Distressed debt investing allows investors to acquire a company’s debt. These are companies on the verge of bankruptcy (liquidation) for failure to meet their financial obligations. Distressed debt investors acquire debt for various reasons.

Some distressed debt investors acquire debt to become the distressed firm’s major creditors. This way they can force a company into bankruptcy for strategic reasons, such as eliminating competition.

Most distressed investors, however, see a path to the company’s profitability. They anticipate a turnaround and want to be the ones to steer the company through restructuring. To do this, they acquire their debt and then work their way into a controlling position. With a controlling interest, they have the leverage to control many aspects of the company’s operations, including the terms of debt restructuring.

Restructuring takes the distressed debt investor from a creditor to an equity owner. Becoming an equity owner means the distressed debt investor would be the last to be paid out should the company fail. If the restructuring is successful, however, the upside can be significant. If the company is liquidated before restructuring occurs the investor, as a debt holder, will be paid before any equity holders.

Distressed investing is often seen as a hostile act, pushing out existing management and taking control of a company or forcing it into bankruptcy. As such, distressed firm owners may be opposed to the idea. Consequently, distressed debt investors may acquire the debt slowly and without drawing attention.

Surreptitious debt acquisition limits due diligence to the distressed company’s publicly available financial records. This means a distressed debt investor risks investing based on an inaccurate or incomplete picture of a distressed company’s financial situation.

Also, secrecy makes it hard to know who else may be buying into the debt. The distressed firm's condition may have attracted several other distressed debt investors, who are also coming in through the backdoor. So when reorganization is triggered, the debt investor with the largest interest gets the voting rights, relegating the others to “accidental partners.”

Another approach, a passive one, involves the strategic acquisition of a distressed firm’s securities. A company’s failure to meet its financial obligations may hurt the value of its share price. Consequently, distressed company-issued securities are typically steeply discounted.

Investors acquire distressed securities of such companies with two assumptions. One, they believe that the debt situation is not as bad as it looks, that the current valuation exaggerates the actual risk of bankruptcy. They anticipate the company will recover and their investments will appreciate over time. Two, they’re confident in the firm’s ability to cover their investment should it be liquidated.

One of the many factors investors consider before investing in a distressed company is its capital structure. For a company on the brink of bankruptcy, the debt type matters.

Loan holders, for example, are prioritized over bondholders during liquidation. Unlike loans, which are lender-give and secured, bonds are offered to the public by the company.

An investor’s financial goals also matter. If the goal is to gain a controlling stake, they may strive for two-thirds of a company’s bonds, knowing they may not be paid out first. As such, they target mismanaged or undervalued companies with a successful business model and an in-demand product or service.

Distressed investing carries significant risk. The worse off a company's capital structure is, the higher the chances for default. Because of the high risk, risk-seeking investors can often acquire debt at a small fraction of its face value.