To paraphrase the immortal Thin Lizzy:
Guess who just got back today?,
Them wild-eyed hedge funds that had been away
Haven't changed, have lots to say
And man, we still know them cats are crazy
After time away from the world of chapter 11 and distressed investing, hedge funds are back in town searching bankruptcies for debt to trade. And, for those who do the work – and know how to do the work – the returns on investment will be tremendous.
From 2003 through the first half of 2007, as hedge funds proliferated and the economy soared, certain hedge funds turned their eyes and wallets to trading in the debt of distressed companies that had commenced chapter 11 cases. In the “era of leverage and unsustainable growth,” the number of companies commencing chapter 11 cases was relatively low and, as a result, the supply of distressed paper was low. However, the demand for distressed paper was great, creating a disequilibrium of supply and demand, resulting in an increase in the price of distressed paper.
Moreover, hedge funds turned each chapter 11 cases into mini trading exchanges as they traded in and out of the capital structure and established ad hoc committees, which took positions in the cases and the outcomes of the positions would either increase or decrease the price of the securities or debt instruments in a company’s capital structure. In that regard, depending on the bet hedge funds placed, they either made money or lost it.
The leverage loan debacle and so called Great Recession that followed sent hedge funds focusing on dealing with redemptions and stopping losses. As a result, the trading in debt of companies in chapter 11 slowed significantly. Also, as the fulcrum security in many chapter 11 cases became the leveraged loan, the opportunity to trade in other securities was gone as they had no value.
However, as the markets have somewhat stabilized (although we are in an “era of leverage and no real growth” and the economy is still in major trouble with market optimism potentially turning into severe pain), hedge funds are reentering the chapter 11 arena. The reentry is not like the end of Caddy Shack when the whole golf club celebrated with Danny Noonen, it is more like Indiana Jones sliding under a closing door and saving his hat at the last minute. In other words, trading only makes sense in select chapter 11 cases. The chapter 11 cases where you are seeing trading increasing are those where unsecured creditors are commencing litigation against secured lenders. In these cases, with unsecured bonds trading for pennies, placing the right bet could result in a major investment return.
How do you make that return? It’s not easy. It takes work. Not just hard work, but smart work. And it takes understanding and foresight and timing and luck. Here are some things to consider:
- Know thy Judge: Bankruptcy judges are sophisticated, intelligent and thoughtful people. The key is that they are people. And as people, they have their own individual styles. Some judges listen to all arguments, say little and then make their rulings. Other judges attempt to push parties to settle. Understanding a judge’s style is important in attempting to decide whether a litigation will settle or go to judgment.
- Know thy Lawyers: Lawyers – despite some views – are also people. And, as such, they have their own styles. In the restructuring world, certain lawyers are known as dealmakers, others litigious and still others shrinking violets. Lawyers also have significant influence over whether a litigation settles or goes to judgment. Understanding whether the lawyers involved will push for settlement or a fight to the end is key
- Know thy Documents: If the litigation is about the documents (e.g., credit agreements, intercreditor agreements, etc.), then read them. The documents may have the answer. Ask, are the terms of the document black and white? If so, can the bankruptcy judge rule on them without discovery? Are the documents ambiguous? Will discovery be necessary? The answer to these questions will unveil whether the litigation will be short, long, expensive, more likely to settle or more likely to go to judgment.
- Know thy Case Law: At the end of the day, the bankruptcy judge will look at the facts, the documents and the law and render a decision. In addition, the lawyers on both sides will look at the same things and render a view on their likelihood of success. It is important to make an independent judgment on the law and who has the better argument before investing. And, don’t be shy to ask lawyers who you trust. A quick read and view of a good lawyer can make the difference between the mansion and the poor house.
- Know thy Company: Does the company need the litigation resolved to emerge from chapter 11? If so, the company may be more apt to settle, determining that a success in the litigation coupled with a delay in emerging is less valuable than settling, paying a little bit and emerging. If the litigation can continue after the company emerges, get ready for a long litigation (especially if there is funding to continue the litigation for a long time).
As the hedge funds are back in town, certain cases may get more litigious. While this means more acrimony for companies trying to restructure their balance sheets and operations, it means more opportunities for hedge funds to place bets on the outcome of litigation and the resulting impact on the price of traded debt. There is one thing for certain:
The hedge funds were asking if trading opportunities were around
How the litigation was, where bonds could be found
Told them the hedge funds were back in bankruptcy
Driving all the debtors crazy
The hedge funds are back in town…
Jon Henes is a partner in the Restructuring Group of the law firm of Kirkland & Ellis. Jon's practice involves representing debtors (including portfolio, privately-held and public companies), creditors' committees and distressed investors (including hedge funds, private equity funds and companies) in acquisitions, restructurings and bankruptcy cases.