A wide variety of commentators have criticized the role of hedge funds in Chapter 11 reorganizations. Critics characterize activist fund investors as raiders and destroyers of value for the sake of selfish arbitrage. New research1 paints a much more nuanced portrait of hedge fund participation in Chapter 11 reorganization cases. While the debate will doubtless continue to rage, these new data add support for the view that hedge funds’ influence may well be more positive than negative.
Active hedge fund participation in Chapter 11 cases has grown substantially since the turn of the 21st century. These investors offer significant, objective advantages through their participation in reorganization cases. They provide a much-needed source of liquidity for complex reorganization, offering financing that would often have been entirely unavailable without the willingness of hedge funds to take on this risk.
And hedge fund financiers often impose much-needed discipline on reorganizing companies. Post-bankruptcy operational performance has shown greater improvement in cases where a distressed investor gained control over the successfully reorganized company, as opposed to cases were activist distressed investors were not present.
Among the most visible criticisms of hedge fund activity in reorganization cases is the accurate observation that funds often make such cases “messier.” That is, they fight tooth-and-nail for propositions that some might consider outweighed by the costs of such battles. The context of such criticisms is vividly illustrated by the expensive, time-consuming, drawn-out disputes over fraudulent conveyance recoveries in the Tribune and Lyondell cases.
Given the spectacular recent successes won by fund proponents of such litigation, and the potential for millions of dollars of recoveries for junior creditors in these cases, it is not at all surprising that the targets of such litigation have been highly critical of the funds’ dogged perseverance. As to whether the advantages of fund participation outweigh the “messiness” and other undesirable effects it might create, one recent study revealingly concluded that one’s perspective on the salutary or rapacious influence of hedge funds “likely turns on where you sit in the company’s capital structure”; that is, senior creditors, equity and ousted management likely feel they lost value or were pursued unjustly for recovery of “technical” fraudulent conveyances while the beneficiaries of these fights, more junior creditors and the reorganizing company’s remaining employees, and the communities where ongoing operations continue, likely have a more positive appraisal. The latter constituencies are, after all, the primary intended beneficiaries of the rescue culture of Chapter 11.
These parties may favor hedge fund participation in particular because of one important empirical observation: hedge fund involvement is associated with more successful reorganizations. “Success” is a subjective term, but the meaning here is success in terms of the Chapter 11 process itself. Cases with hedge fund involvement have been significantly more likely to end with a re-emergence of the business on the other end of a reorganization, preserving value for stakeholders such as employees, communities, trade creditors, taxing authorities and other ongoing counterparties to the reorganized company.
While cases with fund involvement have resulted in more change-of-control plans and going-concern sales (rather than other kinds of less “disruptive” reorganization plans), these cases represent successful business rescue.
That an activist fund investor gains control of the successfully emerged company may be negative for the few who lost control, but this is hardly an indictment of the fund’s impact on company value, especially for the many beneficiaries of the company’s survival. And as for the notion that hedge funds achieve post-emergence control of companies only to loot them and leave them to reenter the bankruptcy process later, the data do not support this conclusion, either. At best, cases with fund involvement have been as likely to result in a later refiling as cases not involving funds, but not significantly more likely.
To be sure, correlation does not necessarily indicate causation here, since hedge funds often are in a position to choose cases in which they will be actively involved, and they may well choose companies that are more likely to be successfully rescued. Nevertheless, these data challenge any simplistic notion that active hedge fund participants are nothing more than self-interested vultures who waste or appropriate value to themselves at the expense of all other constituencies.
Since cases with fund involvement are more likely to result in a change-of-control plan, it stands to reason that those who lost control will take a dim view of this activity, but for the multitude of constituencies affected by a Chapter 11 reorganization who were not in a control position to begin with, hedge fund involvement seems to be correlated with a much more positive outcome, at least in many cases.
Like most academic studies, the one discussed here concludes by noting the many remaining uncertainties and calling for further research and examination. But the empirical record of the positive impacts of hedge fund investors in reorganization cases has grown yet again in a way well worth noting.
1 The data referenced here will appear in a symposium issue of the American Bankruptcy Institute Law Review, vol. 21, issue no. 2 (forthcoming 2014). In particular, see Michelle M. Harner et al., “Activist Investors, Distressed Companies, and Value Uncertainty.”