Making Money in a Down Economy
For the past few years, many businesses have struggled to meet payroll and keep the doors open. But such challenges are not bad news for everyone. At least one group of investors (a/k/a distressed debt investors) has found a way to capitalize on the financial troubles of businesses. In fact, recent reports (see here and here) suggest significant above-market returns for hedge funds that utilize a distressed debt investment strategy (e.g., Avenue Capital Group, Third Avenue Funds, Third Point Funds).
A distressed debt investor basically buys the debt of a troubled company and then flips the debt for a quick profit or seeks returns through a longer investment horizon. Investors that fall in the latter category may simply wait for the debt to be refinanced or cashed out, or they may seek to utilize the leverage associated with the debt instrument upon a default or potential default by the company. In fact, “activist” distressed debt investors may use their distressed debt holdings to influence management decisions (think of Carl Icahn’s letter to CIT bondholders) or gain control of the company through a debt-for-equity exchange or credit bid at an asset sale (think of Carl Icahn’s recent acquisition of Tropicana Entertainment and bid for Trump Entertainment).
The existence of an activist investor in a company’s debt holdings can swiftly change the dynamics of the company’s restructuring negotiations. These investors typically want to achieve their objective at the lowest cost (thereby maximizing their upside), which often conflicts with the objectives of other stakeholders. Conflict can lead to delay, expense, litigation and even liquidation. Many companies, such as Adelphia, Aleris, Foamex, Fairpoint, Lyondell and Tropicana Entertainment, have experienced this type of conflict firsthand.
That being said, hedge funds and private equity firms that typically invest in distressed debt may be a good (or the only) source of funding for troubled companies. And their investment objective (maximizing their upside) is understandable given their obligations to their own fund investors and, let’s be honest, the typical fund fee structure. So the question then becomes who is or should be protecting the interests of other stakeholders to mitigate conflict and obtain a fair deal for the company? Is management, particularly in a distressed situation, up to the task? Even if it is, management typically does not learn about the presence of a distressed debt investor in the company’s capital structure until it is too late. Notably, this issue is beyond the scope of the proposed Hedge Fund Transparency Act of 2009 and the Financial Regulatory Reform: A New Foundation proposal submitted by the Group of 30. Moreover, proposed revisions to Bankruptcy Rule 2019 (requiring some disclosure of holdings) may help some companies and other stakeholders in the bankruptcy context, but again the information may come too late and only for bankrupt companies. And whether you focus on disclosure, representation or accountability in considering the creditor control issue, you certainly need to target more players than just hedge funds and private equity firms.