How can you manage financial risks when investing in distressed assets through private equity?

Distressed assets are undervalued or underperforming businesses that face financial or operational difficulties, such as bankruptcy, default, or litigation. Investing in distressed assets through private equity (PE) can offer attractive returns and opportunities to turn around struggling companies, but it also involves significant financial risks. How can you manage these risks and maximize your chances of success in this challenging field? Here are some tips and best practices to consider.

1 Understand the sources of distress

The first step to managing financial risks when investing in distressed assets is to identify and analyze the causes and extent of their problems. Distress can stem from various factors, such as industry downturns, regulatory changes, competitive pressures, poor management, excessive debt, or legal disputes. You need to assess the viability and potential of the business, its assets, liabilities, cash flows, and market position, and determine whether the distress is temporary or permanent, cyclical or structural, and internal or external. This will help you decide whether to pursue a deal, how to value the asset, and what kind of restructuring or turnaround strategy to implement.

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Aman Soneji

MBA Candidate at HEC Paris | Ex-Goldman Sachs | Private Equity Enthusiast
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Emphasizing the importance of a thorough due diligence process is critical. Start by scrutinizing the root causes of distress—industry dynamics, management issues, or external factors. Distinguish between temporary and permanent problems, and assess if it's a cyclical hiccup or a structural flaw. Dive deep into financial health, scrutinizing assets, liabilities, and cash flows. Only by understanding the full picture can you craft a strategic and informed approach to restructuring or turnaround, minimizing financial risks in the distressed asset game.

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2 Choose the right entry point

The next step is to find the optimal entry point for your investment, depending on the stage and severity of the distress. There are different ways to acquire distressed assets, such as buying debt or equity in the secondary market, participating in auctions or bankruptcy proceedings, or negotiating with creditors or shareholders. Each option has different implications for the price, risk, and control of the deal, as well as the legal and regulatory hurdles involved. You need to weigh the pros and cons of each approach, and consider the timing, competition, and expectations of the stakeholders.

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Noel Mudukuti

Accountant| ACCA, CFPAM,Strategic Professional
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Invest only what you can afford to lose. Distressed asset investing is a risky proposition, and you should only invest what you can afford to lose. It is also important to diversify your portfolio by investing in a variety of different distressed assets.

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3 Mitigate the operational and financial risks

Once you have acquired the distressed asset, you need to take swift and decisive actions to stabilize and improve its performance. This may involve injecting capital, refinancing debt, cutting costs, selling non-core assets, renegotiating contracts, hiring new management, implementing operational changes, or pursuing new markets or products. You also need to monitor and manage the financial risks associated with the investment, such as liquidity, leverage, interest rate, currency, or credit risks. You need to have a clear and realistic exit plan, and be prepared to adapt to changing circumstances and opportunities.

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Aman Soneji

MBA Candidate at HEC Paris | Ex-Goldman Sachs | Private Equity Enthusiast
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Post-acquisition is where the real work begins. Swift and decisive actions are key—capital injection, debt refinancing, cost-cutting, and strategic asset sales are common strategies. Managing financial risks is crucial; keep a keen eye on liquidity, leverage, interest rates, currency, and credit risks. A robust monitoring system is essential. Having a clear exit plan is non-negotiable, and flexibility in adapting to market changes is a must. Success in distressed assets lies not just in acquisition but in the agile and strategic management that follows.

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4 Build trust and alignment with stakeholders

Another key aspect of managing financial risks when investing in distressed assets is to establish and maintain good relationships with the various stakeholders involved in the deal, such as lenders, creditors, shareholders, employees, customers, suppliers, regulators, and courts. These stakeholders may have conflicting interests, expectations, or claims on the asset, and may influence its outcome and value. You need to communicate effectively, transparently, and respectfully with them, and seek to align their incentives and goals with yours. You also need to comply with the relevant legal and ethical standards, and avoid or resolve any disputes or litigation that may arise.

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5 Leverage your expertise and network

Finally, you can enhance your ability to manage financial risks when investing in distressed assets by leveraging your expertise and network in the PE industry and the target sector. You need to have a solid understanding of the technical, legal, and financial aspects of distressed investing, as well as the market dynamics, trends, and opportunities in the industry. You also need to have access to reliable and relevant information, data, and analysis, and to seek advice and support from experts, advisors, or partners. You can also benefit from building a reputation and track record of successful distressed investing, and from cultivating long-term relationships with potential targets, sellers, buyers, or co-investors.

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6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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How can you manage financial risks when investing in distressed assets through private equity?

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1 Understand the sources of distress

2 Choose the right entry point

3 Mitigate the operational and financial risks

4 Build trust and alignment with stakeholders

5 Leverage your expertise and network

6 Here’s what else to consider

Private Equity

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