Research Brief: Hedge Funds Come to Help, Not Harm, Bankrupt Firms

WHAT DID THE STUDY LOOK AT?

In the 1990s, the bankruptcy process in the U.S. and Canada was largely controlled by shareholders and management. Over the past 20 years, control has swung to activist creditors such as hedge funds. Popular opinion is that hedge funds are like vultures, taking control of distressed companies with the intention of quickly dismantling them and maximizing short-term profits. The study examined if this is, indeed, the case, and looked more broadly at the role hedge funds play in the Chapter 11 process and their effect on bankruptcy outcomes.

HOW WAS THE STUDY DESIGNED?

The study was based on a comprehensive sample of 474 Chapter 11 cases from 1996 to 2007, formed by merging a variety of data sources.

WHAT DID THE STUDY FIND?

• Hedge firms were involved in close to 90 percent of the sample cases, confirming the dominant role they play in the distressed debt market.
• These activist investors tend to pick situations in which they can have a big impact on the reorganization process. Unsecured debt is the most popular entry point for hedge funds because  it is “the most likely layer in the capital structure where the enterprise value first fails to fully cover outstanding claims.
• Hedge fund involvement in a bankruptcy increases the likelihood of a successful reorganization; for example, there is a greater chance of emerging from Chapter 11 and better debt recovery for other lenders.
• When a hedge fund has a hand in restructuring, there is a greater chance that debtors lose exclusive rights to file a reorganization plan; higher CEO turnover (27 percent of the sample); and greater adoption of key employee retention plans for senior operating executives (in about half of the sampled companies).
• Bankrupt firms with a hedge fund presence record stronger stock performance at the time of bankruptcy filing, and are saddled with less leveraged debt one year after emerging from bankruptcy.

WHAT DO I NEED TO KNOW?

Hedge funds are motivated to strengthen rather than destroy distressed companies, particularly when they adopt a loan-to-own strategy. Bankrupt firms have a better chance of recovering from bankruptcy if hedge funds are in the driver’s seat — clearly a story of “efficiency gains” rather than “value extraction.”  Hedge funds have also reshaped the bankruptcy process. Where it once was seen as either “management driven” or “senior creditor driven”, the researchers note, the restructuring process driven by hedge funds can best characterized as “management neutral, where managers facilitate and implement the distressed firm’s restructuring plans but do not control the restructuring process.” 

Title: Hedge Funds and Chapter 11

Authors: Wei Jiang (Columbia University), Kai Li (University of British Columbia), Wei Wang (Queen’s School of Business)

Published: Journal of Finance (vol. 67, 513-560). Working paper version available on Social Research Network website

— Alan Morantz