Do hedge funds want restructurings to fail?

The lure of a CDS payout may be encouraging some investors, particularly hedge funds, to hinder corporate restructurings. Laurence Neville reports

There is a growing feeling amongst restructuring experts that the credit default swap market is encouraging hedge funds to obstruct corporate restructurings. At a distressed debt conference given by law firm Latham & Watkins on September 22, Phil Wallace, a corporate recovery partner at KPMG in London, asserted that hedge funds were not interested in rescuing distressed companies but would rather see them fail. He criticises hedge funds that hold credit default swaps (CDS) in companies that are on the verge of insolvency and claims their goal is sometimes to force the company to enter restructuring so that they can receive payouts.

But Wallace adds that his main concern about the CDS market is transparency. “If you look at the stock market, you can see who’s buying what,” he says. “But you cannot see who is shorting stock. That is problematic. In credit it is even worse as you can see neither long nor short sellers.” The problem is compounded by the fact that in the arcane world of hedge funds little is known about the scale of their involvement in CDS – except that it is growing.

Wallace says that in restructuring circumstances, the inability to discover who is a bondholder – or more importantly, who is a bondholder with CDS cover (CDS holders must usually hold the underlying debt to be able to benefit from a payout) – means that efforts to rescue saveable companies may be hindered. “If certain parties on a creditors’ committee have CDS support, their objectives are unlikely to coincide with other bondholders,” he says.

Wallace is not alone in his beliefs. On October 20, Richard Nevins, a restructuring specialist at the investment bank Jefferies, was quoted by the Financial Times as saying: “They [CDS] are raising problems because of the way they divide ownership from risk of loss. They produce perverse incentives for creditors to frustrate a successful restructuring because they get more from failure.” Steven Pearson, restructuring partner at PricewaterhouseCoopers in London also agrees that CDS can have curious effects in restructuring situations. “It is analogous to someone being able to buy insurance on your house so that they benefit if it burns down,” he says.

Although hedge funds will often have bought debt in a distressed company at a lower cost than other stakeholders, that should not necessarily mean that their objectives are different. As Caroline van Scheltinga, managing director in restructuring at Lehman Brothers in New York, notes, once a hedge fund buys debt at a certain price most bondholders would have to mark down their bonds to the same price. “All bondholders at that time have the same aligned interest and that is to maximise recovery,” she says.

What is true is that the various stakeholders may approach the situation differently. One London-based credit trader at a major European investment bank, who declined to be named, says: “Hedge funds behave differently because they’ve bought the debt at 20 cents on the dollar, for instance, and that means they are incentivised to work out the problem as soon as possible.”

Indeed, hedge funds’ haste to work out restructuring situations – so that they can immediately benefit from any rally – can be at odds with other long-term stakeholders, says Van Scheltinga. “The bondholder that bought the original bond at 100 is more upset than the hedge fund that bought in at 50. Whereas the hedge fund would eagerly accept a deal at 75 – a 50% return – the par buyer will take a little longer to accept a 25% haircut and will therefore hold out,” she says. “Emotion in a restructuring is typically dealt with in time.”

A more fundamental point about the role of hedge funds in restructuring situations is made by the anonymous credit trader. “It has always been the case that there have been vulture funds,” he says. “Although some people might find the way they operate distasteful, they do play a crucial role in the market, providing liquidity during troubled times to enable investors who need to exit the debt to do so.”

Van Scheltinga accepts that if a distressed debt fund owns CDS, their goals may not be aligned with other stakeholders. “But in the end distressed funds focus on enterprise value and whether the company is worth preserving, and those are things that all investors should be focused on,” she says. “They can help the restructuring process as a result of their focus on improving recovery time and clarifying the upside potential of a business. After all, they are in the business of valuing assets and if they invest, they want to make money.”

It is unlikely that hedge funds would use a CDS-based strategy as a primary way of making money in a corporate restructuring, says Van Scheltinga. “For a start CDS could be expensive. You only buy them for the perceived risk against your investment, when they are mispriced or as an equivalent to shorting the equity.” She says that it is more likely that a hedge fund would get involved with a corporate restructuring because it could release value from the company rather than benefit from a CDS payout in the case of an actual insolvency. She adds: “Funds may try to use the fact that they could benefit from insolvency to get the attention of other stakeholders and negotiate a better relative payout for themselves.”

Restrictions on behaviour

KPMG’s Wallace says there have been occasions where hedge funds have been short bonds by holding a CDS and then tried to cover their positions in the bond market. One such occasion was the restructuring of the UK subsidiary of US power company TXU, for which KPMG and Ernst & Young acted as administrators in late 2002. “There were plenty of hedge funds that had bought short positions in CDS earlier in that year when such protection was cheap and were eager to buy debt from us as the company had fallen into insolvency,” Wallace says.

In this instance, he says, such behaviour was not detrimental to the company as it was already insolvent. “But if a company is restructuring, it could find itself under pressure if hedge funds held both bonds and derivatives,” he says. “The problem is a fundamental mismatch between goals. If a company is at 80p in the pound and a bondholder has no cover, then the objective is clearly to restructure that company’s debt. But in that situation a bondholder with CDS might get 100p should the company default.” Most CDS are physically settled, meaning that the protection seller is obliged to buy the distressed bond from the protection buyer at par within 30 days of the credit event.

One of the problems with Wallace’s argument is that it relies on inaction by hedge funds. As he concedes, any bondholder that tried to force a default in order to receive a CDS payout would probably breach the terms of the protection. So how do they approach the situation? “In practice, hedge funds or other parties remain fairly quiet. But the intent is there,” he says.

Regardless of whether market participants agree or disagree with Wallace’s statements, few welcome the prospect of more regulation – or even a bondholder register. “The argument about bondholder registers has been discussed forever but it’s simply not in the nature of the instrument,” says a trader working on the European proprietary desk of a major US financial services group. Certainly there is no market interest in keeping track of credit derivative sales, even if it were possible.

The most likely potential solution would be to force hedge funds into greater disclosure but that is likely to be strongly resisted by the sector, which generates alpha chiefly through famously opaque investment strategies. And there is unlikely to be much enthusiasm in the rest of the market for any measures that would increase the already heavy burden of reporting. As one credit market observer in London says: “We really don’t need new rules to address an issue which is a theoretical probability rather than a recurrent problem.”

The CDS triggers Credit default swaps have three main payout triggers: bankruptcy, failure to pay and restructuring. Since the introduction of the International Swaps and Derivatives Association’s (Isda) 2003 Credit Derivatives Definitions and 2002 Master Agreement, bankruptcy is now defined as occurring only when default has occurred. Similarly, restructuring – always notoriously tricky to define, not least because it may not lead to losses by debt investors – has been reclassified by Isda. Credit default swaps (CDS) can now specify the following: • no restructuring, which means that a CDS holder gets nothing; • full restructuring, which allows the protection buyer to deliver bonds of any maturity after restructuring of debt in any form takes place; • modified restructuring, where only bonds with obligations under 30 months are deliverable; • a more loose form of modified restructuring, which extends to 60 months the bonds that are purchased at par by the protection seller.