Abstract
AbstractWe study how distress‐oriented hedge funds (vulture funds) play an important role in the fresh start valuation of firms emerging from Chapter 11 reorganization. We find that loan‐to‐own vultures acquire debt positions of the distressed firm that grant dominant power in the bankruptcy negotiations, and they then use the discretion allowed by fresh start accounting to introduce valuation bias in their favor. We show that the strategic influence over fresh start values can create opportunities to increase vulture investors’ returns at the expense of other claim holders.
Highlights
Active hedge funds have an important role in the resolution of Chapter 11 bankruptcies
This research shows how the fresh start valuation of assets is an important mechanism in the settlements of claims in Chapter 11 bankruptcy
Since the fresh start value of assets of the new emerging firm are based on management-produced forecasts, there is scope for valuation discretion, by claimants with a substantial influence in the bankruptcy negotiations
Summary
Active hedge funds have an important role in the resolution of Chapter 11 bankruptcies. Often senior managers experience a considerable reduction in wealth as their (low priority) equity share in the distressed firm is cancelled under the FS valuation rules This wealth loss can be compensated by pay-to-stay remuneration plans offered by fulcrum creditors who are the key voting party in the reorganization. We collect equity ownership by vulture funds and by other important claimants, on the dates of entry and exit from bankruptcy Based on this analysis, we group vulture funds (VF) into two types: (1) VF that purchased unsecured junior claims of a relatively low seniority which we call VF holding Low-Intermediate Seniority claims, and (2) VF that purchased secured or more senior classes of claims which we call VF holding High-Intermediate Seniority claims. In particular we anticipate that, on average: (a) VF holding low-intermediate seniority claims welcome upward FS valuations; and (b) VF hold high-intermediate seniority claims favor downward FS valuations
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