How do distressed debt funds actually make money?

Question

AcadiFi · Accepted Answer

Distressed debt investors buy claims trading below intrinsic recovery value and realize the gap through restructuring, par recovery, or converting debt into post-reorg equity.

The playbook has three archetypes:

1. Loan-to-own: accumulate enough senior debt in a distressed capital stack to control the restructuring. In Chapter 11, the senior class gets equity in the reorganized company. If you bought at 45 cents and the fulcrum security receives equity worth 70 cents, you capture 25 points plus upside.
2. Par work-outs: buy debt of over-leveraged but operationally sound companies at 70-80 cents. The company refinances or is acquired, and your bonds pull to par. Annualized returns of 20-30% over 18 months are typical.
3. Capital structure arbitrage: buy senior secured and short unsecured of the same issuer, profiting from the spread between recovery assumptions in a downside.

For Lakebend Media senior secured notes at 62 cents with $1.2B EV estimate and $800M secured debt ahead, recovery modeling:

- Upside (refi): pull to 98, +58% gross.
- Base (exchange): new notes at 85, +37%.
- Downside (Ch 11): 75% recovery via asset sale, +21%.

Fund economics: typical distressed PE structure of 2-and-20 with 5-7 year lockups. Returns require patience and control, not just cheap entry.

How do distressed debt funds actually make money?

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