LOS u: Discuss the sources of distressed securities and explain the major strategies for investing in them.

Q1. In distressed securities investing, a private equity fund that seeks to partner with the company in which the fund invests would most likely be called:

A)   a high yield fund.

B)   an orphan equity fund.

C)   a vulture fund.

Q2. In distressed securities investing, the strategy that focuses on trying to find opportunities where the prospects will improve is called:

A)   a momentum strategy. The goal is to find a firm that has “improvement momentum.”

B)   long-only value investing. Its returns depend on the fact that the market for distressed securities is efficient.

C)   long-only value investing. Its returns depend on the fact that not all investors can invest in distressed securities.

Q3. In alternative investments, distressed debt arbitrage seeks to earn a return from:

A)   an improvement in the prospects of the firm only.

B)   the decline of the stock to zero only.

C)   either the decline of the stock to zero or an improvement in the prospects of the firm.

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Q1. In distressed securities investing, a private equity fund that seeks to partner with the company in which the fund invests would most likely be called:

A)   a high yield fund.

B)   an orphan equity fund.

C)   a vulture fund.

Correct answer is C)

A “vulture fund” is a private equity fund that uses an “active” approach where the fund or investor acquires positions in the company, and the investment gives some measure of control. The investor can then influence and assist the company and then acquire more ownership in the process of any reorganization. By providing services and obtaining a strategic position, the investors create their own opportunity.

Q2. In distressed securities investing, the strategy that focuses on trying to find opportunities where the prospects will improve is called:

A)   a momentum strategy. The goal is to find a firm that has “improvement momentum.”

B)   long-only value investing. Its returns depend on the fact that the market for distressed securities is efficient.

C)   long-only value investing. Its returns depend on the fact that not all investors can invest in distressed securities.

Correct answer is C)

This is the basic principal of long-only value investing in distressed securities.

Q3. In alternative investments, distressed debt arbitrage seeks to earn a return from:

A)   an improvement in the prospects of the firm only.

B)   the decline of the stock to zero only.

C)   either the decline of the stock to zero or an improvement in the prospects of the firm.

Correct answer is C)

Distressed debt arbitrage is the purchasing of a company’s distressed debt while selling the equities short. The investment can earn a return in two ways: 1) if the equity declines or goes to zero the investor gains from the short position but may continue to gain from the long bond position, 2) if the company’s prospects improve, because of the seniority of bond claims, the returns to bond holders should be greater than that of equity holders. The possibility of returns from two events provides a good market opportunity.

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