Distressed debt financing

A distressed company is not a dead company. It is one that is still trading, still has customers, and simply cannot meet its liabilities on the terms it agreed to.

Distressed debt financing targets exactly that gap. The investor lends into a business at high risk of bankruptcy or of having to restructure its existing debt, with the money used to clear accumulated dues, reduce leverage and relieve the company of the need to restructure or file. The loan is usually senior, adequately collateralised, and priced well above what a performing company of the same size would pay.

The defining test the workbook sets is not how bad the numbers look. It is whether the company is in operation but requires debt relief.

Chapter 9 describes two routes for a Category I or II AIF.

Direct financing. Senior loans with adequate collateral at an elevated cost; or preferred capital; or structured off-balance-sheet debt. The purpose is debt refinancing, not rescue equity.

Indirect financing through security receipts. Asset Reconstruction Companies registered with the RBI under the SARFAESI Act acquire stressed assets from banks and need capital themselves. An AIF subscribing to an ARC's security receipt issuance is taking exposure to those underlying assets; the SR sits as a debt on the ARC's balance sheet. Category II AIFs can invest in SRs issued by ARCs because they are specifically categorised as Qualified Institutional Buyers under the SARFAESI Act for this purpose.

Two restrictions ride on that permission, and both are conflict-of-interest rules:

• An AIF cannot invest in SRs issued by an ARC which is its own portfolio investee company.
• An AIF cannot invest in SRs that would amount to related party transactions — those backed by the underlying loans of its associate or group companies.

Keep this separate from the Special Situations Fund, which is a registered sub-category of Category I AIF with a statutory list of eligible special situation assets: stressed loans under Clause 58 of the RBI Transfer of Loan Exposure Directions or an approved IBC resolution plan, ARC security receipts, securities of companies whose stressed loans are so available, securities of companies whose borrowings are rated "D" or under the corporate insolvency resolution process, and securities of companies with disclosed payment defaults continuing for at least 90 calendar days and rated "D" or equivalent. Distressed debt financing is a strategy; a Special Situations Fund is a registration.

A Category II AIF running a private credit strategy looks at a specialty chemicals company with Rs 620 crore of revenue and an order book intact, but:

The banks want out. The AIF offers Rs 300 crore of senior secured debt at 16 per cent, against a first charge on the plant and an escrow of receivables, on terms that let the company settle the bank debt at a negotiated Rs 285 crore and clear its statutory dues.

The company is not saved by this. It is bought time — the interest bill is heavy and the whole thesis depends on EBITDA recovering to the Rs 110 crore the turnaround plan projects, at which point leverage falls to 3.6x and the facility can be refinanced by a bank.

That is the trade. A performing borrower of this size might pay around 10 per cent; the AIF earns 600 basis points more for lending where the banks will not, and it is senior and secured while it waits.

Chapter 9 (Investment Strategies), section 9.1.2, items 10 and 11 — Special Situations Debt as per AIF Regulations, and Distressed Debt Opportunities. Expect a question on the defining characteristic of distress financing (a company in operation that needs debt relief), and one on the two restrictions on an AIF investing in an ARC's security receipts.

• Distressed is not insolvent. The workbook's test is a going concern needing debt relief. A company already in liquidation is a different exit, covered in Chapter 12.
• Distressed debt financing is a strategy; a Special Situations Fund is a Category I sub-category with a statutory asset list. A Category II AIF can run the strategy without being an SSF.
• Category II AIFs are QIBs under the SARFAESI Act for this purpose — investing in ARC security receipts. Do not generalise it into QIB status for everything.
• The two SR restrictions are conflict-of-interest rules: no SRs of an ARC that is your own portfolio company, and no SRs that would be related party transactions through group or associate borrowings.
• Distress financing is usually senior and secured, not junior. The extra return comes from the borrower's condition, not from subordination.
• The 90-day default test and the "D" rating belong to the special situation asset definition, not to distressed debt financing generally.