Distressed Investing
The strategy of purchasing the debt or equity of companies in or near financial distress — at severe discounts reflecting fear and forced selling — and profiting when the business stabilizes, restructures, or is liquidated at above-purchase prices.
“We've made a lot of money catching falling knives in the last two decades.”
Concept Analysis
Definition & Origins
Distressed investing is the practice of purchasing the debt or equity of companies that are in or near financial distress — at prices that reflect forced selling, panic, and institutional constraints rather than economic value — and profiting when the business stabilizes, restructures, or is liquidated at prices above the initial purchase price.
Oaktree's distressed debt practice, built primarily by Bruce Karsh beginning in the late 1980s, is one of the most enduring and successful applications of Howard Marks' investment philosophy. The practice began at TCW with the S&L crisis (1989-1992), expanded through the high yield meltdown (1990), the telecom bust (2001-2002), the GFC (2008-2009), the energy distress cycle (2015-2016), and the COVID dislocation (2020). Each cycle generated exceptional returns — not because the analytical framework changed, but because the discipline of applying it consistently was rare.
The strategy's intellectual foundation predates Oaktree. Marks spent his entire career in credit markets — beginning in high yield bonds, where the central lesson was that a bond's riskiness is set not by the issuer's fame but by the price paid relative to the issuer's capacity to pay. In 1988, Marks and Karsh organized their first fund to invest in the debt of companies seemingly at death's door. The very idea made it hard to raise money, and that discomfort was precisely the point: it is what caused distressed debt to be priced cheaper than it should have been, and the returns to be consistently high. What began as an outcast niche within the high yield market became, over three decades and half a dozen credit cycles, the most literal expression of the Oaktree philosophy.
Core Ideas
Distress is a source of mispricing, not a signal of value destruction. The key distinction: temporary financial distress versus permanent economic impairment. Most credit distress is temporary — a liquidity crisis, a cyclical revenue decline, a management transition — in businesses with fundamentally sound underlying economics. Permanent impairment (structural competitive deterioration, irreversible technology displacement) is different and must be avoided. The skill is in making this distinction accurately.
Forced selling creates prices unrelated to fundamental value. The most reliable source of mispricing in credit markets is the forced seller: the bank meeting regulatory capital requirements, the investment-grade fund forced to sell a downgraded holding, the leveraged buyer who cannot roll debt. These sellers are price-takers, not price-setters. Their selling creates opportunities for unconstrained, unlevered buyers who have analyzed the fundamental situation.
Capital structure expertise is the core analytical skill. In distressed investing, understanding who gets what in a restructuring is more important than modeling the business's future cash flows. A company in bankruptcy must be analyzed as a legal and financial engineering problem: what assets exist, what are they worth, how are they divided across creditors according to absolute priority rules, and where does a given investor stand in the waterfall? This is not equity analysis — it requires dedicated expertise.
Patient, long-term capital is a prerequisite. Distressed situations rarely resolve quickly. A bankruptcy can take 18-36 months; an out-of-court restructuring may take 12-24 months; a cyclical recovery may require 3-5 years. Investors who cannot commit permanent or long-lock capital to these situations will face pressure to sell before resolution — potentially at prices below their entry. Oaktree's closed-end fund structure, with 5-7 year lock-ups, is specifically designed to enable this patience.
Timing entry to the distress is less important than price. Unlike equity investing where timing matters significantly, in distressed debt the purchase price relative to expected recovery is the dominant determinant of returns. Buying at 50 cents on the dollar in a situation where recovery is 70-80 cents produces a good return whether the recovery takes 12 months or 36 months. Buying at 85 cents in the same situation generates a poor return regardless of timing.
The opportunity set is cyclical, and the hardest skill is waiting. Distressed investing is not a steady-state strategy. In good times, defaults run near historic lows and mispriced credit is scarce; the supply appears mainly after excess has been corrected. The distressed investor must therefore raise capital before the opportunity exists, hold it without forcing trades, and deploy fastest exactly when every headline says not to. Marks' cycle framework is what makes this timing discipline possible: the correction of past excesses is not a threat to the distressed investor but the very source of the opportunity set.
Practical Application
GFC 2008-2009: Oaktree's Opportunity Fund VI deployed aggressively during the crisis — buying senior secured debt of industrial companies, commercial real estate debt, and corporate bonds at prices that implied catastrophic default scenarios that did not materialize. The fund generated returns in the high 20s% per annum — not because the analysis was brilliant, but because the market was pricing for maximum fear rather than realistic outcomes.
Telecom bust 2001-2002: The collapse of the telecom and media sector (WorldCom, Global Crossing, Adelphia) created enormous distressed debt opportunities. Companies that had borrowed heavily for capital expenditure found revenues insufficient to service debt. Oaktree participated in multiple restructurings, acquiring equity stakes in reorganized companies at prices far below their eventual trading values.
The patience test: Every distressed cycle includes a phase — typically 6-18 months after initial purchase — when positions have moved against the initial thesis, and the temptation to sell is intense. Maintaining conviction through this phase, when the thesis is intact but price has not yet reflected it, is the psychological test that separates successful distressed investors from unsuccessful ones.
COVID 2020: The pandemic produced the fastest credit dislocation on record — from "everything is fine" to systemic crisis to extraordinary Federal Reserve backstop to recovery in a matter of months. Oaktree moved early, but the Fed's unprecedented intervention truncated the opportunity: spreads that had blown out to crisis levels recovered before the full pipeline of defaults and restructurings could develop. The episode confirmed both halves of the framework — the dislocation arrived on schedule, and its ultimate size was set by the policy response, which no investor can forecast.
Common Misconceptions
Misconception 1: Distressed investing is speculation. Buying distressed debt is typically more conservative than buying equity in the same company. Senior secured creditors have priority over equity holders in liquidation, contractual covenants that protect their interests, and the ability to force a restructuring that converts their debt into equity control of the reorganized business.
Misconception 2: You need to predict the macroeconomic environment. Distressed returns are driven primarily by security selection and credit analysis, not macro timing. Oaktree has generated strong distressed returns across multiple different macro environments — because the analysis of individual credit situations is largely independent of the macro forecast.
Misconception 3: Distress alone makes debt cheap. A low dollar price is not a margin of safety by itself. Distressed securities can still be overpriced — when recovery prospects are worse than the market assumes, or when a claim sits behind more debt than the assets can support. The strategy's returns come from buying distress at prices below conservative estimates of recovery value, not from buying distress as such. This is the same price-versus-value discipline that governs every other asset Marks touches.
Howard Marks' Own Words
"My view of cycles tells me the correction of past excesses will give us great opportunities to invest over the next year or two."
"It's no coincidence that distressed debt has been the source of many successful investments for Oaktree; there's no such thing as a distressed company that everyone reveres."
"We've made a lot of money catching falling knives in the last two decades."
"Certainly we'll never let that old saw deter us from taking action when our analysis tells us there are bargains to be had."
"Most great investments begin in discomfort."
"In 1988, when Bruce Karsh and I organized our first fund to invest in the debt of companies seemingly at death's door, the very idea made it hard to raise money, and investing required conviction — on the clients' part and our own — that our analysis and approach would mitigate the risk."
"In the distressed debt funds that we organized in 1990 and 2002, both times of chaos in financial markets, we earned net IRRs in the 30s and 40s."
"The above results suggest we were aided in those funds by people who were willing to sell things far below their worth."
"We buy at low dollar prices from depressed owners at a time when corporate performance is well off from the top. Not a bad formula."
Thought Evolution
Related Concepts
Key Memos
First articulation of the distressed investing framework; establishes loss avoidance as the foundation
The call to action at the depth of the GFC; the most operationally consequential memo in Oaktree's history
Why distressed investing requires courage to act against consensus
The origin story of the 1988 fund; discomfort as the source of distressed debt's pricing edge
Distressed debt's unpopularity as the source of its profitability: buying from depressed owners when performance is well off the top
Why the COVID distressed opportunity was smaller than expected after unprecedented Fed intervention