The best way to begin the risk management process in distressed assets is to carefully do the homework. By this, we mean that investment decisions should be subject to a rigorous analytical process that has clearly identified the potential rewards and risks of the investment. Third party research is a useful analytical tool, but should always be supplemented with independent analysis. At DebtProfilers, we prefer to follow the progress of situations for a significant amount of time before committing capital. This careful approach allows problems to be uncovered so they may be properly evaluated.
Access to debt portfolio cases and throughout analysis is also an important risk reduction technique. We prefer to invest in portfolios where we can have a dialogue with debt portfolio owner and origins of debt itself. This allows us to get much closer to the investment and develop a better understanding of the situation than would be possible through simply looking at papers. Our research process on a potential investment begins by identifying the key drivers that will make an investment either a success or a failure. Once these issues have been identified, they are then analysed. The variables will be different for each investment – sometimes we may be analysing a debt origins specifics or debtor’s credit rating. In all cases we are evaluating the quality of debt portfolio and our objectives to recover as much debt as we can through all possible means.
Once we are confident that the key drivers have been properly identified and analysed, we then put together three scenarios for how we believe the investment might perform on a going-forward basis. These three scenarios are the upside, the base case and the downside. In the upside case, we are evaluating what our potential return will be if the outcome of our key variables is favourable. In the base case, we determine how our upside will be impacted if, for example, timing is delayed or valuations are lower than in our upside. In the downside scenario, we evaluate what our risk is if things do not go our way – in other words, how much money will we make. It is the outcome in the downside scenario that actually eliminates from consideration most of the investments we look at. If we find that we could potentially lose a material amount of money in an investment, we will eliminate it from consideration regardless of the upside. We would always prefer to be in a series of investments where the upside is attractive and the potential downside is extremely limited.