Distressed debt funds are investment vehicles that specialize in acquiring the debt of companies, projects, or assets that are experiencing financial difficulty, often trading well below face value.
These funds typically step in when borrowers are under stress — such as in bankruptcy, restructuring, or facing liquidity shortfalls — and aim to generate returns by either a restructuring process, gaining equity through debt-for-equity swaps, or profiting when the underlying borrower recovers.
By investing in distressed securities, investors have the opportunity to acquire real estate assets at significant discounts to market value while benefiting from the strong legal protections of a first-lien creditor.
To demonstrate the potential of distressed debt funds, Constitution Lending’s Credit Fund generated a 57.60% net return in 2024.
This comprehensive guide will explain what distressed debt funds are, how they work, and why Constitution Lending stands out as a partner for investors seeking distressed opportunities.
Book a call with the General Partner to learn more about Constitution Lending’s distressed debt investing strategy.
What is Distressed Debt Investing?
Typically, distressed debt involves corporate debt held by companies facing financial distress, such as cash flow shortages, unstable capital structure, or debt overload. However, as we discuss later, distressed debt investing goes beyond high-risk distressed companies and can also include mortgage loans on investment properties where the borrower has stopped paying.
In most cases, distressed debt investors aim to resolve the debt by negotiating with the borrower or receiving the loan payoff. If that is not feasible, they may take possession of the underlying property through foreclosure. This strategy can be highly profitable, especially when the distressed loan is backed by a valuable asset, and the total payoff is sufficient to ensure a profitable return even after the carry and legal costs.
How Do Distressed Debt Funds Work?
Investors in distressed debt funds pool their capital to purchase troubled loans. Once these loans are acquired, the fund works through various strategies such as negotiating with the borrower, foreclosing on the property, or reselling the asset to realize a profit. The returns on distressed debt investments can be substantial, especially when loans are bought at a steep discount relative to the underlying asset’s value.
Advantages of Distressed Real Estate Debt Over Corporate Debt
Investing in distressed debt securities, or any asset class focused on purchasing corporate finance debt, involves substantial default and credit risk since there is typically no collateral securing the debt. Some corporate debt is secured by company assets such as equipment, IP, and inventory, but these items depreciate over time and are hard to value and sell.
The lack of stable collateral makes investing in distressed company debt inherently speculative.
In search of stable capital protection, more investors are turning to real estate-focused distressed debt funds. Unlike corporate assets, real estate tends to appreciate over time, is simpler to value, and is significantly easier to sell.
Real estate debt funds can purchase loans at deep discounts secured by a property worth substantially more than the owed amount. They can accrue interest as they liquidate the property and use the sale proceeds to recover the full owed amount.
Let’s use our fund, Constitution Lending, as an example to discuss how distressed real estate debt funds can generate high returns and protect investors’ capital.
How Constitution Lending Generated 57.60% Returns in 2024 with Distressed Real Estate Debt Investing
Constitution Lending’s distressed debt fund specializes in acquiring non-performing loans — loans in which the borrower has defaulted — for less than the outstanding balance. These loans are backed by real estate worth substantially more than the amount owed.
This strategy offers multiple advantages over funds that purchase distressed corporate debt, namely, the protection provided by the underlying property.
As first-lien creditors, we have the right to foreclose on and sell the underlying property and use the proceeds to recover the amount owed. Corporate debt doesn’t offer this capital protection because they are often unsecured or backed by company assets that depreciate, making them difficult to value and liquidate.
Read more: Investing in Real Estate Debt Funds: A Comprehensive Guide
Real Estate Debt Markets Are Inefficient, Allowing Us to Purchase Non-Performing Loans at Discounts
Real estate debt markets are inefficient, meaning that assets are often not sold at their intrinsic market value due to regulatory constraints, liquidity issues, and other factors.
For example, regulations such as the Dodd-Frank Act and Basel III mandate that banks limit the number of distressed loans on their balance sheets. Because of this, banks look to clean up their balance sheet by selling distressed loans to funds specializing in debt resolution.
Through the relationships we built with banks and non bank lenders over the last several years, we can purchase these distressed loans at discounts to what the borrower owes and foreclose on the underlying property. We can then use the proceeds to realize the full owed amount.
We Purchase Distressed Real Estate Loans With Default Interest Rates Between 18% to 24%
We also leverage the default interest rate on a loan to earn higher returns.
A default interest rate is a higher interest rate that applies when a borrower defaults, ranging from 18% to 24%.
However, it’s rare for borrowers to pay the default interest rate monthly. Instead, we add the default interest penalty to the borrower’s outstanding balance and realize this gain when the property is sold. The proceeds are then used to settle the owed amount.
How We Protect Investors’ Capital Against Credit, Default, and Market Risk
We protect fund distressed investors’ capital by exclusively purchasing non-performing loans with low LTV ratios.
LTV compares the owed loan amount to the value of the collateral backing the loan. For instance, if the borrower owes $600K and the underlying property has a valuation of $1MM, the loan’s LTV ratio is 60%. Lower LTV ratios are safer because there’s more collateral backing the loan.
Most of the loans in our fund have LTV ratios below 60%. This provides significant borrower equity to cushion against property value losses. A 60% LTV ratio means that up to 40% of the property’s value could be lost (which is highly unlikely), and senior debt investors can still recover their full principal.
Key Details About Constitution Lending’s Credit Fund
Minimum Investment Amount
Constitution Lending gives non institutional investors access to investment grade non-performing loans with a minimum investment requirement of $20K.
This is substantially less than the minimum investment requirements of most distressed debt funds and even private equity firms, which is at least $250K to $1MM.
Lock-up Periods
Lock-up periods refer to the designated timeframe during which investors are restricted from withdrawing their capital after depositing it into a fund.
Lock-up periods protect asset managers and investors by ensuring they have a stable amount of funds to execute their alternative investment strategy instead of having to focus on liquidating distressed assets (which are illiquid and difficult to sell quickly).
Constitution Lending’s non-performing loan fund has an 18-month lock-up period.
Fund Distributions
The Constitution Lending fund distributes earnings to investors quarterly after the 18-month lock-up period.
Factors to Consider When Choosing a Debt Fund: 4 Due Diligence Strategies
- What is the LTV for the loans in the fund? Consider the average LTV of the distressed debt in the fund and opt for a fund that mainly consists of low LTV loans, typically below 60%. This way, investors are protected by the borrower’s equity if the collateral loses value.
- What’s the fund manager’s track record? Analyze the fund manager's track record before investing and check their expertise in loan underwriting, servicing, recovery, and liquidation, which are all critical to effectively executing distressed debt investing strategies.
- What is the fee structure? We recommend asking portfolio managers about management fees, repayments, performance incentives, and other expenses.
- What are the rules around liquidity? Consider how long after the initial deposit you can withdraw your money. Funds like Constitution Lending have 18-month lock-up periods, while most distressed, private equity, and hedge funds have multi-year lock-ups and place restrictions on the maximum withdrawal amount.
Capitalize on High Yields and Strong Principal Protection With Constitution Lending
You can learn more about Constitution Lending’s non-performing loan investing strategy by scheduling a call with a portfolio manager.
