Distressed debt firms, as their name implies, purchase debt securities in companies that have either filed for bankruptcy or appear likely to do so in the near future. Their penchant for seeking out highly troubled companies has led some in the financial press to refer to them as "vulture capitalists." The unflattering metaphor only goes so far, however. Distressed debt firms do seek out the troubled. However, they make their highest returns not by liquidating a company, but by nursing it back to health.

The strategy of distressed debt firms involves first becoming a major creditor of the target company by buying debt securities (bank debt or bonds) at a discount. This gives them the leverage they need to call many of the shots during either the reorganization or liquidation of the company. In the event of a liquidation, distressed debt firms, by standing ahead of the equity holders in the line to be repaid, often recover all of their money, if not a healthy return on their investment. Usually, however, the more desirable outcome is a reorganization that allows the company to emerge from bankruptcy protection. As part of these reorganizations, distressed debt firms often forgive the debt obligations of the company, in return for enough equity in the company to compensate them. (This strategy explains why distressed debt firms are considered to be private equity firms.) Unburdened of the interest payments on the forgiven debt, the company becomes better positioned to rejuvenate itself. In addition, distressed debt firms typically employ people with expertise in effecting "workouts," or company turnarounds. When the emergent company improves its financial perfomance and re-gains credibility in the marketplace, distressed debt firms stand to profit from cashing out their equity positions.