Distressed Debt Investing: Fulcrum Securities, Chapter 11 Math, and the Rise of Lender Fights

Distressed debt investors buy the bonds and loans of companies in or near default at a discount, betting that what they eventually recover will be worth more than they paid. The work is mostly two estimates: what the business is worth, and how that value will be split among the creditors fighting over it.

There has been plenty of supply. S&P Global Market Intelligence counted 785 US corporate bankruptcy filings in 2025, the most since 2010, and 372 in the first half of 2026, level with the year before. Recoveries have also fallen. S&P research reported by Bloomberg in August 2026 found that 23% of bankruptcies over the previous three years returned less than 30 cents on the dollar to creditors, against 7% from 2008 to 2022. A major reason is the out-of-court restructurings covered below, which often leave some lenders worse off before a bankruptcy even starts.

Valuation: two numbers

Debt is usually called distressed when it yields roughly 10 percentage points more than Treasuries or trades well below par. Analysts start with two values:

• Liquidation value, what the assets would bring if sold piecemeal. It sets a floor, and in Chapter 11 each dissenting creditor must receive at least this much (the "best interests" test).
• Reorganized enterprise value, what the business is worth as a going concern with less debt, usually from comparable company multiples and a discounted cash flow. See our business valuation guide for the methods.

The claims then go into a waterfall in order of priority: administrative and priority claims, DIP financing, secured debt by lien priority, unsecured debt, then equity.

An illustration: finding the fulcrum

A company emerging from Chapter 11 is valued at $600 million. Its claims are a $50 million DIP loan, $20 million of administrative and priority claims, $400 million of first-lien loans, $200 million of second-lien notes, and $300 million of unsecured notes.

• After the DIP and administrative claims, $530 million remains.
• First-lien lenders take $400 million and are paid in full.
• The remaining $130 million goes to second-lien holders: 65 cents on the dollar, most likely in new equity.
• Unsecured holders get nothing under strict priority.

The second lien is the fulcrum. An investor who bought it at 40 cents would make 62.5% if the recovery arrives as modeled; spread over two years, that is about 27% a year. Now change one assumption. At a $500 million valuation, second-lien recovery drops to 15 cents and the same purchase loses 62.5%. At $700 million, second-lien holders are paid in full and the unsecured notes become the fulcrum, recovering 10 cents. The valuation drives everything, and the company, each creditor class, and the court's expert witnesses will all argue for a different one.

Strategies

• Control, or "loan to own." A fund buys enough of the fulcrum class to steer the plan, often a blocking position of more than one third, and converts it into control of the reorganized company.
• Active non-control. Investors join ad hoc groups or creditor committees and negotiate, without seeking control.
• Trading. Investors buy discounted debt expecting the price to rise as uncertainty resolves, for example when a plan is filed or a refinancing looks likely.
• DIP and rescue financing. Lenders provide new money with priority and fees, often with the right to convert or roll up existing debt.
• Trade claims. Funds buy suppliers' unpaid invoices at a discount; claims transfers are recorded with the court under Bankruptcy Rule 3001(e).

Chapter 11 voting

A class of claims accepts a plan when creditors holding at least two thirds of the dollar amount and more than half of the number of claims actually voting say yes, under 11 U.S.C. § 1126(c). Holding most of the dollars is not enough on its own.

An illustration: a fund holds $140 million of a $200 million class, and 40 other holders own the remaining $60 million. If all vote and 25 of the small holders reject the plan, only 16 of 41 claims have accepted. The class rejects the plan even though holders of well over two thirds of the dollars voted yes. The plan can then be confirmed only through cramdown, which needs at least one other impaired class to accept and requires the plan to be fair and equitable to the dissenting class.

Two other voting rules matter. Courts can designate, and disregard, votes cast in bad faith; in the DBSD case in 2011, the Second Circuit disqualified the votes of a competitor that bought claims to block a plan and gain strategic control. And since the Supreme Court's June 2024 decision in Harrington v. Purdue Pharma, a Chapter 11 plan cannot release claims against non-debtors, such as owners or directors, without the affected claimants' consent (opinion). That has made opt-in and opt-out mechanics for releases a regular fight in plan negotiations.

Liability management: the fight before bankruptcy

Many troubled companies now restructure out of court first, through liability management exercises (LMEs) that let a majority group of lenders improve its position at the expense of the rest:

• Uptiers. The company issues new super-priority debt to a majority group, which exchanges its old loans into the new, higher-ranked tranche. Excluded lenders drop down the waterfall.
• Drop-downs. Valuable assets, such as the intellectual property in J.Crew's 2016-17 transaction, move to a subsidiary outside the lenders' collateral and support new borrowing.
• Double dips. Structures that give new lenders two claims against the same group of companies.

Courts have split on uptiers. On December 31, 2024, the Fifth Circuit held that Serta Simmons's 2020 uptier was not an "open market purchase" permitted by its credit agreement, while New York's Appellate Division, the same day, upheld Mitel's 2022 uptier because Mitel's agreement allowed "purchases" without the "open market" qualifier. Mayer Brown's summary covers both. The lesson for investors is that the exact wording of each credit agreement now affects recovery as much as the business does. Lenders respond with cooperation agreements, in which holders of a class agree to negotiate only as a group, and with "Serta" and "J.Crew" blocker clauses in new deals.

When buying a loan or bond, check whether a cooperation agreement exists and whether you can join it, which LME protections the documents contain, and whether a majority group could act without you.

Taxes on distressed bonds

A bond bought below its face value on the secondary market has market discount. When you sell it or it is repaid, gain up to the accrued market discount is taxed as ordinary income, not capital gain, unless the discount is below a small de minimis amount. On a bond bought at 40 cents, most of the profit can be ordinary income. Interest the issuer has stopped paying also raises accrual and bad debt questions. IRS Publication 550 explains market discount; get tax advice before buying individual distressed bonds in a taxable account.

How individuals get exposure

• High-yield bond funds hold some distressed debt but are mostly performing bonds; see our high-yield bond guide.
• Interval funds and some closed-end funds specialize in stressed and distressed credit, with limited periodic liquidity.
• Business development companies mostly hold performing senior loans to middle-market companies; they are closer to private credit than to distressed investing.
• Private drawdown funds run by specialist managers usually require accredited investor or qualified purchaser status, high minimums, and lockups of several years. See our alternative investments guide for access rules.

Buying the stock of a bankrupt company is a different bet. OTC tickers of companies in bankruptcy often carry a "Q" suffix, and the shares are usually cancelled under the plan. Hertz shareholders recovering value in 2021 was a rare exception, made possible by a rebound in used car prices.

Due diligence checklist

1. Build the full capital structure, including leases, pensions, and trade claims, with each class's collateral and guarantees.
2. Estimate liquidation value and reorganized enterprise value, and run the waterfall at several valuations to see where the fulcrum sits.
3. Read the credit agreement or indenture for LME protections, voting thresholds, and amendment rules.
4. Identify the other holders, any cooperation agreement, and how many holders sit in your class, not just the dollar amounts.
5. Model the timeline: a prepackaged case can take weeks, a contested case years, and legal fees come out of recoveries.
6. For fund investments, ask how the manager performed in past default cycles, how it values illiquid positions, and what liquidity terms apply. Our advisor selection guide covers finding independent help.

For restructurings that end in a sale, our M&A due diligence guide covers the buyer's side.

This guide is for informational purposes only and does not constitute investment, legal, or tax advice. Distressed debt is high risk and illiquid and can result in total loss. Bankruptcy outcomes depend on specific documents, courts, and facts. Consult qualified financial, legal, and tax advisors before investing.