More evidence that distressed debt funds are a phoenix, not a vulture

phoenixSince well before the days of Gordon Gekko, regulators and policymakers have pondered whether vulture capitalists add value or simply destroy what little hope is left for ailing companies.

In general, research seems to suggest that private equity firms (of both the vulture and non-vulture persuasion) add significant social value (see AllAboutAlpha.com coverage) by reducing, not increasing the rate of bankruptcy of target companies.  Other studies have found that activist hedge funds are also associated with more successful outcomes – but mainly because they know how to pick the winning situations before diving in (see AllAboutAlpha.com coverage).  And further research suggests that activist hedge funds serve an important role in keeping management honest – a role some say should be played more aggressively by institutional investors (see AllAboutAlpha.com coverage).

A study released last month adds to the evidence that activist hedge funds add long-term value.  In an unfortunately titled paper (given recent blow-ups) called “Hedge Funds in Chapter 11”, Wei Jiang of Columbia, Kai Li of the University of British Columbia and Wei Wang of Canada’s prestigious Queen’s University (disclosure: am an alumnus) argue that the involvement of activist hedge funds in distressed situations is a predictor of better outcomes.

How much better?  When the trio compared the returns of Chapter 11 cases where hedge funds as major creditors with returns from Chapter 11 cases where hedge funds were absent, they found that hedge fund involvement was good news…

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The authors also found that there is higher CEO “turnover” (a euphemism for CEO’s being shown the door) when hedge funds are involved in bankruptcy proceedings.  However they also argue that hedge funds’ proclivity to institute key employee retention programs illustrates that they are by no means “anti-management”.

The most common way for activist hedge funds to play the distressed debt game is though unsecured credit, they found.  This is because subordinated debt is a “fulcrum” security where payback is uncertain enough to warrant out-sized returns, but feasible enough to warrant an activist investment.

In a finding reminiscent of one of the previous studies cited above, the trio finds that hedge funds tend to invest in unsecured debt of distressed companies with strong fundamentals and a low ratio of secured debt to assets.  Once they do, the stock market seems to react positively to their involvement.

The cynic in us wonders if hedge funds are just better at finding opportunities and if the ensuing positive equity performance is really just a self-realized prophecy.

If the cynic in us is wrong, however, and activist hedge funds really do add value to distressed companies, then they are essentially arbitraging the difference between the value the market puts on unsecured distressed debt and the actual value of that debt given that it may not actually be that unsecured after all.

Paradoxically, distressed equity hedge funds seek out companies with high levels of secured debt.  As the authors hypothesize, this makes equity the “fulcrum” security whose outcome is now the most uncertain.  They suggest that secured debt holders of companies with high levels of (undercollateralized) secured debt are more likely to leave unsecured creditors high and dry.  Yet, the authors also found that the presence of hedge funds on the Chapter 11 equity committee was not as strong a predictor of future returns.

The study contains a lot more interesting observations about the type of company targeted by activist hedge funds (e.g. that activists have longer time horizons than both liquidators and out-right acquirers).

In the end, the authors quote another author on the topic, Paul Goldschmid, when they conclude that distressed debt investors are “more like a phoenix than a vulture.”

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