The Role of Hedge Funds in Corporate Restructurings

by David M. Reeder

The Role of Hedge Funds in Corporate Restructurings.

        A new major player is emerging on the corporate restructuring and bankruptcy scene world-wide; hedge funds. Playing the role of "liquidity provider", for a price, hedge funds can bring sorely needed cash to the table early in a corporate reorganization.

        Much has been written about hedge funds in the financial press. The image that is most often portrayed is that of an entity with huge amounts of money at its disposal, taking very aggressive positions in the equity, debt, and arbitrage markets.

        First, a quick look at what a hedge fund is. The term "hedge", from the phrase "to hedge your bets", has traditionally referred to a strategy where a company with exposure to price changes of commodities, such as petroleum, precious metals, or agricultural commodities, will take a position in the futures market which will offset any negative price swings in the commodity in question. Thus, hedging has been viewed as a risk-limiting strategy, since in limits downside risk if the price of the commodity decreases, but eliminates the upside potential if the market price of the commodity increases.

        Suffice it to say, modern hedge funds are not in the business of eliminating upside in order to limit downside. The hedge fund of today is an entity that is: 1) unregulated or minimally regulated; 2) not a bank or insurance company; 3) that is in control of sizable amounts of money; 4) invested mainly by large investors able to withstand financial risk; and finally 5) attempting to make truly outstanding returns in return for taking above-average risks.

        Hedge funds are able to find opportunities in dealing with troubled companies either inside or outside of bankruptcy, due to their flexibility and willingness to take whatever position makes financial sense. This makes them very valuable players in cases of companies which have a strong core business, but are beset with a serious financial downturn. A hedge fund can extend credit, being able to move more quickly, and with less regulatory restraints than a commercial bank. It can also take an equity position, majority, or even minority, giving them an edge on the private equity firms which normally insist on control. They can adjust their target rates for the risk which they asses to be inherent in the transaction, keeping in mind that a substantial component of their business is assessing risk.

        In a recent article by John Willcock, Editor of Global Turnaround, London, UK, which appeared in Insol World, the journal of Insol, the organization of insolvency professionals and investors world-wide, Terry Hughes of Silver Point Capital, a 6 billion dollar hedge fund, made several poignant observations regarding the role of hedge funds in corporate restructurings. First, he showed the flexibility of hedge funds over traditional players with the following illustration: "You can understand hedge funds by comparing them to private equity, banks, and mezzanine investors. All three live in silos. Private equity houses buy all of the equity in a company, and want to control the whole company. If they can’t, they don’t invest. Banks want to lend, and if a company can’t pass the appropriate credit assessment, then they don’t lend. Mezzanine investors want a minimum rate of return before they invest." Huges continues: "Our ability is to run up and down the capital structure of the company, investing where we want. We’re not restricted to one silo."

        Assessing the risk of investing in companies which have already entered the bankruptcy process offers unique challenges. Investing in bankrupt companies has been referred to as "investment’s black art". One thing is sure, when investing in bankrupt companies: you are really are buying at the bottom. The question is, of course, will it ever come off of the bottom. Many hedge fund managers have had very good experiences that answer in the positive. If the company has good fundamentals, an established core business, and a discernable market share, than it can, through the chapter 11 process, confirm a plan of reorganization that will enable it to shed millions if not billions in debt, and emerge from bankruptcy is leaner more attractive entity. Corporate bankruptcy has been compared to the "fat farm, where people go to shed pounds, hopefully emerging ready for their high school reunion."

        The hedge-fund industry is widely reported to exceed $1 trillion in assets. In the mean time, the face value of distressed debt has grown to $718 billion this year, nearly 10 times the $77 billion it amounted to in 1998, according to Bloomberg.

        Due to their ability to be aggressive, flexible, and fast to act, hedge funds will continue to play an expanding role in bringing liquidity to the table in more and more corporate insolvencies, both inside and outside of bankruptcy. Stay tuned.