George J. Schultze is the managing member and founder of Schultze Asset Management LLC (SAM), and chairs the firm’s Investment and Strategy Committees. Schultze is widely recognized as an expert on distressed and special situations investing, wrote the book on Vulture Investing, and is often quoted in the media regarding high-profile reorganization cases.
Russ Alan Prince: What is distressed investing?
George Schultze: Distressed investing involves buying stock, corporate bonds or loans issued by a company that is in financial trouble due to unsustainable debt, failure to adapt to changing market conditions, or unexpected secular change and is probably headed into bankruptcy. Distressed investors buy these securities when they have fallen in value and believe there is a potential for profit from a restructuring or a bankruptcy payout.
The goal of distressed investing is to identify companies trading at levels below their fundamental value or where a positive emergence from distress is expected. It’s a style of investing that looks to take advantage of inefficiencies in the market and can deliver strong returns in both bull and bear markets.
Regardless of what ultimately forces a company into bankruptcy or distress, a complex bankruptcy can take years to resolve, presenting many opportunities along the way to invest in distressed securities before, during and after distress. Events like spinoffs, mergers and special dividends can help generate the final gains at the tail end of a distressed securities investment cycle.
Distressed investing is very much a fundamental value investment philosophy. It entails finding companies that are trading at a sharp discount to fair value and buying them through their debt that will eventually turn into equity. The opportunity comes from the arbitrage between those two markets.
Prince: You say that companies in distress present multiple opportunities for investors. Why don’t more investors pursue this investment strategy?
Schultze: The primary reason more people don’t do it is that successful distressed investing takes a lot of hard work. It entails doing solid and comprehensive research that pays attention to the fundamentals coupled with an understanding and analysis of macroeconomic trends. You not only have to be able to read a balance sheet and analyze debt ratios and EBITDA, and other fundamentals of the business but also understand what all those numbers mean.
You have to be able to look at secular market trends and try and figure out what they mean. You have to understand the distressed company’s place in its industry and its industry’s place in the overall economy. And then you have to know what to do with all that knowledge.
Companies coming out of a reorganization are often underpriced by the market. Post-bankruptcy, the actual fundamental value of a company might not have changed that much. However, the price of its stock may have changed substantially depending on who owns it and what else is going on.
The best avenue for most investors when it comes to investing in distressed securities is to work with an experienced manager who understands how to invest both long and short, before, during and after bankruptcy, rather than trying to do it on their own. Distressed investing takes considerably more due diligence than purchasing a mutual fund or an ETF tracking a major index. However, the payback can often be well worth the invested time and capital.
Prince: Your firm has been in business for 25 years now. What’s the most interesting bankruptcy you’ve seen in that time?
Schultze: There have been numerous large bankruptcies over the last 25 years, going back to Enron in 2001, which at the time was the largest bankruptcy in U.S. history and resulted in around $11 billion in shareholder losses. That record was broken a year later when WorldCom filed for bankruptcy and then again when Lehman Brothers failed during the great financial crisis in 2008.
It is hard to identify the most interesting bankruptcy I’ve seen, but Pacific Gas & Electric, which has gone into bankruptcy twice, is certainly among them. I started following this company around the time of its initial bankruptcy in 2001 when it was a victim of Enron’s manipulation of the California energy market. Ultimately, regulators allowed PG&E to pass its losses on to its more than five million ratepayers in the form of above-market rates. The company emerged from bankruptcy, with shareholders getting a minimal recovery. After the California wildfires in 2017, regulators once again allowed PG&E to pass the cost of its recovery on to its customers. The company was not as lucky after the next round of devastating wildfires in 2019, which caused an estimated $30 billion in damages, not including damage to uninsured or under-insured victims, personal injury claims and other costs.
In one of the largest bankruptcies in history, Pacific Gas & Electric restructured again in 2020 after paying $13.5 billion to wildfire claimants in cash and new stock issued. It also paid $12 billion to settle municipality and insurance claims. At the same time, the company was able to maintain tens of billions of dollars in tax loss carryforwards, which will shield it from significant taxes going forward. Additionally, future stock sales by the wildfire claimants will further increase the company’s tax loss carryforwards, all making this a great example of why bankruptcy does not necessarily mean the end of the line for any company.
Russ Alan Prince is the executive director of Private Wealth magazine and chief content officer for High-Net-Worth Genius. He consults with family offices, the wealthy, fast-tracking entrepreneurs and select professionals.
