The Lehman Brothers Holdings bankruptcy has been a gold mine for many large hedge fund firms. So have the infamous downfalls of MF Global and the Madoff estate and the misfortunes at Eastman Kodak Co. Bankruptcy claims are one of the few high-yielding debt instruments out there these days. Hedge fund managers are able to buy the claims against a bankrupt entity, often at deep discounts. That money pays off creditors, and the fund manager profits when the courts finalize a settlement and distributions are made. The distributions might be in the form of cash, a conversion of debt to equity, or restructured debt.
Over the past two years, liquidations of claims against Lehman, which filed the largest U.S. bankruptcy ever in September 2008, have earned John Paulson’s Paulson & Co. at least $1 billion and Elliott Management Corp. about $700 million. (Both firms are based in New York.) Others that have made money from Lehman include Baupost Group in Boston; Contrarian Capital Management in Greenwich, Connecticut; and New York’s York Capital Management and Solus Alternative Asset Management.
But bankruptcy claims are a cyclical business. The pickings are plentiful in times of high default rates, which was the case in 2009, when the global corporate default rate hit a three-decade high, according to Standard & Poor’s (see chart). Many of the payouts for Lehman and other large bankruptcies from the high-default period of 2008–’10 have been made. The days of easy money may be reaching an end.
“Almost all of the 2008 liquidations are currently in the harvest period or will be within the next year and a half, which is the average life of many remaining claims,” says Thomas Williams, CIO at Pine Grove Asset Management in New York, a $1 billion fund of hedge funds.
Williams has a preference for hedge funds that invest in late-stage bankruptcy claims, and many of these have been paid out now. A big exception, however, is the $38 billion in claims against Lehman Brothers Inc. and Lehman Brothers International (Europe), two divisions of the firm that didn’t reach a bankruptcy settlement until February of this year. The liquidation process for LBI and LBIE claims will continue for another couple of years, portfolio managers say.
There are good reasons to gravitate toward claims in the late stage — usually about two years or more into the bankruptcy process. Late-stage claims offer yields in the high single or low double digits with very little risk. At this point in the cycle, the balance sheet has more cash and there has been a lot progress in liquidating assets,” says Williams. “So the risk of having surprises in valuation goes down. The range of outcomes grows narrower in the late stages of bankruptcy claims.” But the next round of opportunities seems to be coming largely from earlier-stage claims. The global corporate default rate was 0 percent for corporate grade and 2.3 percent for speculative grade for the first three-quarters of 2013—nowhere near the 2009 peak.
A portfolio manager has to be selective when picking early-stage claims, but Jon Bauer, CEO and CIO of $3.7 billion Contrarian Capital, prefers early-stage claims in any cycle because the yields can be much higher. “With late stage there is more certainty, but if we can’t earn double digits, we’re not interested,” says Bauer. “Later the claims become more of an arbitrage.” Contrarian Capital is currently the largest secondary creditor in Circuit City and the largest in SPhinX, a $2.5 billion hedge fund firm that went bankrupt after the CEO of its parent company, the Chicago commodities broker-dealer Refco, turned out to have hidden $430 million in bad debt.
The best opportunities are in companies that were formerly investment grade that have become fallen angels,” says Bauer. Alan Mintz, a co-founder of $1.5 billion Stone Lion Capital Partners in New York, believes a lower-default environment is actually the best time to look for bankruptcy positions. “It’s a play in the credit market but it’s idiosyncratic,” he says. When there are not so many defaults and credit markets are trading at tighter spreads, he says, bankruptcy claims are an investment with little correlation to market performance. Stone Lion is holding defaulted bonds from the $4.2 billion bankruptcy of Jefferson County, Ala. , and Mintz says the managers are looking at the defaulted municipal bonds of Detroit and Puerto Rico. Detroit, however, poses a particular challenge because of the city’s diminished revenue base. “Revenues for a city usually come from taxes,” he points out. “It’s different from a corporation, which has an easier ability to rework the cost structure.” The best way to make money from municipal bankruptcies, he says, is to get in early and profit when the debt is refinanced.
And one of the attractions of any bankruptcy claim is that occasionally a buyer will turn up for an old claim. In the past year Williams has seen two fund managers sell off old remainders from Enron Corp. In both cases the claims had no value until unexpected distributions added more than 150 basis points.
“Every now and then you can get a good surprise,” says Williams.
