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The Role of Activist Hedge Funds in Distressed Firms

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The Role of Activist Hedge Funds in Distressed Firms The Role of Activist Hedge Funds in Distressed Firms Jongha Lim1, 2 Fisher College of Business The Ohio State University This Version: November 19th, 2010 Abstract Frictions to efficient bargaining provide an opportunity for a hedge fund to invest in distressed firms, facilitate reorganizations, and capture some of the rents from doing so. This paper considers a sample of 184 financially distressed firms for the period from 1998 to 2009, and finds that distressed investing has become an important avenue for activism by hedge funds. Distress-focused hedge funds utilize a „fulcrum‟ investment strategy so as to maximize their influence on the reorganization process. Empirical evidence is consistent with the view that hedge funds capture some of the rents they create by reorganizing the distressed firms. First, distress-oriented hedge funds tend to target economically healthy firms in which contracting difficulties are likely to prevent efficient reorganization. Second, hedge funds‟ presence as creditors leads to effective restructuring through both debt-equity swaps and pre-packaged filings. In addition, when hedge funds inject new equity capital into targeted firms, the duration of distress is significantly reduced. Both debt and equity investments by hedge funds are associated with significantly higher probabilities of successful restructuring. Lastly, distress-focused funds in my sample have produced an annual compounded return of 8.6% over the 1998-2009 period, which is economically significant, compared to 3.2% generated by the stock market over the same period. 1 Contacts: Jongha Lim, Doctoral student, Fisher College of Business, The Ohio State University, 2100 Neil Ave, Columbus, Ohio, 43210; E-mail: [email protected]. 2 I greatly appreciate the helpful comments and advice from Anil Makhija, Bernadette Minton, René Stulz, and Michael Weisbach. I am also grateful for valuable discussions with Jack Bao, Itzhak Ben-David, Ji-woong Chung, Isil Erel, Kewei Hou, Berk Sensoy, and Yingdi Wang. I thank seminar participants at the Ohio State University. I thank Wonik Choi for his great support. All errors are mine. 1 I. Introduction According to the Coase Theorem, when a firm goes into financial distress, parties can costlessly recontract and reemerge from distress without any real consequences. In the Coasian world, bargaining among parties will always lead to an efficient outcome. However, it is likely that in practice, the assumptions underlying the Coase Theorem do not hold. In practice, restructuring the liabilities of a distressed firm involves substantial costs, if it is even possible at all. Information asymmetries, different incentives, coordination problems between debt holders, illiquidity in both the markets for real and financial assets, together with a reluctance on the part of banks and public debt holders to accept equity for debt, all contribute to the difficulties that firms have reorganizing when in financial distress.3 In that sense, financial distress is a situation in which contracting problems cause deviations from first-best allocation of resources, creating real costs for the parties involved. These contracting difficulties present a market opportunity for an active investor, who can strategically choose to take positions in distressed companies for whom a restructuring would create efficiencies, facilitate these firms‟ reorganization, and capture some of the rents arising from these efficiencies. Hedge funds, whose managers have strong performance-related incentives and a great degree of flexibility as to the securities they can hold, provide such a possible active investor. An individual with financial resources and a specialty in distress resolution can form a hedge fund, purchase securities that enable the investor to finesse the contractual problems preventing a profitable restructuring, and share in the efficiency rents from a successful restructuring. This paper argues that distress-oriented hedge funds are an institution that has evolved around these contracting difficulties, and that the returns to these hedge funds come from rents associated with the reorganization of economically sound but financially distressed firms. 3 See, for example, Gertner and Scharfstein (1991), Shleifer and Vishny (1992), Giammarino (1989), James (1995), Bulow and Shoven (1978) for a theoretical discussion of the way in which these factors contribute to the costs of resolving distress, and Jensen (1991) for the opposite Coasian view that distress is relatively costless. Among empirical studies, Gilson (1997), James (1996), Asquith, Gertner, and Scharfstein (1994), Brown, James, and Mooradian (1994), Pulvino (1998) provide evidence that these obstacles to bargaining generate real costs, while Andrade and Kaplan (1998b, 1994a, and 1998) provide evidence that financial distress is relatively costless. 2 This view of distress-oriented hedge funds contains a number of empirically-verifiable predictions. First, it predicts that the strategy executed by hedge funds will be the acquisition of positions that allow them to have the largest influence on the restructuring and to maximize the rents from successful reorganization. Institutionally, these positions are known as the fulcrum point, which is defined as the point in the capital structure where the enterprise value no longer fully covers the claim, and therefore is most likely to receive equity in the reorganized company. Second, firms targeted by hedge funds are those for which contracting problems are likely to prevent efficient reorganization. These firms are likely to be those with relatively high transaction costs and complicated capital structures made up of securities held by a number of different institutions with different incentives, but also those firms whose fundamental value is such that the firm will likely be profitable conditional on restructuring. Third, this view predicts that the presence of a hedge fund will affect the restructuring process and outcome positively. Hedge funds can facilitate the restructuring efforts by enhancing the use of flexible means of restructuring such as debt-equity swaps and pre-packaged filings. Also, reduced frictions in bargaining will lead to a faster restructuring as well as to a higher probability of a successful restructuring. I examine these hypotheses for a sample of 184 distressed firms which either restructured their debt privately out-of-court or formally under Chapter 11 for the period from 1998 to 2009. I find evidence that hedge funds actively participated in distressed-firm restructuring, suggesting that distressed investing has become an important avenue for activism by hedge funds. Based on information available in news reports, various documents filed to the U.S. Securities and Exchange Commission (SEC), and bankruptcy documents, I identify hedge funds‟ involvements in the troubled firms‟ restructuring in 119 firms (64.7% of the sample). In extreme cases, hedge funds were involved in all distressed firms in my sample in year 2006. Empirical findings are consistent with the predictions described above. First, hedge funds acquire the so-called fulcrum position to strategically obtain a measure of control over the course of a company‟s turnaround, and at the same time to seek upside potential in the reorganized firm via post-restructuring ownership. Hedge funds achieve this fulcrum position in various ways; they purchase fulcrum securities 3 in 69 cases (37.5% of the sample), inject new equity capital in 35 cases (19% of the sample), and pursue loan-to-own strategy in 32 cases (17.4% of the sample). Hedge funds often increase leverage to influence the restructuring process by taking a seat on the creditors‟ committee (54 cases, 45.4% of the sample) and/or by leading negotiations of a pre-packaged deal (28 cases, 66.7% of all pre-packs). These positions vest hedge funds with 34.5% ownership on average in the reorganized firms. Second, I find that hedge funds target firms in which contracting problems are likely to be more severe but potential profitability is higher, if the firm is successfully restructured. Firms targeted by hedge funds have more debt classes than other similar firms and more often have both public and bank debt outstanding, both of which increase the difficulties of restructuring. Furthermore, target firms are more likely to suffer from an imminent liquidity crunch because they tend to have relatively high current debt due and low cash holdings. Target firms, however, do not seem to suffer from severe economic distress compared to non-targeted distressed firms and by industry standards. Target firms have had better operating performance than non-target firms and similar performance to the industry median firm in the years prior to distress. Such characteristics of target firms are consistent with the hypothesis that hedge funds capture some of the rents arising from the reorganization of economically sound but financially distressed firms. Third, evidence in this paper suggests that hedge funds can help facilitate reorganization. As creditors, hedge funds enhance the use of debt-equity swaps and pre-packaged deals. Meanwhile, by bringing fresh equity capital into a distressed firm, hedge funds facilitate the reorganization process. All types of hedge funds‟ investments, with the exception of the purchase of old equity securities, lead to a significantly higher probability of emergence from distress. Interpretation of the results about the hedge funds‟ influence on the restructuring
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