Creating liquidity in an illiquid world

The early 2000s rocked the financial
world with the dot-com bubble, interest rate hikes and of course 9/11 wiping
billions of dollars off net asset values. The resulting recession inspired
Warren Buffet to famously state that “you only find out who is swimming naked
when the tide goes out”. Roll the clock forward 10 years and the tide has
receded again with many investments being exposed in all their glory. 

This recession was of course cradled in
the credit markets which led to unprecedented levels of illiquidity in what
were previously considered liquid asset classes. It resulted in the creation of
some frustrated, opaque and often decentralised market segments. Such
illiquidity has extended to elements of the MBS, ABS, CDO, auction rate notes
and many other asset classes, each of which justify their own article. This
article focuses on opportunities for funds and their investors exposed to
illiquid assets in financial sector bankruptcies such as Madoff, Lehman, Bear
Stearns ABS funds, Sphinx and Refco. However, the solutions are equally
applicable to the numerous suspended fund of funds, residual private equity
portfolios and, indeed, most distressed illiquid asset classes.

It would be remiss to fail point out
that, of course, not all illiquid assets are as a result of distress. Many
illiquid opportunities include exciting (but illiquid) equity in private
companies such as Facebook or LinkedIn as well as public companies that have
restricted stock, employee stock options, warrants, convertible debt and Rule
144 securities. Again, the market has evolved and there are buyers that will
provide a liquidity solution. 

So turning to investors’ exposure to
bankruptcies, there are now a growing number of sophisticated market
participants with an appetite and willingness to acquire this class of
“investment” and their existence and growth has been an important contributor
to unlocking capital, creating liquidity and ultimately a more efficient
market. The estimated market value for bankruptcy claims is often quoted to be
in the region of $500 billion with increasing year on year trade volumes
suggesting a growing asset class. At its heart the market is about exchanging
claims against insolvent debtors be they seeking protection under the US
Bankruptcy Code, UK Insolvency Act or, in the case of offshore funds, under the
relevant company and fund legislation in Cayman, BVI and beyond. 

Evidence suggests that the more complex
bankruptcies can last for over a decade to be finally resolved and financial
sector bankruptcies are always complex. Take the creditors of Enron who are
still to this day receiving distributions on their claims that were filed
shortly after the company entered into insolvency proceedings in 2001. Or Lehman,
my former colleague Tony Lomas of PwC in the UK and an administrator of the
Europe assets of Lehman explained to The Telegraph that he expects to be
donning a pipe and slippers in retirement before final resolution of Lehman,
one of the most complex insolvencies of all time and that is expected to take
up to 20 years to fully unravel. 

Of course the collapse of Bernard L
Madoff Investment Securities LLC, of such staggering proportion and complexity
as to give Carlos Ponzi a headache, has already passed its second anniversary
and will likely be another lengthy affair. I will use Madoff as an example to
explore the bankruptcy claims market further. 

Benefits for the seller

The benefits of selling a trade or
bankruptcy claim are numerous and the motivations of sellers can vary broadly. 

  • Liquidity – First and foremost,
    immediate cash is of course the primary objective. A cents on the dollar or
    pennies on the pound price today that reflects the underlying value and risk
    and allows a seller to convert the claim back to cash and utilise the proceeds. 
  • Certainty of timing – A sale provides
    certainty as to timing of recovery and allows a seller to benefit from the time
    value of money, avoid the long and uncertain wait for the full unravelling of a
    complex estate and avoid the hidden opportunity cost of doing nothing. 
  • Certainty of value – A seller gets
    certainty as to value and does not have to carry the risk on the uncertain
    outcome of what maybe a highly complex, multi-jurisdictional bankruptcy outside
    of their strategy and expertise. 
  • Return to strategy – In a scenario like
    Madoff, the investors’ chosen investment asset class was effectively converted
    from what they believed was a highly liquid equity strategy investment into in
    to an illiquid, hard to value, often unregulated asset class that they are
    unlikely to have expertise or even the mandate to invest in. One consistent, if
    perhaps unsubtle, observation is that of the many investors exposed to such a
    bankruptcy, none are there willingly and all would benefit from a return to
    their strategy of choice. 
  • Distributions in kind – Illiquid assets
    are often distributed in kind to investors at the end of the wind down of a
    fund be it through bankruptcy, liquidation or having simply been economically
    run off by the manager. Such assets may include bankruptcy claims but more
    typically consist of the flotsam and jetsam of residual illiquid assets at the
    end of a funds life. Whilst there are structures to house such assets at low
    cost, it is more common for funds to simple distribute them in kind and move on
    leaving individual investors with self management of their pro rata proportion
    of the asset. Again, a cash sale eliminates this risk and inconvenience for
  • Stigma – Motivations to sell can vary
    significantly from the purely economical to the emotive depending on the fact
    pattern and situational need of the seller. In the case of contentious
    bankruptcies often investors simply want to be dissociated from the bad
    experience or CIOs do not like to be reminded of bad decisions from the past at
    every month’s portfolio review for the rest of their careers. 

Risks for the buyer

Buyer’s intentions are purely economic
whether intending to hold a claim for the short or long term. The price is
broadly a product of the assessment of the potential assets and liabilities of
the bankrupt estate (normally based upon very limited and far from perfect
information), the time value of money and risk analysis of what is typically a
complex, multi-faceted and multi-jurisdictional affair. Further, the Madoff
bankruptcy has already created new legal precedents and will likely continue to
do so adding a further layer of uncertainty. Complexity, uncertainty and
delayed distributions amplify risk for a buyer and price is, of course,
inversely correlated to risk. That said, it is helpful for potential sellers to
understand the risks they are exposed to and transfer to a buyer when selling.  

In the case of Madoff, the structure and
pricing of the sale of a direct claim is dependent on a complex matrix of facts
relating to the seller, the status of their claim and even their past
relationship with Madoff. Some considerations include: the type of claim
(private or institutional, customer fund or general estate, etc), the
jurisdiction of the claimant and, of course, the timing and value of past
subscriptions and redemptions. The later issue often needs to be resolved with
the Madoff trustee and his approach towards seeking claw backs and settlements
under US Law and specifically the US Bankruptcy Code’s 90 day preferential
payment rules. The good news is that the Trustee has stated a preference to
reach settlement rather than litigate where he can. As a buyer you can provide
the capital and resource to settle such claw backs and reach a mutually beneficial
tripartite solution for trustee, seller and buyer.

Acquiring a shareholder’s interest in a
Madoff feeder fund adds an additional level of complexity and uncertainty given
the shareholding is a further and significant step removed from the feeder
fund’s direct claim in the Madoff estate. To give some colour on the additional
uncertainties these may include: the introduction of often conflicting multiple
jurisdictions and bankruptcy regimes (eg Cayman, BVI, UK, Swiss feeder funds
into the US Madoff); the feeder funds exposure to litigation risk such as
indemnity claims from service providers; uncertainty on the basis for allowing
and valuing claims (on a money in/money out basis per the US or on another
basis depending on the feeder fund’s jurisdiction); preference period and
pre-preference period claw back demands on subsequent transferees; the cost and
uncertainty of possible recoveries from rights of action against service
providers; timing of distributions many years into the future; the costs of managing
all the above, etc. It is a complicated affair.

Of course there are also benefits to the
investment manager, board of directors or liquidator of a collapsed fund in
encouraging the sale of such shareholders claims. The numerous, typically
disgruntled, investors are consolidated into those that have a risk appetite,
understanding and willingness to be in the asset class and can even, where
merited, source complementary capital such as funding litigation. 

Both direct and indirect claims are
further impacted by issues the Madoff estate itself faces. For example the
basis upon which distributions will be calculated (the denominator). The US
courts have ruled that victim’s losses will be calculated on a money in/money
out methodology rather than a last statement methodology. However, this is
subject to appeal, the outcome of which could have a very material impact such
as increasing the denominator upon which distributions are calculated by
several multiples. 

In summary there is a growing appetite
for the acquisition of illiquid assets of all classes be they bankruptcy
claims, suspended fund of funds, credit securities or residual private equity
or other asset portfolios. Adam Levitin of the Georgetown University Law Centre
views “the creation of a market in bankruptcy claims is the single most
important development in the bankruptcy world since the Bankruptcy Code’s
enactment in 1978”. Each such transaction contributes to the healing of the
market by unlocking capital, creating liquidity and ultimately a more efficient


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Lawrence Edwards

Lawrence Edwards has 20 years’ experience of providing advisory, executive and fiduciary services to institutional and private clients. His experience spans the entire life cycle from creation and fundraising, on-going operations including corporate finance, asset acquisition and divestiture through to the restructuring, workout and ultimate termination of structures. He has successfully advised many of the industry’s highest value and profile wind downs. Lawrence’s career commenced at PricewaterhouseCoopers in the UK before moving to the Cayman Islands. He is a Fellow of the Association of Chartered Certified Accountants, a qualified Member of the Association of Business Recovery Professionals and an accredited commercial mediator.  

Lawrence Edwards FCCA, MABRP
Managing Director
Delta Group – Cayman
PO Box 11820
4th Floor Harbour Place
103 South Church Street
George Town
Grand Cayman
Cayman Islands KY1-1009

T: +1 (345) 743 6611
E: [email protected]