Risk and Return Among Special Situations vs. Other Private Investments

Introduction and Core Concepts

Special situation investing comes in various shapes and sizes—distressed debt, restructuring scenarios, turnarounds, capital structure arbitrage, you name it. Essentially, these are unique events that aren’t part of a company’s “normal” life cycle. From an investor’s standpoint, these investments can be quite tempting because of the possibility of outsized returns. However, you know how the saying goes: there’s no free lunch in finance. So yep, more reward often implies more risk, and special situations can hit you with challenges in volatility, correlation, illiquidity, and operational complexity.

The moral of the story here? If you’re going to dabble in special situations, tread carefully, do your homework, and be prepared to hold on for a bumpy but potentially lucrative ride. Below, we’re going to delve into a full breakdown of how these special situation investments compare with other private asset classes like private equity, private debt, and real estate from a risk-return viewpoint.

Expected Returns in Special Situations

Most folks are drawn to special situation investments for one major reason: the opportunity to achieve alpha (i.e., above-benchmark returns credited to manager skill, timing, or unique insights). Here’s why:

• Distressed or Mispriced Assets. During market turmoil or company-specific crises, assets can become mispriced. Investors with the patience, specialized expertise, and capital to invest when everyone else is fleeing can scoop up bargains.

• Forced Seller Dynamics. Banks, institutional investors, or even governments sometimes need to offload certain assets quickly (maybe due to regulatory constraints or liquidity crunches). That forced selling can create a discount for the opportunistic buyer.

• Catalyst-Driven Upside. Special situations can be triggered by corporate events like reorganizations, spin-offs, or negotiated debt restructuring. If such events unlock new cash flows or reduce liabilities, the valuation of the underlying investment can soar.

At the same time, no matter how cool the deal might look in a pitch deck, you’ve still got to be aware that an incorrectly timed or poorly executed special situation strategy can quickly lead to capital losses. A lot depends on the investor’s ability to actively manage, or at least influence, the restructuring process.

Example: Distressed Corporate Debt

Imagine a manufacturing company with a heavy debt load that’s having trouble meeting interest payments. Its senior bonds might be trading at, say, 70 cents on the dollar. An investor confident that (1) the company can renegotiate with creditors, and (2) operations are still sound enough for a turnaround, might buy that debt hoping for it to trade back up above par once conditions improve or a restructuring plan is in place. If the strategy works, the investor’s total return can be massive. But if the business fails to restructure, well, you’re left with a big hole in your investment pool—an unpredictable scenario that underscores the high-risk nature of special situations.

Volatility and Correlation

Volatility in special situation investing is often event-driven. So, these investments can have a relatively low correlation to traditional benchmarks, at least during normal times. That said, abrupt shifts in markets or unexpected events—like a disappointed restructuring outcome—can create dramatic price swings.

• Negative or Low Correlation. Because special situations aren’t purely driven by typical market factors, they can provide diversification benefits to an equity-focused portfolio. Some managers consider them a hedge in times of market stress if they’re carefully selected.

• Event-Driven Shocks. If the catalyst for a special situation fails to materialize (e.g., a deal falls through, secured creditors refuse terms), the investment could drop sharply in value. So volatility can look smooth until it suddenly doesn’t—kind of a calm-before-the-storm dynamic.

• Broad Market Stress. In a crisis scenario—like 2008 or early 2020—virtually all asset correlations can spike. That includes special situations, especially if abrupt market declines halt credit lines, disrupt restructuring negotiations, or depress asset values.

The upshot is that special situations can appear statistically uncorrelated, but that subtlety shouldn’t lull you into complacency. Historical correlations can be fleeting, and if the “alpha” story unravels, correlation might not be the only problem you’ll face.

Illiquidity Woes

Illiquidity is a biggie in special situations—yes, even bigger than typical private investments. When you invest in a distressed business or distressed real estate property, you often have to wait for an entire turnaround or reorganization process that might span months or even years. You rarely have a deep market to exit if you need quick cash.

• Restructuring Timelines. Bankruptcies and restructurings can be lengthy, with court procedures, negotiations among debt holders, and official committees. Your money is stuck until it’s all sorted out.

• Market Sentiment. If credit markets freeze or the broader economy dips, it can be tough to find a buyer or refinance. Liquidity might vanish at exactly the worst time to exit.

• Patience Premium. Investors who are comfortable with locking up capital for longer durations often demand—and hopefully earn—a premium for accepting that illiquidity. This is precisely why the return potential in special situations can be so high for those with the fortitude to stay the course.

Operational Complexity and Manager Skill

Operational complexity is sometimes the hidden dimension. You’d be surprised how many moving pieces show up in distressed scenarios, from negotiating with labor unions and major suppliers to carving out non-core assets and reconfiguring capital structures. This environment can be both rewarding and complicated:

• Active Involvement. Turnaround opportunities might require you to bring in fresh management, renegotiate contracts, or trim down certain business lines. If your team is not prepared for that level of involvement, special situations might prove too intense.

• Legal Complexity. In distress, the legal framework (bankruptcy laws, creditor rights, etc.) shapes the playing field. Knowing the ins and outs (or employing an experienced legal team) is critical to shape an advantageous restructuring deal.

• Redundant or Poisonous Assets. Companies in trouble might own assets that are effectively worthless, or they might have complicated off-balance-sheet liabilities. Sorting that out can be time-consuming and unpredictable.

• Potential Alpha. Precisely because of these complexities, successful managers can achieve above-market returns. The skill required, however, is substantial.

Comparison with Other Private Market Investments

Versus Traditional Private Equity

Traditional private equity (PE) typically invests in going concerns seeking growth or buyout opportunities. Special situation investments differ because:

• Timing. Special situation deals often arise from crises or forced sales. Traditional PE deals unfold in a more methodical manner—think carefully planned buyouts, not 11th-hour rescue financing.

• Risk-Return Profile. Both can deliver high returns, but special situation returns may rely heavily on event triggers or resolution of distress. Traditional PE bets more on longer-term operational improvements and market expansion.

• Manager Skill Requirements. All private equity managers require skill, but special situation managers might need deeper legal and restructuring expertise.

Versus Private Debt

Private debt funds often lend to (reasonably) stable companies that can’t or won’t tap public markets. Compare this with special situation lending:

• Risk. Special situation debt might target borrowers in imminent or actual distress. Rates and arrangement fees might be higher, but so are default and restructuring risks.

• Collateral and Priority. Many special situation debt deals hinge on your ability to secure senior positions in the capital structure or valuable collateral.

• Return Drivers. Private debt often seeks steady coupons, while special situation debt invests hoping for price appreciation or a workout that yields a strong payoff.

Versus Private Real Estate

Real estate is largely about physical properties, stable cash flows (like rent), or cyclical property-level expansions or renovations. However, some distressed or opportunistic real estate deals do overlap with special situations:

• Tangible Assets. Real estate has an underlying physical property, which can help anchor valuations but still carries potentially high leverage and cyclical risk.

• Complexity in Zoning or Development. Distressed real estate involves issues like unpaid property taxes, foreclosure processes, or major structural renovations. Timelines can be just as uncertain as any distressed corporate scenario.

• Market Dependency. Real estate can be influenced by local economic conditions, interest rates, and regulatory policies. Special situation real estate is no exception—it adds a distressed layer on top of an inherently cyclical market.

Diagram: Risk-Return Spectrum in Private Investments

Below is a simple Mermaid diagram illustrating a conceptual risk-return spectrum of various private market investments, showing how special situations often sit at the higher-risk end.

    flowchart LR
	    A["Lower <br/> Risk <br/> (Private Debt)"] --> B["Moderate <br/> Risk <br/> (Traditional PE)"]
	    B --> C["Higher <br/> Risk <br/> (Special Situations)"]
	    C --> D["Potential <br/> Highest <br/> Return"]

Glossary

• “Alpha” – The excess return generated by a strategy over its benchmark or market-based expectation due to manager skill or unique insights.
• “Correlation” – Statistical measure of how two assets or markets move in relation to each other. A correlation of +1 indicates perfect alignment in movement, whereas –1 indicates perfect opposition.
• “Opportunistic Strategy” – An investment approach that pursues unusual, temporary, or market-imperfection-driven opportunities to seek higher-than-typical returns.
• “Market Stress” – Periods when financial markets experience significant uncertainty or downside volatility; can cause liquidity to dry up and correlations to converge.

Practical Insights, Pitfalls, and Best Practices

• Thorough Due Diligence. Review the target’s operating environment, the creditors’ claims, and the existing management team. Even small oversights can spiral into major losses if distress worsens.
• Understanding Stakeholder Hierarchies. In distressed deals, senior secured creditors often have priority that can overshadow junior stakeholders. Aligning your position with (or just behind) the most protected creditor classes can be wise, though not always feasible.
• Realistic Turnaround Plans. Overly optimistic growth or cost reduction forecasts can break a deal if the market environment shifts. Plan with conservative assumptions.
• Regulatory and Legal Framework. If you’re dealing in a jurisdiction with uncertain property rights or a murky legal environment, that adds complexity. Engage local counsel with proven track records.
• Reassessment of Correlation. Even if an investment looks uncorrelated, check tail risks. In severe recessions, your special situation might crater along with everything else—even if it typically shows minimal correlation.

Exam Tips for CFA® Level III Candidates

• Apply Scenario Analysis. Expect item sets or essays with partial information about a distressed firm’s capital structure. You may need to evaluate how potential triggers (like lower interest rates or a successful restructuring) drive returns.
• Watch for Ethical and Fiduciary Angles. The CFA Institute Code of Ethics emphasizes fair dealing, duty of loyalty, and thorough understanding of client constraints. Distressed investments often carry extra conflict-of-interest and disclosure concerns.
• Time Your Responses. Because exam scenarios can be complex, read carefully. Identify the key event catalysts or restructuring steps. Then weigh potential outcomes for risk and return.
• Cross-Asset Comparisons. The exam might ask you to justify a distressed investment’s place within a broader asset allocation. Points to highlight: correlation benefits, illiquidity premium, and managerial expertise.
• Shorthand for Distressed Waterfalls. You may see references to absolute priority rules (like who gets paid first in bankruptcy). Make sure you have those rules memorized, or at least conceptually mapped.

References and Further Reading

• Kaplan, S., & Strömberg, P. “Leveraged Buyouts and Private Equity,” Journal of Economic Perspectives.
• Turnaround Management Association (turnaround.org). Helpful for insight on operational turnarounds.
• Moody’s and S&P Credit Rating Research. For data on default and recovery rates in distressed scenarios.

Anyway, special situations can be pretty exciting—some folks basically live for the challenge of turning around a failing enterprise. But it’s not one-size-fits-all. You absolutely need the right expertise, appetite for volatility, and patient capital. If those pieces are in place, then yeah, you really might be able to seize that elusive alpha.

Test Your Knowledge: Risk & Return in Special Situation Investments