Are hedge funds abusing bankruptcy?

By Felix Salmon
September 7, 2010
Mike Spector and Tom McGinty have a big piece in the WSJ looking at the role of hedge funds in bankruptcy negotiations. They're not fans:

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Mike Spector and Tom McGinty have a big piece in the WSJ looking at the role of hedge funds in bankruptcy negotiations. They’re not fans:

The bankruptcy process was created decades ago as a way to give ailing businesses a chance to heal and creditors a shot at repayment. Hedge funds and other big investors have transformed it into something else: a money-making venue where, after buying up distressed companies’ debt at a deep discount, they can ply their sophisticated trading techniques in quest of profits…

To some in the bankruptcy bar, the investors’ tactics are an affront to a tradition meant to nurse companies back to health and save jobs. At worst, say critics, the involvement of distressed-debt investors can turn a bankruptcy case into an insiders’ game, putting at a disadvantage other creditors and even the judge…

Testifying this February before the judiciary panel rewriting disclosure rules, Judge Gerber urged strong regulation: “The notion that the transparency and integrity of the bankruptcy system upon which people have relied for decades can be abandoned or cut back to serve investors’ desires is very troublesome to me. In fact, it’s downright offensive.”

Bankruptcy cases can, like most contested litigation, become highly contentious things. But the thing which bothers me about the article is that it seems to assume that if hedge funds profit by trading in and out of debt over the course of these cases, then the company itself is likely to be the loser. And that doesn’t ring true to me: the aim here is generally to maximize the recovery for the class of creditors which ends up with control of the company. And that, in turn, means maximizing the value of the company.

To a first approximation, control of the company will pass to a certain class of creditors, and that class, along with everybody senior to that class, can normally be considered winners. Meanwhile, everybody junior to that class is likely to come out a loser.

When it comes to the company itself, however, along with its customers, suppliers, employees, and other stakeholders, things aren’t nearly that simple. There’s a case to be made — although the WSJ fails to even attempt to make it — that the longer and more acrimonious the bankruptcy process, the worse things are for the company in question. If that’s true, then the presence of lots of highly-litigious hedge funds with differing economic interests is likely to hurt the company.

There’s also the possibility that the existence of lots of CDS holders will make any restructuring that much more difficult.

But ultimately I think this is something which needs to be looked at empirically, rather than anecdotally. Is there any concrete evidence that the costs of bankruptcy have risen, from the point of view of the companies being restructured?

If that’s too hard to find, then is there at least any evidence that companies are spending longer in bankruptcy, and that spending more time in bankruptcy is ultimately harmful to their economic value?

It’s not in and of itself a bad thing when hedge funds are making money in bankruptcy negotiations — especially if ultimately they’re making a private-equity play, looking to take operating control of a company rather than remaining passive investors. So while this is a subject worthy of serious investigation, I’d love to see it written about much more from the companies’ point of view than from the hedge funds’. Only then will we know whether significant damage is being done.

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