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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I also had some questions about that article this morning. It almost totally ignores the enormous power bankruptcy judges have to corral litigous creditors. Most large debtors these days come into bankruptcy with a plan that secured creditors have already lined up to support. Unsecured and equity can raise all the objections they want, but to the extent that the judge doesn’t care to lift exclusivity or listen to lawyers argue about valuation (they usually don’t care to do either for very long), the judge will quickly overrule them. Unless a higher court will stay the sale of assets/plan effectiveness (they usually won’t), these objections become moot in short order. That’s not to say that there isn’t always somebody in the room arguing that
equity is in the money – it’s just that they have a limited number of tools for actually delaying the process, given that they know the equity only really has limited option value, the judge knows the same thing, and good bankruptcy lit counsel is expensive. They throw up enough objections to occasionally persuade the other parties to throw them 1-5% of the new equity and pay their expenses, and then everybody goes to the bar down the street from the courthouse by 5:30.

Furthermore, no one is more conscious of the time value of money and the risk of delay than leveraged investors in high-yield debt (i.e. hedge funds). I can’t name any bankruptcies that were meaningfully delayed by hedge funds and I can think of several that were sped up by the consolidation of claims into a small number of hands with expertise and an interest in speedy reorganization (GGP, Extended Stay, etc.).

Posted by najdorf | Report as abusive

While the idea of ‘hedging’ is nothing more than sensible investment practice, Hedge Funds in 2010 are nothing less than sociopathic. Like many heavily packaged products and directionalising malpractices, they have nothing to do with – and make no contribution to – the greater good.

I doubt if any ordinary investor or mezzanine entrepreneur will ever be able to take bourses seriously until the influence of hedgies has been reduced – preferably by a major Crash rather than regulation. Crash 2 is coming for sure, but if what happens is that hedgies simply indulge in necrophilia, it will be time for Congress in the US, and the Commission in the EU, to put a pillow over some faces out there. usive-insiders-believe.html

Posted by nbywardslog | Report as abusive