Several companies have trended recently for getting close to bankruptcy or filing for bankruptcy. It seems like the biggest and most obvious red flag not to invest, yet it is a strategy to see a company in financial turmoil or post-bankruptcy and invest money.
Is it a smart strategy? Is it risky? Are there significant returns? Should you start investing in bankrupt companies? Let’s talk about it!
What is Bankruptcy?
The big question is, what even is bankruptcy?
Bankruptcy is when you can no longer fulfill your financial obligations. It can happen to a business, individual, or organization; bankruptcy is their financial status once filing.
Within the world of business, there are two different types of bankruptcy a company can file for
- Chapter 11 (what Yellow did) is when a company asks for the opportunity to restructure its finances to recover and bounce back.
- Chapter 7 is when the company is officially forsaken and has no opportunity for a future.
Obviously, you can’t take advantage of a Chapter 7 filing, but what is the strategy for investing in companies who file for Chapter 11?
What is the investing strategy?
If a company files for Chapter 11 bankruptcy, it is because it can’t pay to keep the company going, so it looks for other means to continue. Here are two reasons it could be a good strategy to invest in one of these companies.
- Turnaround Potential: If an investor has industry-specific knowledge or understanding of how the company can turn around, they might invest expecting a substantial turnaround. The profit that comes out of it would ultimately be worth the effort.
- Distressed Debt Investing: Investors and Hedge Funds will buy companies’ debt in or near bankruptcy, expecting to be paid back with interest once the company recovers. This can be a significant process, so it’s an investment for the long term.
The whole idea is to invest when a company is at a low, so then when it recovers, you’ll be there for the high. Here is a list of companies that filed for bankruptcy and then recovered. I bet you wish you could’ve gotten involved in these.
- Marvel Entertainment
- General Motors
- Six Flags
Does that list and those reasons mean you should invest in bankrupt companies? Not necessarily.
Should you invest in companies going bankrupt?
There is substantial risk involved in investing in bankrupt companies. A few factors explain why a company files, so you don’t want to get caught up in what could happen. The potential for high returns doesn’t mean you’ll get high returns. Here’s a list of adverse outcomes that could happen.
- The company never recovers.
- No creditor priority.
- Lose Investment.
- Drawn out legal process.
So who is investing in bankrupt companies if it’s such a risky business? Financial individuals or industries that know what they’re doing. Even professionals take risks when they invest in distressed funds.
Investopedia explains how Vulture Funds “take extreme bets on distressed debt and high-yield investing, also deploying legal actions in their management strategies to obtain contracted payouts.” So there’s more here at play than just a company looking for money, but risk, contractural payouts, and the potential of getting nothing.
Individual investors participate in investing frenzies surrounding Yellow, Tupperware, etc., but should you?
You might have personal knowledge of an industry, company, financing plan, etc., that could turn a company around. You could even research to see if a company is likely to recover. Investing in a bankrupt company could be a financial opportunity in both cases, but it isn’t without risk. Investing based on positive quantitative data of companies already in the green, through Equities Lab, is the safest lane rather than betting on the recovery for a higher return.