The Evolution and Tactics of Modern Distressed Debt Investing

The Evolution and Tactics of Modern Distressed Debt Investing

Distressed debt investing in 2026 looks nothing like it did a decade ago. What was once a relatively straightforward exercise in asset coverage and recovery math has morphed into a high-stakes arena defined by litigation threats, tactical positioning, and the subtle art of creditor control.

At a recent roundtable in Los Angeles, a group representing the views of investors, advisors, and covenant specialists explored this transformation – candidly discussing how liability management exercises (LMEs), co-op agreements, and increasingly permissive loan documentation have rewritten the distressed playbook. What emerged was a portrait of a market that is not only more complex, but also more adversarial and strategically nuanced than ever before.

When Math Was Enough

Veterans of the mid-2010s remember simpler times. Back then, distressed investing could often be reduced to a spreadsheet exercise – model the liquidation value, buy cheaply, and wait for the process to work itself out.

One investor recalled snapping up second-lien bonds in a bankrupt energy company for 11 cents on the dollar, expecting a 50–60 cent recovery. The strategy was almost mechanical: buy low, sit tight, collect your check. And it worked.

Today, that same playbook would almost certainly fail. Instead of a linear court process, investors face a labyrinth of roll-up DIP financings, aggressive uptiering transactions, restructuring support agreements favoring insiders, and swift equitizations that upend capital structures overnight. The shift is profound – distressed investing has become as much about structure and creditor dynamics as it is about value.

The Rise of the LME Era

The most dramatic catalyst for this evolution has been the rise of the liability management exercise. Rather than taking companies directly into bankruptcy, sponsors now engineer transactions that reallocate value through creative financing.

Uptier exchanges, super-priority roll-ups, and majority-amendment mechanics are the new tools of choice. One investor at the roundtable described a situation where a restructuring support agreement left his fund with just 3% of its expected economics. Only through litigation and a competing proposal in Chapter 11 did the situation rebalance. The protection didn’t come from the documents – it came from leverage, size, and persistence.

That distinction is important: in today’s market, control of process often trumps the written word.

Do Documents Still Matter?

It’s an unsettling question for lenders who take comfort in their covenants: do credit agreements still matter in a world where most provisions can be amended by majority consent? As one advisor put it, “what’s prohibited today might be permitted tomorrow.”

Sacred rights still have value, but even those can be blunted by court rulings or post-confirmation maneuvers. The stories shared during our discussion painted a consistent picture – roll-up DIPs being challenged, rights offerings shifting economics after the fact, minority creditors priced out of litigation entirely. The upshot: document literacy matters, but control of the creditor group matters more.

A New Battlefield: Creditor Dynamics

In this environment, knowing who else owns the paper may be just as important as knowing what the paper says. The insider-versus-outsider divide has become a defining feature of modern restructurings. Investors noted an emerging convention – insiders offer outsiders a spread of about ten to fifteen points to avoid litigation. It’s an uneasy peace, and not always sustainable.

The tools of creditor control are also evolving: anti-cooperation clauses, ownership caps, and “anti-snitch” provisions are emerging. Each speaks to the rise of creditor-on-creditor warfare – and a market still trying to impose order on itself.

Litigation as Strategy — and as Constraint

Litigation has become a weapon of choice, but a costly one. Challenging roll-ups, delaying filings, or arguing implied covenant breaches can shift negotiating dynamics – yet one investor admitted walking away from a ten-million-dollar claim when legal fees threatened to consume most of the upside. The new reality is stark: a right has value only if it can afford to be enforced.

Private Credit Joins the Party

Many once saw private credit as insulated from these dynamics – predictable, bilateral, and relationship-driven. That insulation is quickly thinning. As private credit deals grow larger and more syndicated, documentation flexibility increases while lender cohesion erodes. Maintenance covenants are softening, MFN protections are loosening, and “club” arrangements increasingly mirror the fractured syndicates of the leveraged loan world. Distress is quietly migrating from the public to the private markets.

Are LMEs Solving Anything?

As one participant wryly noted, “it’s hard to LME your way out of a leverage problem.” Shuffling tranches may buy time, but it rarely fixes fundamentals. Unless earnings rise or debt falls, stress eventually resurfaces. Data discussed at the event suggested many LME-heavy companies reach Chapter 11 within 12 to 18 months – evidence that these deals often delay, rather than prevent, the inevitable.

Picking Battles and Finding Leverage

So who’s navigating this new landscape effectively? The consensus was pragmatic: scale and selectivity matter most. Being a small holder in a hostile capital structure is perilous; being a decisive one can reshape the outcome. Investors who choose their battles, secure influence early, and anticipate sponsor behavior tend to fare best.

Creative Positioning and the Next Wave

The playbook has also expanded. Beyond standard distressed trades, investors are pursuing busted converts, equitizing undervalued issuers, swapping unsecured debt into first-lien positions, and underwriting new-money injections for structural priority. The rewards can mirror equity-like upside – but only for those positioned on the right side of the dynamic.

The Road Ahead

If there’s one takeaway from today’s distressed market, it’s that intelligence beats instinct. Tomorrow’s successful investors will pair document fluency with deep insights into lender psychology, litigation economics, and bankruptcy strategy. Value still matters – but only in context.

In 2015, math was enough. In 2026, math is only the opening move. The real game is about structure, strategy, and control. And for anyone stepping into the fray, the crucial question isn’t simply “What is this bond worth?” — it’s “Am I in the right seat at the table?”

‍