural disasters such as hurricanes, earthquakes, or floods. Special situations investors assess the risk-return profile of these instruments and may provide capital to insurers or reinsurers.

• Bankruptcy and Liquidation Scenarios: Investing in distressed companies that are undergoing bankruptcy proceedings or liquidation. Special situations investors may acquire assets or claims at discounted prices with the expectation of realizing value through the bankruptcy process or asset sales. For example, see STEPHEN G. MOYER, DISTRESSED DEBT ANALYSIS: STRATEGIES FOR SPECULATIVE INVESTORS (J. Ross Publ'g. 2005) (providing an extensive introduction to distressed asset investing), Chaim J. Fortgang and Thomas Moers Mayer, Trading Claims and Taking Control of Corporations in Chapter 11, 12 CARDOZO L. REV. 1 (1990) (providing an extensive discussion of the legal uncertainties and advanced discovery issues pertinent to trading in claims).

To conclude, special situations investing encompasses many different types of investment opportunities characterized by their complexity, uniqueness, or unconventional characteristics. Such investments require specialized expertise, thorough due diligence, and active management to navigate the risks and capitalize on the opportunities presented by these situations.

It is also an ideal framework from which to commence an approach to financial analysis of any particular issuer because one must comprehend the unplanned, unintended, and possibly, worst-case-scenario from the perspective of both the issuer and its creditors. For example, the following excerpts from Stephen G. Moyer's treatise on distressed asset investing provide an excellent reference for understanding the difficulties encountered in special situations investing: Credit Tolerance, EBITDA Caveats, and EBITDA Comparisons.[1] 

[1] Compare the accompanying linked text with Removal of Certain References to Credit Ratings and Amendment to the Issuer Diversification Requirement in the Money Market Fund Rule, Investment Company Act Release No. 31184 (Jul. 23, 2014) [79 FR 47986, at 47991-47993 (Aug. 14, 2014)] (providing a discussion of credit rating factors and security analysis processes which were promulgated in summary as a revised rule 2(a)(7), to quote, "Managers of floating NAV funds, in an effort to limit volatility, might further limit their investments in relatively riskier portfolio securities, or conversely, in an effort to increase yield, might increase their investments in such securities. As described in more detail below, we request comment on the extent to which the re-proposed standard may affect the potential incentive for certain funds to invest in riskier securities (i.e., those securities that would be second tier under current rule 2a–7). Would a finding that issuers have an ‘‘exceptionally strong capacity’’ to meet their short-term obligations mitigate any risks associated with floating NAV funds’ potential incentives to invest in riskier securities? Would a finding that issuers have a ‘‘superior,’’ ‘‘very strong,’’ or ‘‘strong’’ repayment ability be a sufficient risk mitigant? 

Also under the amendments to rule 2a–7 we adopted today, all money market funds (including those still able to transact at a stable NAV) will be required to disclose daily the market value of their portfolios generally to the fourth decimal place.[footnote omitted] If a money market fund were to invest to a greater extent than its peer funds in riskier second tier securities, then that fund would have greater volatility in price or market value of its shares, as compared to the volatility and price of its peer funds’ shares. We request comment on whether potential incentives for increased investments in riskier second tier securities would be reduced by market discipline resulting from these newly required disclosures. 

Rule 2a–7 does not set forth any specific factors that a board (or its delegate) should consider in determining minimal credit risks. In response to our 2011 proposal to replace an objective standard of an NRSRO rating for eligible securities with a subjective standard, some commenters advocated that we develop specific guidance in connection with assessments of credit quality.[footnote omitted] We have provided guidance before regarding certain factors to be considered in minimal credit risk determinations for asset-backed securities under rule 2a–7 and in our release removing references to credit ratings from the net capital rule under the Securities Exchange Act of 1934.[footnote omitted] Commission staff also has provided guidance in the past on factors that a board could consider in performing credit assessments under rule 2a–7.[footnote omitted]

Our staff also has had opportunities to observe how money market fund advisers evaluate minimal credit risk through its examinations of money market funds. Although staff has noted a range in the quality and breadth of credit risk analyses among the money market funds examined, staff has also observed that when performing their minimal credit risk determinations, most of the advisers to these funds evaluate some common factors that bear on the ability of an issuer or guarantor to meet its short-term financial obligations.[footnote omitted] Based on the staff’s experience and in consideration of general criteria included in recommendations by an industry money market working group of best practices for making minimal credit risk determinations,[footnote omitted] we believe that an assessment of the strength of any issuer’s or guarantor’s ability to satisfy these obligations generally should include an analysis of the following factors to the extent appropriate: (i) The issuer or guarantor’s financial condition, i.e., analysis of recent financial statements, including trends relating to cash flow, revenue, expenses, profitability, short-term and total debt service coverage, and leverage (including financial leverage and operating leverage); [footnote omitted] (ii) the issuer or guarantor’s liquidity, including bank lines of credit and alternative sources of liquidity; (iii) the issuer or guarantor’s ability to react to future events, including a discussion of a ‘‘worst case scenario,’’ and its ability to repay debt in a highly adverse situation; and (iv) the strength of the issuer or guarantor’s industry within the economy and relative to economic trends as well as the issuer or guarantor’s competitive position within its industry (including diversification in sources of profitability, if applicable).[footnote omitted] In addition, a minimal credit risk evaluation could include an analysis of whether the price and/or yield of a security is similar to that of other securities in the fund’s portfolio.[footnote omitted]

The staff has also observed other factors that money market fund advisers may take into account when evaluating minimal credit risks of particular asset classes. To the extent applicable, fund advisers may wish to consider the following additional factors: 

• For municipal securities: (i) Sources of repayment; (ii) issuer demographics (favorable or unfavorable); [footnote omitted] (iii) the issuer’s autonomy in raising taxes and revenue; (iv) the issuer’s reliance on outside revenue sources, such as revenue from a state or Federal government entity; and (v) the strength and stability of the supporting economy.[footnote omitted]

• For conduit securities under rule 2a–7: [footnote omitted] Analysis of the underlying obligor as described above for all securities except asset backed securities (including asset backed commercial paper).[footnote omitted] 

• For asset backed securities (including asset backed commercial paper): (i) Analysis of the underlying assets to ensure they are properly valued and that there is adequate coverage for the cash flows required to repay the asset backed security under various market conditions; (ii) analysis of the terms of any liquidity or other support provided; and (iii) legal and structural analyses to determine that the particular asset backed security involves no more than minimal credit risks for the money market fund.[footnote omitted]

• For other structured securities, such as variable rate demand notes,[footnote omitted] tender option bonds,[footnote omitted] extendible bonds [footnote omitted] or ‘‘step up’’ securities,[footnote omitted] or other structures, in addition to analysis of the issuer or obligor’s financial condition, as described above, analysis of the protections for the money market fund provided by the legal structure of the security.[footnote omitted] 

• For repurchase agreements that are ‘‘collateralized fully’’ under rule 2a–7,[footnote omitted] an assessment of the creditworthiness of the counterparty,[footnote omitted] of the volatility and liquidity of the market for collateral, if the collateral is a government agency collateralized mortgage obligation or mortgage backed security, or other nonstandardized security, and the process for liquidating collateral.[footnote omitted]

• For repurchase agreements that are not fully collateralized under rule 2a–7, a financial analysis and assessment of the minimal credit risk of the counterparty, as described above, without regard to the value of the collateral, and consideration of the type of collateral accepted and the ability of the money market fund to liquidate the collateral.")

Compare supra with Example EBITDA Comparison, Credit Tolerance, and EBITDA Caveats.

See Restructuring, Thirteen-week Cash Flow Model, and Investment Banking.

See also Commercial Finance, Distinguishing Revenue and Free Cash Flow, and Distinguishing Revenue and FFO.