Wei Jiang, Kai Li, and Wei Wang
Hedge fund activism in Chapter 11 firms
Journal of Finance | Volume 67, Issue 2 (Apr 2012), 513–560

Investor activism has become increasingly prevalent in Corporate America over the past two decades. Through acquiring equity ownership in underperforming firms with poor corporate governance practices, activist investors help the targeted firms improve performance through various forms of intervention. Over the last decade, a new breed of activist investors has been on the rise. This under-studied group of investors specializes in trading claims of distressed firms with an intention to influence reorganization, and hedge funds have emerged as the most active players in this field due to their ability to hold highly concentrated and illiquid positions as well as their minimum disclosure requirements. More specifically, these hedge fund investors aggressively acquire distressed debt claims and equity stakes of distressed companies, serve on the unsecured creditors committee or equity committee, and pursue the loan-to-own strategy, whereby a hedge fund acquires the debt of a distressed borrower with the intention of converting the acquired position into a controlling equity stake upon the firm's emergence from Chapter 11. In Jiang-Li-Wang (JF 2012), we study the roles of activist hedge funds in Chapter 11 firms and the effects of their presence on the nature and outcomes of the bankruptcy process.

Hedge fund involvement in largest 500 bankruptcies

To form our sample of study, we start started with the largest 500 U.S. Chapter 11 cases filed during the period from 1996 to 2007. We then obtain information on important milestones reached during restructuring (such as the extension of the exclusivity period, debtor-in-possession financing, approval of key employee retention plan (KERP), and top management turnover). Further, we gathered final outcomes such as emergence from bankruptcy, acquisition, or liquidation, from a variety of sources including BankruptcyData.com, Bankruptcy DataSource, PublicAccess to Court Electronic Records (PACER), and news searches in Factiva and LexisNexis. Next, we resort to BankruptcyData.com, 8K and 10K filings, proxy statements, Schedule 13D and Form 13F filings, and news searches to identify hedge-fund involvement in these distressed companies. We obtain firm-level financial and stock price information from Compustat, CapIQ, 10-K filings on EDGAR, and CRSP.

1: Hedge-fund presence in Chapter 11 by timing and entry and their role
Panel A: Hedge-Fund Presence before bankruptcy
Hedge-Fund Presence % of total 474 cases
Largest unsecured creditors 25.1
Largest shareholders 48.5
13D filing 7.0
Panel B: Hedge-Fund Presence during bankruptcy
Hedge-Fund Presence % of total 474 cases
Unsecured creditors committee 38.5
Debtor-in-possession financing 9.1
13D filing 4.4
Equity committee 5.8
Panel C: Both before and during bankruptcy
Hedge-Fund presence % of total 474 cases
Loan-to-own 27.7
Debt side 60.7
Equity side 53.4
Overall 87.4

Table 1 presents the overview of hedge-fund involvement during the Chapter 11 process, grouped by the timing of their entry and their roles, respectively. We show that 87% of the cases have publicly observable hedge-fund involvement in some form. Further, in 61% of the cases, hedge funds are present on the debt side (versus 53% in equity), and in 28% of the cases, hedge funds adopt a loan-to-own strategy. The five most active funds are: Oaktree Capital Management, Cerberus Capital Management, Loomis Sayles & Co, Appaloosa Management, and PPM America Special Investments Fund.

Hedge funds choose wisely and affect outcomes

The relationship between a hedge fund's presence and bankruptcy outcomes can be classified as one of two varieties:

  1. a pure selection effect, whereby informed hedge funds merely pick the target that offers the best expected payoff, but do not affect the value of the underlying assets, and
  2. a pure treatment effect, whereby hedge funds change the outcome and hence the value of the underlying assets even if they were randomly assigned to distressed firms.
A priori, a combination of these two effects is likely at work. Hedge funds are sophisticated investors that and could potentially profit from their company-picking skills even if they remain passive stakeholders. At the same time, hedge funds are likely to choose investment opportunities in which they can more effectively influence the outcome in their favor. It is worth noting that our measures for hedge-fund participation embed their activist roles. For example, if hedge funds can achieve the desired outcome just by picking the right companies without exerting influence during the Chapter 11 process, they could remain passive stakeholders without the costly voluntary effort of forming and serving on those committees.

To accommodate both the selection and the treatment effects, we use the following model: HFPart*i = Xi⋅β + εi . We set HFParti (unstarred) to 1 if HFPart*i≥0 and to 0 otherwise. The model is Outcomei = Zi⋅γ + μ⋅ HFParti + ηi

HFPart is an indicator variable for hedge-fund participation in various ways, and Outcome is one of the Chapter 11 outcome variables that we examine in Tables 2-3. A selection problem exists if the correlation between the error disturbances of the two equations is not zero, that is, corrii) ≠ 0.

2: Effects of hedge funds on unsecured creditors committee, Probit/OLS
Panel A: Hedge Funds on Creditors Committee
Emerge Duration Loss
Exclusivity
APR
Creditor
Debt
Recovery
CEO
Turnover
KERP
0.37** 0.17** 0.26 0.38** 0.01 0.16 0.32**
[0.16] [0.08] [0.17] [0.19] [0.04] [0.15] [0.15]
Panel B: Hedge Funds on Equity Committee
Emerge Duration Dist
Equity
Debt
Recovery
Stock
Return
CEO
Turnover
KERP
0.39 0.16 1.25*** 0.18*** 0.16*** 0.68** –0.18
[0.30] [0.15] [0.28] [0.07] [0.04] [0.27] [0.29]
Panel C: Hedge Funds Loan-To-Own
Duration Loss
Exclusivity
ARP
Creditor
Dist
Equity
Debt
Recovery
CEO
Turnover
KERP
0.05 –0.08 0.67*** 0.33** 0.06 –0.14 0.30*
[0.09] [0.18] [0.18] [0.17] [0.04] [0.17] [0.16]
Standard errors are in parentheses. One, two, and three stars mark statistical significance at the 10%, 5%, and 1% level, respectively.
This table shows the effect of hedge-fund presence on the unsecured creditors committee, the equity committee, and hedge funds adopting a loan-to-own strategy on Chapter 11 outcome. This includes emergence (Emerge), the logarithm of the number of months in bankruptcy (Duration), the debtor's loss of exclusive rights to file a plan of reorganization after 180 days in bankruptcy (LossExclusivity), APR deviation for secured creditors (APRCreditor), average recovery rate of all corporate debt at plan confirmation (DebtRecovery), CEO turnover during Chapter 11 reorganization (CEOTurnover), adoptions of key employee retention plan (KERP), equity holders receiving positive payoffs (DistEquity), and standardized equity abnormal monthly returns from two days before filing to plan confirmation (StkRet). This table presents results from a simple probit (when the outcome variable is binary) or an OLS (when the outcome variable is continuous) regression model.
3: Effects of hedge funds on unsecured creditors committee, binary outcome with a binary endogenous explanatory variable model/treatment regression
Panel A: Hedge Funds on Creditors Committee
Emerge Duration Loss
Exclusivity
APR
Creditor
Debt
Recovery
CEO
Turnover
KERP
0.779 0.365 1.884*** 0.743 0.500*** 1.306*** –0.085
[1.056] [0.490] [0.109] [1.148] [0.141] [0.379] [1.036]
Panel B: Hedge Funds on Equity Committee
Emerge Duration Dist
Equity
Debt
Recovery
Stock
Return
CEO
Turnover
KERP
1.21* –0.55* –0.33 0.19 0.14** 2.33*** 0.280
[0.66] [0.32] [0.47] [0.22] [0.07] [0.17] [0.96]
Panel C: Hedge Funds Loan-To-Own
Duration Loss
Exclusivity
ARP
Creditor
Dist
Equity
Debt
Recovery
CEO
Turnover
KERP
0.33 1.60*** –0.18 1.11 0.71*** 1.09*** –0.18
[0.57] [0.29] [0.77] [0.74] [0.07] [0.39] [0.78]
Standard errors are in parentheses. One, two, and three stars mark statistical significance at the 10%, 5%, and 1% level, respectively.
This table is like the previous table, but presents results from a binary outcome model with a binary endogenous explanatory variable (when the outcome variable is binary) or a treatment regression model (when the outcome variable is continuous).

Distinguishing selection from influence

For identification, we need instrumental variables that effectively predict hedge-fund participation but do not affect outcome variables other than through hedge funds. The first variable is the lagged three-month return on an index of distress-investing hedge funds using data from CISDM. The second variable is the residual from regressing the raw lagged three-month return on the S&P 500 index on the return of index of distress-investing. Both variables are valid instruments because they capture the capital supply conditions of hedge-fund distress investment but are also unlikely to directly impact reorganization outcomes of individual cases due to both the exogeneity of market-wide returns to an individual firm and the lack of autocorrelation in returns. Tables 2 and 3 present key results from the simple probit or OLS regression models without and without instrumentation for HFPart, respectively. They examine the effect of hedge-fund participation on creditors committee, equity committee and loan-to-own strategies on Chapter 11 outcomes.

Our results suggest that hedge-fund presence on the unsecured creditors committee is positively associated with all seven outcome variables, and the effects are significant (at the 5% level) for emergence from bankruptcy, duration in bankruptcy, absolute priority rule (APR) deviations for the secured creditors, and the adoption of a KERP. Once the selection effect is taken into account, the coefficient on Hedge Funds on Creditors Committee becomes significant in the outcome equations for the debtor's loss of exclusive rights to file a plan, debt recovery, and CEO turnover, but loses significance in other outcome equations. Our results from both the un-instrumented and instrumented regressions indicate an interesting combination of investment selection abilities possessed by hedge-fund creditors, as well as the activist roles they play. As skilled investors, hedge funds invest in the unsecured debt of distressed firms that are more likely to offer desirable outcomes for that class of claim holders (including emergence, more frequent APR deviations for secured creditors in favor of unsecured creditors, and retention of key employees). Conversely, the debtor's loss of exclusive rights to file a reorganization plan after 180 days and higher CEO turnover rates also appear to be caused by hedge-fund actions.

The effects of hedge-fund presence on the equity committee share similarities to, as well as exhibit differences from, those related to their presence on unsecured creditors committee. Similar to their creditor counterparts, hedge-fund equity holders are just as vigilant in pushing out failed CEOs. The instrumental variable approach allows us to conclude that hedge funds do not serve on the equity committees randomly. In fact, they target companies with more entrenched management. Hedge-fund presence on the equity committee is associated with a large increase in the probability of a positive distribution to existing equity holders, controlling for firm and case characteristics. This effect is rendered insignificant when the instrumental variable approach is used. Together, these results offer strong evidence in support of hedge funds' ability to pick stocks of distressed firms with better prospects for existing shareholders, but offer less evidence for hedge funds' activist role in making the distribution happen.

The results of hedge funds' loan-to-own strategies appear to be a natural blend of their roles on creditors and on equity committees, consistent with the hedge funds' dual roles first as creditors and then as new shareholders. Hedge funds' loan-to-own strategies are pro-KERP, and are associated with greater distributions to both unsecured creditors and shareholders. The effects are significant on the debtor's loss of exclusivity, debt recovery, and CEO turnover in the instrumented model. All of these relationships indicate that the loan-to-own players act like unsecured creditors in exerting their influence over management. At the same time, they value continuity by retaining companies' key employees given that they have a relatively long investment horizon in firms that emerge from Chapter 11.

Our results thus far suggest that hedge funds are effective in achieving their desired outcomes for the claims they invest in. Most notably, our instrumented results on higher debt recovery and stock returns with hedge-fund activism are more supportive of efficiency gains rather than value extraction by hedge funds from other claims. Such value creation may come from overcoming secured creditors' liquidation bias (i.e. a higher probability of emergence), confronting underperforming managers (i.e. a higher probability of loss of exclusivity and a higher CEO turnover rate), retaining key personnel (i.e. more frequent adoptions of KERP), and relaxing financial constraints (i.e. the loan-to-own strategy).

Markets recognize hedge fund activism effectiveness

To provide further evidence in support of efficiency gains brought by hedge funds as opposed to value extractions from other claims, we adopt an event study that relates changes in stock prices around the bankruptcy filing to hedge-fund involvement on the debt side that is observable at that time. In our sample of 277 cases, hedge funds are listed among the largest unsecured creditors on the bankruptcy petition forms in 75 cases. Figure 1 plots the cumulative abnormal returns (CARs) of the group with hedge funds as creditors and the group without hedge funds for the [–10, +10] window, where day 0 is the date of the Chapter 11 filing. We show that after the Chapter 11 filing, the group with hedge-fund presence experiences price increases, while the group without any hedge-fund presence continues to experience price declines.

1: Event study around Chapter 11 filing
figjlw1
This figure shows the cumulative abnormal returns (CARs, adjusted by the CRSP equal-weighted return) from the 10 days before to the 10 days after a Chapter 11 filing. The solid line represents CARs for 75 cases with at least one hedge fund listed as the largest unsecured creditor. The dashed line represents CARs for 202 cases without any hedge fund listed as the largest unsecured creditor.

Conclusion

To conclude, our study finds that hedge funds' choice in distressed targets and positions in the capital structure reflect both their firm-picking skills and their desire to have a larger impact on the restructuring process. Hedge funds are largely effective in achieving favorable outcomes for the claims that they choose to invest in. Their success in helping distressed firms reorganize does not come at the expense of other claimants, but rather from creating value for the firm as a whole. This study adds to our understanding of the major forces underlying the patterns of, and changes in, the Chapter 11 process in the United States over the past decade. Additionally, it contributes to the growing research on investor activism. By analyzing hedge-fund holdings across the capital structures of firms in Chapter 11 restructuring, our work also stimulates new theoretical research on bankruptcy that allows for complex and dynamic interactions among the variety of relevant stakeholders.

 

 

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