Master of Law & Finance Thesis
University of Amsterdam
Law Faculty
Vultures or White Knights: Distressed Debt Investors
The consequences of DDIs and its investors on creditors and other
stakeholders
17
thof July 2020
Name: Fermi Brouwer
Student Number: 11202343
Mastertrack: Law & Finance
E-mail: fermi.brouwer@gmail.com
Supervisor: M. Malakotipour
Abstract
Activist distressed debt investors are beneficial and demandable investors. The activist strategy they follow increases the probability of rehabilitation of the debtor and the recovery rate for creditors in reorganization. Activist investors reduce managerial moral hazard, maximize firm value, increase liquidity and decrease the cost of capital. They are Lenders of Last Resort. Costs of activist investors could supposedly be limited by imposing, among others, regulatory enforcements on the invocation of CROs and notification of a significant distressed debt purchase/position.
Table of Content
INTRODUCTION ... 4
I. DISTRESSED DEBT INVESTMENTS ... 6
1.1 DISTRESSED DEBT:BONDS AND LOANS ... 7
1.2 THE MARKET VALUE OF THE DISTRESSED DEBT MARKET ... 8
1.3 STRATEGIES ... 9
1.3.1 Passive Investment... 9
1.3.2 Active Investment ... 9
1.4 THE DISTRESSED DEBT INVESTOR ... 12
1.4.1 Geographical ... 12
1.4.2 Institutional Investors... 13
1.5 DISTRESSED DEBT TARGET COMPANIES... 13
1.5.1 Distressed Debt Targets: Passive ... 13
1.5.2 Distressed Debt Targets: Activist ... 14
1.6 CONCLUSION ... 15
II. INVESTOR’S INFLUENCE ON MANAGEMENT ... 16
2.1 PRE-RESTRUCTURING ... 16
2.2 IN RESTRUCTURING ... 16
2.3 INFLUENCING THE MANAGEMENT:COSTLY OR BENEFICIAL? ... 17
2.3.1 Managerial Activities ... 18
2.3.2 Managerial Moral Hazard ... 19
2.4 CONCLUSION ... 20
III. INVESTOR’S INFLUENCE ON FIRM VALUE ... 21
3.1 PROFIT MAXIMIZATION ... 21
3.2 EFFECTIVE NEGOTIATIONS ... 22
3.3 CONCLUSION ... 23
IV. PLACE OF DISTRESSED DEBT INVESTORS IN THE FINANCIAL SYSTEM... 24
4.1 REPLACEMENT FOR OTHER SOPHISTICATED INVESTORS... 24
4.2 EARLY EXIT FOR CREDITORS ... 25
4.3 CONCLUSION ... 26
V. INSOLVENCY PROCEEDING AND OTHER CREDITORS... 27
5.1ACTIVIST INVESTOR RETURN... 27
5.2REORGANIZATION PROCEDURE ... 28
5.3 DIFFERENT INVESTMENT INCENTIVES ... 31
5.4 THE WAR BETWEEN ACTIVIST DISTRESSED DEBT INVESTORS ... 31
5.5 CREDIT BIDDING ... 32
5.6 CONCLUSION ... 33
VI. VIABILITY OF THE DISTRESSED FIRM ... 34
VII. SUGGESTIONS FOR REGULATORY ENFORCEMENTS ... 35
7.1 Injunction Procedures ... 35
7.2 Restricted Veto Rights ... 35
7.3 Chief Restructuring Officer ... 36
7.4 Notification of Significant Distressed Debt Purchase ... 37
CONCLUSION... 38
Introduction
The greatest concern for investors is the situation that a firm gets into financial distress. In this situation, the value of assets may not be sufficient to cover the outstanding debt and, hence, the firm becomes insolvent. Within insolvency, the distressed firm could opt either for liquidation or reorganization.1 Recovery ratios2 of the latter are significantly higher, around the world,
(73% to 27%) relative to the former, the overall recovery ratio for both liquidation and reorganization procedures is 37%.3 Sequential, it is unlikely that the bulk of the creditors will
receive the repayment of their claim on the debtor in full. Within reorganization proceedings, there is a stay on individual enforcement actions covering all creditors.
Since the late 1900s there arose a new genuine asset investment class: Distressed Debt Investments (DDIs).4 This investment strategy pursues to make a significant profit by using
debt of a distressed or bankrupt firm. The question is, whether these kind of investors are desirable. This thesis will extensively review the Distressed Debt Investors (hereinafter, referred to as investors) and their impact on creditors in the reorganization proceeding along with several economic implications. The concentration of this paper is mainly on the activist investors in the United States.
The aspects that will be examined are the consequences and influence of investors on micro-economical level (management, firm value, etc.), in relation to other creditors in reorganization proceedings and the financial system. The objective of this thesis is to examine whether investors are vultures or white knights. Also the paper makes suggestions for regulatory enforcements to tackle the potential costs of activist investors for other stakeholders.
Chapter I introduces the subject and explains the distressed debt market and its investors. Chapter II discusses if managements incentives change due to activist investors’ influence. Chapter III will examine if the influence of activist investors will lead to the maximization of the value of the distressed firm. Chapter IV discusses the perceptive place that activist investors
1 The U.S. Bankruptcy Code enables two proceedings: Liquidation (Chapter 7) and Reorganization (Chapter 11). 2 Recovery Ratios represent the extent to which a principal on defaulted debt can be recovered, expressed as a
percentage of face value.
3 Oscar Couwenberg and Abe de Jong, 'Costs And Recovery Rates In The Dutch Liquidation-Based Bankruptcy
System' (2008) 26 European Journal of Law and Economics, p. 21.
4 Edward I Altman and Edith Hotchkiss, Corporate Financial Distress And Bankruptcy (3rd edn, John Wiley &
occupy in the financial system and so whether they have a positive effect on financial stability. Chapter V examines activist investors’ potential costs and benefits on insolvency proceedings and the other creditors and will look if they are beneficial for the proceeding. Chapter VI elaborates on empirical research of the viability of a distressed firm in relation with the presence of investors. The last Chapter provides recommendations for possible regulatory enforcements to tackle the potential costs of Investors.
I. Distressed Debt Investments
Distressed Debt Investments (hereinafter referred as DDIs) is an investment strategy and, as the name reveals, refers to investments in distressed (corporate) debt. Although it may seem a questionable way of investing, it can be a highly profitable one.
For the sake of simplicity, this paper will not rely on the technical definition of the DDIs as referred in the literature.5 For the purpose of this research, DDIs refer to investments in the debt
of a distressed firm that carries a significantly high default risk.
This chapter covers the main characteristics of DDIs, its market (paragraph 1.2), the leading strategies (paragraph 1.3), the Distressed Debt Investors (paragraph 1.4), and the characteristics of DDI targets (paragraph 1.5). The chapter ends with a conclusion on DDIs.
5 Edward I. Altman and Robert Benhenni, 'The Anatomy Of Distressed Debt Markets' (2019) 11 Annual Review
of Financial Economics, p. 22. (In the definition of the leading academic Prof. Altman, he established two categories: 1. “Distressed: bonds or loans whose yield to maturity was equal to or greater than 10% above the 10-year US government bond rate. 2. Defaulted: bonds or loans of firms that defaulted on their debt
1.1 Distressed Debt: Bonds and Loans
To understand DDIs, it is necessary to clarify what distressed debt can be. Examples of distressed debt are High Yield and Junk Bonds.6 However, it is not limited to public bonds.
Private loans have a significant role in the DDIs7, notwithstanding the fact that the distressed
bond market is roughly 2 times bigger than the distressed private loan market.8
Although the bond market is more liquid and accessible, bank loans might be equally suitable for DDI and have a similar credit risk.9 However, due to the fact that news of a bank loan sale
conveys negative certification, bank loan sales might impose negative effects on bankruptcy. 10
This did not withhold the growth of a secondary loan market into an over-the-counter market where loans are not only sold but also traded.11 The secondary loan market consists of traded
claims from both banks and trade creditors (e.g. suppliers). The next section will elaborate further on the Distressed Debt Market.
Sometimes, creditors prefer a cash out at a discount (to face value) rather than awaiting the longitudinal reorganization process.12 Chapter IV will elaborate further on this phenomenon.
So, a Distressed Debt Investor could purchase (un)secured bank loans, (un)secured bonds and trade credit to accomplish a DDI trade. This chapter shows that Investors mainly prefer unsecured bonds over secured credit, while in other situations they prefer secured debt over unsecured debt. All the distressed debt together forms the whole Distressed Debt Market.
6 Ibid 4, p. 185.
7 Ibid 4, p. 185.
8 Edward I. Altman, NYU Salomon Center Defaulted Bond And Bank Loan Databases (2020), Database. 9 Default rates in the syndicated bank loan market: A mortality analysis.
10 Sandeep Dahiya, Manju Puri and Anthony Saunders, 'Bank Borrowers And Loan Sales: New Evidence On The
Uniqueness Of Bank Loans*' (2003) 76 The Journal of Business, p. 563.
11 João A.C. Santos and Peter Nigro, 'Is The Secondary Loan Market Valuable To Borrowers?' (2009) 49 The
Quarterly Review of Economics and Finance, p. 1410.
12 Frederick Tung, 'Confirmation And Claims Trading' (1996) 90 Northwestern university Law Review, p. 1684.
1.2 The Market Value of the Distressed Debt Market
Now we have seen what the Distressed Debt market consists of, the question is: what is the size of the market? According to the Altman-Kuehne reports, the size of the distressed and defaulted debt market grew respectively from a market value and face value of $200 and $300 billion in 1990 to $413 and $773 billion in 2019.13 The data shows that after a financial crisis, which of
course increases the probability of bankruptcies, the size of the market grew substantially. The market shrinks again after the year of significant growth. However, the market value remains at a higher value compared to the pre-crisis level.
Table 1. Size of the defaulted and distressed debt market, 1990–2017 (billions of dollars).14
This pattern suggests that after the current COVID-19 and oil crises, the size of the distressed and defaulted debt market will grow in the long term. Investors already anticipate this trend.15
In fact, when more firms are in financial distress, more opportunities for investors will arise. The Distressed Debt Market grows significantly in times of economic rumour and it shrinks in booms.16 2020 is predicted to be a booming year for DD investors, but the question that arises
is how do these investors make a profit by buying highly distressed or (almost) bankrupt debt? In the next section, two different DDI strategies will be discussed.
13 Ibid 5, p. 23.
14 Ibid 5, p. 24.
15Melissa Karsh and Michael McDonald, 'Pimco Steps Up Distressed Bet With Another $3 Billion Fund'
(Bloomberg 2020) <https://www.bloomberg.com/news/articles/2020-04-22/pimco-steps-up-distressed-bet-with-another-3-billion-fund-plan> accessed 23 April 2020.
16 Allison McNeely and Katherine Doherty, 'Distressed Debt Traders Have Tons Of Cash And Nothing To Buy'
(Bloomberg 2020) <https://www.bloomberg.com/news/articles/2019-07-19/distressed-debt-traders-have-tons-of-cash-and-nothing-to-buy> accessed 19 July 2019.
1.3 Strategies
Investors buy the firm’s debt solely as an investment opportunity. The reasoning could be undervaluation of the debt or “a hidden value”. The nature of Distressed Debt makes it a risky investment class. The debt is in or on the verge of bankruptcy. The previous aspects of DDI should be taken into account to understand which strategies investors use. This section distinguishes the two main strategies: the passive and the active.
1.3.1 Passive Investment
The easiest and most common type is the passive DDI strategy. Within this strategy, investors simply make the bet that the distressed firm will find a turnaround strategy and will not enter into insolvency. Passivist investors buy a firm’s distressed or defaulted debt against an extremely discounted price relative to par value under the condition that they are convinced that the debt is undervalued. The most convenient way to do this is by buying a bond on the liquid financial markets. If the firm succeeds in a financial turnaround, it will avoid liquidation and successfully emerge from restructuring. After the restructuring, the investor makes a significant profit by selling the bonds for a price closer to par (short-term) or by reclaiming the refunds on the credit (long-term).17 The return on passive DDIs can vary dependent on how discounted the
buy price is and at after what time the investor exits.
The passive DDI strategy is a strategy based on the undervaluation of assets, in this case, claims against the firm. Investors buy, in what in their eyes is, undervalued debt to make a profit by selling it for a higher price.
1.3.2 Active Investment
The active control strategy is the main concentration of the paper. For this strategy, the sole act of buying undervalued bonds and wait until the price increases is insufficient. Activist distressed debt investors (hereinafter, activist investors) will attempt to get control of the firm they invest in.18 Activist investors focus on purchasing a substantial debt position in a distressed
firm to become a large creditor. In this way, they realise control of the firm inside or outside an insolvency proceeding. This control can be realised in different ways. The two most common paths are the following:
17 Ibid 5, p. 26.
1.3.2.1 Debt Covenants and Statutory Rights
Creditors have contractual (covenant) and statutory, which are jurisdiction specific,19 rights that
they can invoke against the debtor when the debtor violates a clause or is on the verge of violation.20 For example, the debtor violates a covenant. The violation appears to give the
creditor a contractual right, stated in the credit agreement, to reclaim the principal of the extended credit. A different example is the situation when there is not a violation yet, but it is on the verge of violation. In this case, the debtor is under threat of the reclaim of the principal by the creditor. This threat, the potential violation, already indicates power from the debtor to the creditors.21 The reclaim of a credit can be fatal for a firm. Therefore, creditors do not only
exercise control over the debtor in case of insolvency, but also pre-insolvency. Creditors have the power to strongly influence the corporate governance and business operations of the distressed firm in and outside of insolvency.
It is common sense, that an activist investor effectuates a considerable degree of power over the debtor’s business operations and liabilities by purchasing a significant creditor position. This power arises from the above mentioned contractual and statutory rights allocated to creditors. The contractual and statutory powers are stronger for (bank) loans than for public bondholders, due to the consolidated characteristics of loans and divided nature of bonds.22 1.3.2.2 Debt-to- Equity Swap
For the second path, activist investors choose to swap their debt for equity (debt-to-equity swap). They will attempt to take the lead in the restructuring process. To realise this controlling position in the firm’s debt, the activist investor has to acquire a certain amount of debt-to-total market value. The thresholds for a controlling position in the firm’s debt constitutes of two parts, which are jurisdiction specific. For example, in the United States and more western jurisdictions the threshold is as follows: first, activist investors need to possess one third of the total market value of the debt of the distressed firm to be able to “block” reorganization plans in the proceeding. Secondly, to achieve a “controlling” position, the activist investor must
19 Adalet McGowan and Dan Andrews, 'DESIGN OF INSOLVENCY REGIMES ACROSS COUNTRIES' (OECD 2020)
<http://www.oecd.org/officialdocuments/publicdisplaydocumentpdf/?cote=ECO/WKP(2018)52&docLanguage =En> accessed 14 July 2020.
20 David J. Denis and Jing Wang, 'Debt Covenant Renegotiations And Creditor Control Rights' (2013) 113 Journal
of Financial Economics.
21 Ibid 20.
22 Adam B. Badawi, 'Debt Contract Terms And Creditor Control' (2019) 4 Journal of Law, Finance, and
possess half of the total market value of the debt of the distressed firm in the reorganization proceeding.23
It is crucial to note that taking control of a firm, often requires an additional capital injection to ensure a successful turnaround of the distressed firm. 24 The purchase of debt or the additional
capital injections by the activist investor can be seen as a loan-to-own strategy: the activist investor becomes a creditor in the firm. Their objective is to get ownership of the firm by swapping their debt for equity. An activist investor can stipulate the debt-to-equity swap as a part of the reorganization plan. In this case, the creditor and shareholders agree that the principal of the creditor’s claim will be (partly) written down. The creditors will be compensated by receiving new issued of shares of the firm.
If creditors want to swap their debt for equity within restructuring, their proposal has to be accepted by all the creditor classes or negotiating parties, since it is a part of the reorganization plan. However, if a creditor class declines the proposal, the court can still make the reorganization plan enforceable. The so called cross-class cramdown clause makes it possible that the court is able, under circumstances, to enforce a reorganization plan even when dissenting classes are present. On the other hand, in case that the shareholders agree with the swap, a restructuring procedure is unnecessary.
A recent example of a debt-to-equity swap in insolvency is the insolvency of American Apparel: “American Apparel was found in financial distress. In 2015, the clothing corporation
filed for bankruptcy.25 American Apparel came into the hands of its bondholders which
swapped their whole debt position for shareholders capital, through a debt-to-equity swap.”26
After the swap the activist investor may not only hold claims against the firm, but (also) a large stake in the firm’s equity. When the firm is transformed into a healthy corporation, activist investors seek an exit of their investment by selling their shares.
23 Ibid 5, p. 25. Table 2.
24Ibid 4, p. 189.
25 Clare Hutchison, 'American Apparel Files For Bankruptcy In The US' Independent (2015)
<https://www.independent.co.uk/news/business/news/american-apparel-files-for-bankruptcy-in-the-us-a6679621.html> accessed 14 July 2020.
26 Financial Times, 'American Apparel: Frayed Bonds' (2016)
This paragraph will discuss the most common exit-strategies. The first exit-strategy is that the activist investor sells (within three years) the equity of the “new healthy and sound” firm, included the control premium. The second strategy is that the activist investor repeats the strategy discussed above several times for firms within the same industry. In this way, the activist investor “roles-up” multiple distressed firms from the same industry.27 Activist
investors will opt for a combined sale of the firms.28 It is clear that in order to buy a significant
debt position and to stipulate the activist strategy, large capital is necessary. The following section will clarify the characteristics of distressed debt investors.
1.4 The Distressed Debt Investor
DDI has begun and evolved most within the United States(U.S.). Therefore, a considerable number of investors operates in the U.S. To make a complete overview of the Distressed Debt market and its investments, this section will delve more into the following questions: who are the investors and where are they located?
1.4.1 Geographical
The significant growth of the market value of the distressed debt market is enabled by an increase of distressed debt investors. Research on the distressed debt market dated from 2018 shows that the U.S. counted more than 200 distressed debt investors. 100 of those operated internationally.29 Europe is gradually receiving attention of distressed debt investors from
around the world. European distressed debt under asset-management will hit a record of $50 billion in June 2020, and potentially much more because of the recently started COVID and oil crises.30 However, not every part of the world is that attractive for DDIs. Jurisdictions have
different insolvency procedures and governmental policies. Whether DDI is promising is closely related with the policies in the jurisdiction where the investment is made. This is clearly visible in Japan. The Japanese government encourages banks with their policies to hold their
non-performing loans and to solve them on their own.31 The Japanese Distressed Debt market
is therefore underdeveloped and unattractive for investors.
27 The restructuring of Allied Holdings, Inc is an example of the roll-up strategy. Paragraph 1.5.2 on Activist
Targets will elaborate further on the case.
28 Ibid 4, p. 189. 29 Ibid 5, p. 24.
30 Abhinav Ramnarayan and Simon Jessop, 'Investors Build War Chests To Buy Bonds Of Distressed European
Companies' Reuters (2020) <https://www.reuters.com/article/us-europe-funds-debt/investors-build-war-chests-to-buy-bonds-of-distressed-european-companies-idUSKBN1ZN1JJ> accessed 5 July 2020.
1.4.2 Institutional Investors
We have seen in which parts of the world distressed debt investors are the most active. This section will discuss who these investors actually are. Investors do certainly not recoil from a risky investment. In general, they are a group of investors specified in the distressed debt market only. Their investment horizon is often equal to 0.5 to 3 years.32 Distressed debt investors
manage around $50 million to $15 billion assets in their portfolio, with a market total of $400 - $500 billion funds under management.33 Those large asset-managers are mostly hedge funds,
private equity firms and mutual funds.34 Hedge Funds are the kind of investors which are
involved the most in the turnaround variant and are responsible for half of the annual trading volume in distressed debt.35 These large institutional investors are increasingly looking for
DDIs. Financial heavyweights like KKR, JP Morgan and CVC raised at the start of 2020
summed up more than $3,5 billion for new specialized DDIs funds.36
Is there room for smaller retail investors in the distressed debt markets, with all the “big boys”? Certainly not in the field of the active strategy, due to the required significant capital. Following the passive strategy on the other hand, a little capital could be sufficient. Retail investors could make a bet on the turnaround of a firm by (passively) buying the firm’s bonds on the financial markets. So, “heavyweights” are able to opt for both the active and passive strategy, while the smaller retail investors are limited to the passive strategy.
1.5 Distressed Debt Target Companies
Distressed debt targets are obviously financially distressed firms with (large) debt. However, not all distressed firms are suited for pursuing any of the two strategies. For this reason, targets can be categorised into active and passive targets. Examples are given to clarify.
1.5.1 Distressed Debt Targets: Passive
Following the passive strategy (as discussed above), passivist investors bet against a successful pre-bankruptcy workout or post-bankruptcy restructuring of the distressed firm. Passive
32 Ibid 4, p. 187. 33 Ibid 5, p. 24. 34 Ibid, 5, p. 26.
35 Wei Jiang, Kai Li and Wei Wang, 'Hedge Funds And Chapter 11' (2012) 67 The Journal of Finance, p. 514. 36 Abhinav Ramnarayan and Simon Jessop, 'Investors Build War Chests To Buy Bonds Of Distressed European
Companies' Reuters (2020) <https://www.reuters.com/article/us-europe-funds-debt/investors-build-war-chests-to-buy-bonds-of-distressed-european-companies-idUSKBN1ZN1JJ> accessed 5 July 2020.
investors will purchase debt of a distressed firm if they are convinced, to a reasonable degree, that the target will stay solvent, without the passive investor’s interference in the debtor’s governance. Passive investors simply believe that the distressed firm’s debt is undervalued. Preferably, passive distressed debt targets have issued bonds on the financial markets. This makes it convenient for passive investing.
The world’s biggest distressed debt investor, Oaktree Capital, states on their website that financially distressed firm will become a target when credit standards sink followed by
economic weakness.37 For example, due to liquidity problems Firm A cannot pay coupons on
its debt. The operations, on the other hand, are still viable. Nevertheless, Firm A is in distress. The bonds are highly discounted, because of the missed coupon payment. If a passive investor is convinced that Firm A will survive the liquidity problems, the investor would consider Firm A is a potential target.
1.5.2 Distressed Debt Targets: Activist
Activist investors are constantly looking for bargains on the bond and secondary loan market. As clarified above, the objective of the purchase of the debt is to ultimately receive control of the distressed firm through a controlling credit position. Activist investors want to sell the restructured firm or will use the roll-up strategy. For this strategy, the activist investor will search for a (distressed) and undervalued industry.
Activists investors preferably search for distressed firms with unsecured debt (in the form of bonds) and overcollateralized secured debt. In this situation, the unsecured debt has a supportive function. Secured debt is low risk, because of the overcollateralized situation. This makes it possible that unsecured debtors can take the lead. The unsecured debt is in this situation a suited target for activist investors.38 The next section clarifies the previous with a historical example. 1.5.2.1 Allied Holding, Inc.
Allied Holding, Inc. is an logistic company that supports the automotive industry. Investor Yucaipa purchased 66% of Allied Holding, Inc.’s unsecured bonds one year after its Chapter
37 'Distressed Debt' (Oaktreecapital.com, 2020)
<https://www.oaktreecapital.com/strategies/credit/distressed-debt> accessed 2 June 2020.
11 filing. Yucaipa received the control of Allied’s reorganization proceeding. With this control, Yucaipa stipulated a debt-to-equity swap along with new secured financing. Due to the received shares, Yucaipa gained after restructuring substantial control rights over Allied Holding, Inc. Yucaipa used the roll-up strategy. They consolidated several distressed firms in the logistic sector to exit through a combined sale of the shares.39
1.6 Conclusion
Since 1990 the distressed debt market has grown, thanks to increasing investor’s interest, into a mature asset investment class.40 In times of economic uncertainty, distressed debt markets
tend to significantly grow. Years of recession and crises are beneficial times for DDIs. So 2020 promises to become a great year for the distressed debt market and its investors.
DDIs are in general divided in two main strategies, namely activist and passive. The passive strategy is suitable for both retail and institutional investors while the active strategy is only suitable for institutional investors. Regardless of which strategy you choose, distressed debt investing is a high risk investment class. The key concept in the distressed debt market is that investors need to predict the probability of bankruptcy before they decide to invest. The Z-score model is one that is commonly used within the bankruptcy probability models.41 This makes it
a difficult and risky way of investing. The probability models are inaccurate because of accounting-based measures, which neglect the “forward effect” of the firm”. These models focus only on past firm performance.42
The activist distressed debt strategy of large institutional investors, with all its possible positive and negative externalities, will be the core of this research. Questions as: “are activist investors vultures or white knights?” will be covered. The next chapter will examine the influence of activist investors on the management of a distressed firm.
39 Michelle M. Harner, 'The Corporate Governance And Public Policy Implications Of Activist Distressed Debt
Investing' (2008) 77 Fordham Law Review, p. 718 – 720.
40 Ibid 4, p. 189.
41 Edward I. Altman, 'FINANCIAL RATIOS, DISCRIMINANT ANALYSIS AND THE PREDICTION OF CORPORATE
BANKRUPTCY' (1968) 23 The Journal of Finance.
42 Stephen A. Hillegeist and others, 'Assessing The Probability Of Bankruptcy' (2004) 9 Review of Accounting
II. Investor’s Influence on Management
The previous chapter clarified that activist investors attempt to control the firm within and after restructuring. Thanks to a debt-to-equity swap, activist investors are the potential new owners of the firm. This chapter will examine what the consequences are for the management of the distressed firm, since they have to deal with a new controlling shareholder post-restructuring. Situations where the management has to deal with the activist investor much earlier in the process will also be covered.
2.1 Pre-Restructuring
The nature of activist investing is inside the influence of the management of the distressed firm salvaged. As section 1.3.2.1 discussed, activist investors could possibly start influencing the management already pre-reorganization. Activist investors purchase a controlling stake in the company’s debt. In this way, they can stipulate for them (solely) favorable terms. Thereafter, activist investors can use their controlling creditor position to threaten the distressed firm before a covenant is violated. The controlling creditor could for example reclaim the principle. The management should attach great importance to the demands of the activist investor, ignorance could mean insolvency of the firm. Using the leverage of reclaiming the principal of an important and significant loan for the firm could hurt the firm badly. A consequence could be that the firm will enter into distress and eventually become insolvent. This, of course, must be avoided at all times.
2.2 In Restructuring
In other situations, the management is surprised with the activist investors’ presence.
Due to the purchase of distressed debt on the secondary market by the activist investor, the dynamics of the original relation between debtor and creditor change.43 Often, the management
of the distressed firm is ignorant of the fact that an activist investor purchased a (controlling) position. In some cases, activist investors announce themselves only after the moment when
restructuring proceedings already have started.44 The management did not know that a large
part of its debt was sold to a third party and so who their creditors are. This could give activist
43 Michelle M. Harner, 'Activist Distressed Debtholders: The New Barbarians At The Gate?' (2011) 89
Washington University Law Review, p. 164.
44 Michelle M. Harner, Jamie Marcinic Griffin and Jennifer Ivey-Crickenberger, 'Activist Investors, Distressed
investors the opportunity to blind-side the debtor and its other creditors and prepare their own restructuring plan that differs significantly form the traditional creditors. The ignorant management of the distressed firm and its creditors could be put on the wrong track.45 Activist
strategies differ from standard creditor strategies within restructurings. Activist investors could make preparations of a restructuring plan while other stakeholders do not even know the existence of that investor, moreover the existence of that restructuring plan. This plot-twist could involve unexpected costs for the distressed firm and other creditors when preparations were already made for a restructuring plan by the debtor and the known creditors. Within DDIs activist investors have the controlling power to overrule these plans.46 These unexpected costs
has potential consequences on the length of the restructuring proceeding, the recovery rate of the creditors and the probability of rehabilitation of the debtor. Chapter V will discuss the consequences on the insolvency proceeding and other creditors in more detail.
Now it is clear that activist investors have several tools to influence the management of the distressed firm, it is crucial to know whether this influence is beneficial for the debtor and its stakeholders.
2.3 Influencing the Management: Costly or Beneficial?
This paragraph will examine what activist investors require from the management board and if these requirements are beneficial or not. Academics argue that activist investors use terrorist litigation tactics to extract hold-up value settlements from senior creditors.47 The management
board will and has to spend more on expensive attorneys relative to situation when there are no activist investors involved.48 So, direct costs of insolvency will increase.49 This tale could hurt
the distressed firm, management and especially other stakeholders. Higher direct costs of insolvency means a lower recovery rate for creditors. However, empirical research shows that the direct costs of insolvency is relatively small, briefly 1,3 percent of the appraised value.50
So, is the attempt of activist investors on influencing the management costly or beneficial? To answer this, it has to be clear what activist investors’ objectives and results are.
45 Ibid 44.
46 Ibid 5, p. 25.
47 Jr. Ross and L. Wilbur, 'Statement To The American Bankruptcy Institution Commission To Study Reform Of
Chapter 11' (American Bankruptcy Institution Commission 2013).
48 Jared A. Ellias, 'Do Activist Investors Constrain Managerial Moral Hazard In Chapter 11?: Evidence From
Junior Activist Investing' (2015) 8 Journal of Legal Analysis, p. 494.
49 Ibid 48, p. 497. 50 Ibid 48, p. 498.
2.3.1 Managerial Activities
When a firm is solvent, the management has the right to govern the firm. The governance means the direction of running the day-to-day business. In other words, the management board has the ultimate decision-making authority. This ultimate decision-making power reaches the policy of the firm and monitors the operations.51 In insolvency, within most jurisdictions the management
has to hand over the day-to-day running of the company to an (independent) administrator.52 In
the main jurisdiction where DDIs take place and the main concentration of this paper, the U.S., the reorganization proceeding does not require the management board to hand over the management to an independent administrator. Resulting from Delaware case law within insolvency cases, under the US law, the management’s fiduciary duty shifts from the shareholders to all the stakeholders53 of the firm.54
First of all, the fact that management remains in place during Chapter 11 proceedings does not mean that they stay in charge.55 In Chapter 11 proceedings, the management of the debtor has
the exclusive right to propose the restructuring plan during the first 120 days of the Chapter 11 proceeding.56 When the restructuring plan is formulated, it will be sent to the Court which
enables the voting for holders of a claim or interest.57 Therefore it is obvious that the
management is the party that formulates and designs the restructuring plans. Within DDI, it is completely the opposite. The management is rarely the party that designs the restructuring plan. Often, the creditors design restructuring plans. The activist investors have a lot of power in these proceedings, because of their big stake in the leverage of the distressed firm.58 With this
power, activist investors, very often, try to replace the leadership role of the management to take charge of restructuring.59 Other creditors, shareholders and employees take part in the
process and have a voice as well. Therefore, negotiations are necessary for all the stakeholders to design a consensual plan for the future of the distressed firm. We can conclude that even
51 Jonathan Berk and Peter DeMarzo, Corporate Finance (4th edn, Pearson 2017), p. 41.
52 For example, paragraph 68 of the Dutch Bankruptcy Code states that the administrator is entitled with the
management and liquidation of the bankrupt estate.
53 Stakeholders include all parties that have an interest or a claim against the firm: e.g. employees and
creditors.
54 Credit Lyonnais Bank Nederland, N.V vs Pathe Communications Corp. [1991] Civ A. No. 12150 & Geyer vs
Ingersoll Publications [1992] Co. 621 A.2d 784 & Production Resources Group, L.L.C. v. NCT Group, Inc [2004].
55 Ibid 39, p. 760.
56 U.S. Bankruptcy Code, Chapter 11 § 1121 (b). 57 U.S. Bankruptcy Code, Chapter 11 § 1126 (a). 58 Ibid 39, p. 760.
while Chapter 11 proceeding prescribes a stay on the management, they have insignificant power in the proceeding with activist investors. So a restructuring plan that is designed and negotiated with all stakeholders is in the light of residual claimants a fair and beneficial phenomenon. This could be different if the plan is designed by a minority of creditors with a high percentage in the leverage of the firm. In this situation, the activist investor could take advantage of the fact that the management is not in charge at the expense of the other creditors. If the management takes a protective role for all stakeholders, which is required by law, the negative impact of an activist investor’s restructuring plan for other stakeholder could be reduced.60 Activist investors attract a lot of power in restructuring proceedings at the expense
of the management.
2.3.2 Managerial Moral Hazard
The previous paragraphs showed that the management board loses significant power in the distressed firm to activist investors, but it is still unclear if this is beneficial or not. This section examines whether activist investors constrain or drive managerial moral hazard.
Firstly, it is important to understand that managerial moral hazard occurs both in solvent and insolvent firms. The phenomenon of management that acts self-interest is not sporadically. Academics discuss the fact that managers in restructuring proceedings have powerful incentives to under-appraise the firm. This is, because managers often receive lucrative stock grants at the appraised value of the assets when the firm emerges from a restructuring.61 The lower the
appraised value of the assets, the lower the initial value of the stock granted, thus the higher the potential profit of the management on these stock grants. Senior (secured) creditors could benefit from a low appraisal as well, due to executing the assets at the real price and receiving the difference between the height of the claim and the low appraised value. This means that the low appraisal comes at the expense of more junior creditors. They will receive a smaller recovery relative to the situation where the valuation was done properly. Research shows that activism of junior creditors, which are mostly activist investors as clarified in section 1.5.2, is positively correlated with the appraised value of the company.62 Activist investors produce a
higher appraisal than the market expectation.63
60 Ibid 39, p. 765.
61 Ibid 48, p. 495. 62 Ibid 39, p. 496. 63 Ibid 39, p. 497.
Research on managerial moral hazard suggest that activist (junior) investors constrain managerial self-dealing and promote the bankruptcy policy goals of maximizing creditor recoveries and distributing the firm’s value in accordance with the absolute priority rule.64
2.4 Conclusion
The fact that the Chapter 11 proceedings are debtor-friendly does not mitigate the powers of the activist investors. In general, activist investors do not use their powers in a harmful manner. Moreover, there is evidence that activist investors influence the activities of the management positively.
The presence of activist investors in a Chapter 11 proceeding in combination with the U.S. Bankruptcy code are increasingly important in insolvency. Activist investors are a well suited replacement of the management, because they influence the governance beneficially and are more fair for the largest part of the stakeholders. The managements rights are constrained to guarding stakeholder rights. There is no evidence that activist investors replace the management for unjust enrichment, rather they benefit the more junior creditors and the insolvency proceeding by mitigating managerial and senior creditor’s self-interest.
Now it is clear that activist investors predominantly influence the management of the distressed firm the question arises as to whether this influence benefits the firm value as well as the firm’s decision-making?
64 Ibid 39, p. 493.
III. Investor’s Influence on Firm Value
Firm value maximization by an activist investor could invoke a “free-ridings benefit” for the other creditors. This chapter will examine if activist investors increase firm value. If the question can be answered positively, the chapter will discuss how they do it.
3.1 Profit Maximization
Activist investors always try to maximize their return on investments. So, does this value maximization correlate with the firm value of the distressed firm. A hurdle could be that value maximization of the investment of the activist investor not necessarily means value maximization for the distressed firm and the other creditors. A lot of issues could arise on the firm value maximization within restructuring proceedings. Academics argue that when a firm is in a state of insolvency, there sporadically is a party whose self-interested decisions can be relied on to maximize firm value.65 This section will examine whether this applies to activist
investors’ decisions regarding the restructuring of a distressed firm.
As mentioned earlier (Chapter 1), activist investors often have the intention to carry out a loan-to-own strategy. They swap their claims into shares. The ultimate objective is to sell the converted shares when the reorganization of the distressed firm is successfully finished. Activist investors will do whatever it takes to maximize the value of the shares, because they want to maximize their return on investment. Maximization of firm value results from the maximization of share price.66 Therefore, it can be concluded that activist investor’s objective is to maximize
the value of the distressed firm.67 Due to the intention of becoming the residual owner
post-restructuring, activist investors will, already during the proceeding, act more as the management board (as discussed in Chapter 2).68 This could lead to potential agency costs between the
controlling creditor, namely the activist investor, and the other creditors. Especially if we compare the objectives of activist investors with the objectives of normal banks and trade creditors. The interests of banks, as creditors, is to keep as much debt as possible on the
65 Paul M. Goldschmid, 'More Phoenix Than Vulture: The Case For Distressed Investor Presence In The
Bankruptcy Reorganization Process' (2005) 1 Columbia Business Law Review, p. 198.
66 Aswath Damodaran, 'The Objective In Corporate Finance' (NYU Stern School of Business).
67 Lynn M. LoPucki, 'The Myth Of The Residual Owner: An Empirical Study' [2003] SSRN Electronic Journal. (In
the academic literature, this theory is often referred as “frequently invoked hero theory” of the residual actor. The activist investor is the residual actor in the meaning of the word. In a solvent company, the shareholders can be seen as the residual actor.)
insolvent firm since they see little to be gained and much to be lost by providing the debtor with financial flexibility.69 This financial flexibility is necessary for a successful turnaround and so
for the efficient maximization of the firm value. The flexibility of activist investors will be discussed in detail in the following chapter.
3.2 Effective Negotiations
Activist investors, most often hedge funds, are suitable for the maximization of the firm value. Investing in firms to increase share price, and thus equity value, is a daily-business for them. Activist investors improve business performance for their shares in the future. They have sufficient recourses and knowledge to make good (management) decisions for the distressed firm and, therefore, they can find creative business solutions. 70
We saw that activist investors purchase a lot of debt. Sometimes even in different credit classes. One way to maximize firm value is to consolidate debt. The purchase of all the debt leads to consolidation of claims.71 Also, activist investors are highly intellectual investors. That in
combination with the fact that they are experienced negotiators, especially activist investors within reorganization proceedings, makes that the negotiations are more effective. The objective of negotiating is to get a higher or better eventual price/value than when you take a deal immediately. Activist investors’ negotiation could be seen as more convenient from a financial and psychological perspective, relative to negotiations with original, pre-restructuring, creditors. Head of Restructuring of investment bank Lazard stated: “I would rather deal with a distressed debt investor who paid fifty cents on the dollar than a dozen bankers who all made the original loan. The bankers signed onto the original business plan that failed, and they want their money back.”72 In other words, activist investors have the incentive to make a profit, while
bankers have (at this point) the incentives to get their money back. The probability that activist investors make a profit is significantly higher relative to the probability that original creditors receiver their investment back.
69 Ibid 65, p. 256.
70 Daniel B. Kamensky, 'Furthering The Goals Of Chapter 11: Considering The Positive Role Of Hedge Funds In
The Reorganization Process' (2014) 22 American Bankruptcy Institute Law Review, p. 239.
71 With claim consolidation, creditor’s claims will unite in one specific investor’s pocket. 72 Ibid 65, p. 259.
3.3 Conclusion
Everything taken into account, activist investors could be seen as having a positive effect on the firm value. This is especially the case when the objective of the investor is to become residual owner after the reorganization. The distressed firm, and so the other creditors, will benefit from a debt-to-equity swap of the activist investor because of the incentive to maximize the firm value. Activist investors unlock value. 73 Now it is very likely that activist investors
maximize the value of the distressed firm, the next chapter will examine how activist investors relate to and which place they take within the financial system.
73 Edith S. Hotchkiss and Robert M. Mooradian, 'Vulture Investors And The Market For Control Of Distressed
IV. Place of Distressed Debt Investors in the Financial System
Activist investors, e.g. hedge funds and private equity firms are known for their investment strategies. They will collect capital from investors, mostly pension funds and wealthy individuals and transform these liquid liabilities into less liquid investments, namely distressed debt. It is remarkable that activist investors have a more extensive place in the financial system than traditional institutional investors. This chapter continues arguing why distressed debt investors are beneficial for the financial system.
Eminently, activist investors are sophisticated investors. If hedge funds will become a creditor of the distressed firm, significant knowledge in the reorganization and firm value maximization process will be added.74
Why does society has to welcome distressed debt investors and in what respect does their presence influence the financial system?
4.1 Replacement for other Sophisticated Investors
Just like hedge funds, the traditional bank is a sophisticated investor as well. However, there are still differences between the strategies and operations of the two. Naturally, banks are more risk-averse than hedge funds. Bankers want certainty in their investments, while hedge funds are more likely to take risks to receive a higher on investment. Chapter 1 discussed the risks of DDIs. The risk of DDI is closely connected with the probability of default of the distressed firm.75 Due to the difference in risk-aversity, hedge funds are more willing to invest in a
distressed firm relative to a traditional bank. The investment targets is not the sole thing that distinct hedge funds and banks. Activist investors are also significantly more flexible by nature relative to traditional banks.76 Investments strategies of banks and activist investors are very
different.77 The traditional investment strategy of banks is: extending credit, monitoring the
debtor, and receiving its payments. Alternatives like debt-to-equity swaps happen sporadically for banks when they play a role as creditors, while it is ‘daily business’ for hedge funds. This in combination with the risk-aversion of banks, ensures that there is a small probability that banks are willing to invest in distressed form, and thus to save these firms. Banks are often not
74 Ibid 70, p. 235.
75 See Chapter 1 on the risk measurements of DDIs. 76 Ibid 70, p. 235.
willing to extend a new loan when the firm is in distress, while activist investors are more willing to do so.78 This is beneficial when a distressed firm’s business operations are still viable,
but the capital structure is inadequate. By letting these companies bleed to death, the objective of insolvency proceedings (maximizing the recovery rate for creditors and increasing the probability of rehabilitation of the debtor)79 will be neglected and viable businesses will become
unnecessarily insolvent. Activist investors could be the white knight that can lead the distressed firm return to solvency. They replace traditional (risk-averse) creditors in situations of distress. Thanks to activist investors, a distressed firm’s probability of access to new capital increases. Without the existence of hedge funds, many distressed firms would not have access to financing. This will have the consequence of more insolvencies. Hedge funds are open for investing, even in times of market volatility and distress.80 They provide distressed firms with
additional financing options in critical moments.81 When there is more financing available for
distressed firms, liquidity in the distressed debt market increases. It is also known that liquid markets benefits pricing discovery for financial products. A liquid market, with ten-thousands of trades per day, is more accurate than an illiquid market, with only a few trades per day. The liquid market gives a better approximation of the real value of a financial product.82 Activist
investors enhance price discovery in the distressed debt market. On top of that, an increase in financing options mean that more credit is available in the market. This will eventually lead to a decrease in the cost of capital.
4.2 Early Exit for Creditors
Less sophisticated creditors, e.g. trade creditors, could also benefit from the appearance of activist investors. The activist investor could be beneficial with the respect to the distressed debtor. However, activist investors could also be beneficial for creditors that want to exit their investment. Many creditors, including trade creditors, have little knowledge and time for insolvency proceedings. Insolvency of a debtor could be really harmful for them. I will clarify this on the basis of an example:
78 Ibid 5, p. 24. 79 Ibid 70, p. 235. 80 Ibid 70, p. 236. 81 Ibid 70, p. 238. 82 Ibid 70, p. 235.
Department Store A enters into insolvency. Towel Maker B is one of its many creditors. Department Store A is one of the biggest clients of Towel Maker B. If Towel Maker B has to
wait for more than 2 years until they receive a part of the claim (say: 32%) they have rights to,
Towel Maker B will enter in distress itself.
Activist investor, namely Hedge Fund C, comes into play. Hedge Fund C makes a bid on the
Towel Maker B’s creditposition: 30% of the face value.83 Towel Maker B has now the
opportunity to sell their complete interest in Department Store A. Due to this, Towel Maker B does not have to wait before a small part of their claim will be repaid. Towel Maker B has to significantly depreciate the trade with Department Store A á 70%, but will remain solvent.
Hedge Fund C provided liquidity to Towel Maker B. In general, activist investors could resolve
potential liquidity problems of creditors of a firm in distress and will decrease the potential domino-effect of insolvency.84
4.3 Conclusion
Activist investors are sophisticated investors with the knowledge, financial recourses and will to, in contrast to traditional banks, improve the probability of viability of the debtor and to offer ‘exit’ opportunities for less sophisticated creditors.
Activist investors make it possible for creditors to adjust their own risk profiles, by selling distressed products.85 In fact, society should be happy to welcome activist investors. They can
take the place of Lender of Last Resort to rescue a distressed firm.86
83 The fact that Hedge Fund C bids 2% under the recovery rate is not particularly abuse of circumstances. Hedge
Fund C opens an opportunity for Towel Maker B. However, it is a high risk trade. The haircut is reasonable. Also keeping in mind “the time value of money”: the X amount of money today has a higher value than the X amount of money tomorrow.
84 Ibid 70, p. 237. 85 Ibid 70, p. 238. 86 Ibid 44, p. 179.
V. Insolvency Proceeding and Other Creditors
The previous Chapters discussed the nature of the distressed debt investors and their influences on the management and firm value and their special role in the financial system. This chapter will focus on whether activist investors are beneficial or inexpedient for other creditors within or outside the reorganization proceeding. Regarding this question, there exist competing views.87
This chapter clarifies what the potential costs and benefits are concerning activist investors pre- and during restructuring. In addition, Chapter 7 introduces possible and suitable norms that regulators could impose to limit the costs caused by activist investors, while maintaining its benefits.
The following issues in this Chapter: are activist return externalities (paragraph 5.1), the reorganization procedure (paragraph 5.2), different investment incentives (paragraph 5.3), the war between activist distressed debt investors (paragraph 5.4) and the externalities of the credit bidding strategy (paragraph 5.5).
To determine what the costs and benefits are regarding activist investors within restructuring proceedings, the paper refers to the same insolvency objectives as in the previous Chapter: maximization of the recovery rate and maximize the probability to rehabilitate the distressed firm.88
5.1 Activist Investor Return
The literature discusses many negative externalities from activist investing.89 It is common
knowledge that investors want to maximize their return of investments, but does this self-interest of activist investors immediately hurt the self-interest of the other creditors? Some academics plea that a self-interest is not necessarily a negative intention for other creditors.90
Self-interest creates an issue when activist investors want to maximize their return at all costs.91
87 Keith Sharfman and G. Ray Warner, 'Hedge Funds In Bankruptcy' (2014) 22 American Bankruptcy Institute
Law Review, p. 63.
88 Section 4.1.
89 Michelle M. Harner, 'Trends In Distressed Debt Investing: An Empirical Study Of Investors' Objectives' (2008)
American Bankrupcty Institute Law Review, p. 100-110.
90 Ibid 70, p. 242. 91 Ibid 89, p. 104.
This would implicate that if activist investors could possibly generate a higher return by operating disadvantageous to other creditors, they will do it. This is not always the case within activist investing, because activist investors are creditors as well. Proponents of investor activism in distressed firms rely on the ultimate objectives in the nature of creditors: the reclaim of the principal amount. Their argument basically says that activist investors maximize firm value for their own return and also for other creditors’ claims.92 This self-interest for
maximizing firm value would benefit both the activist investor’s return as the other creditors’ return.
Albeit the above, as we have discussed, many activist investors do not want to realize the repayment of the principal amount.93 Activist investors are likely to stipulate the opportunity
of a debt-to-equity swap instead of reclaiming of the initial principal amount. One may wonder if the self-interest of activist investors in the situation of a debt-to-equity swap is beneficial for the other creditors? The tunnel-vision of activist investors for maximizing their own investment return might lead to a lower recovery rate for creditors. In light of the discussion in Chapter 3, the question can be answered positively. Chapter 3 discussed that activist investors maximize firm value. Activist investors bring excellent knowledge and experience to the distressed firm’s reorganizations.94 Their knowledge and experience has a beneficial consequence for less active
and intellectual creditors in the debtor’s turnaround. This in combination with the firm maximization contributes not to a free-ride problem, but a free-ride benefit for the other creditors. An activist investor, e.g. a hedge fund, that takes the lead in a reorganization procedure does not have to be harmful to other creditors. In the next paragraph, we discuss the influence of activist investors in a reorganization procedure.
5.2 Reorganization Procedure
To examine whether activist investors benefit or expropriate other creditors, we need to discuss activist investor’s influence on the insolvency procedures.
The first element is the length of the reorganization proceeding. Long insolvency procedures are costly for both the viability of the distressed firm and the principal claim of its creditors. Delay of the restructuring process could realize a value destruction at the expense of other
92 Ibid 70, p 246. 93 Section 1.3.2.2. 94 Ibid 35, p. 514.
creditors and even in some situations on the activist investor’s stake itself. The quicker the reorganization the better. The question that arises is as follows: do activist investors increase or decrease the period of insolvency procedures? The question could be answered in the affirmative: activist investors could decrease the reorganization period. This is, because they usually consolidate debt to get controlling power in the firm’s reorganization proceeding. When there are less investors and individua with opinions and visions, plan-making becomes less contentious and quick. On the other hand, activist investors could also have negative influence on the length of the reorganization proceeding if they (only) possess a blocking position in the distressed firm’s debt.95 With this, they are in the position to delay the restructuring process by
consequently voting against reorganization plans that do not converge with their own investment strategy. Activist investors could squeeze all other stakeholders out until the point that they all agree with the proposed activist reorganization plan. Eventually there is no other possible outcome besides the activist investors plan apart from liquidation. When activist investors choose for blocking all restructuring plans apart from their own, the insolvency procedure becomes unnecessarily long. History shows that delay of the restructuring process sometimes causes a forced liquidation of the debtor.96 On top of the above, research shows that
activist investors cause relatively more litigation in insolvency procedures.97 When other
creditors feel disadvantaged, they would not hesitate to file a lawsuit. In these situations, the firm value is decreased “way more than necessary”, because of an ignorant activist investor. In fact, this counteracts firm value maximization and decreases creditor’s reclaim. Restructuring procedures with activist investors are possible longer and more expensive than procedures without such investors. However, research shows that the median length of situations where activist investors are active is significantly higher related to proceedings without them. On the other hand, the average length does not significantly increase.98 In conclusion, on average,
activist investors do not significantly benefit or hurt the length of the reorganization proceeding.
Second, the controlling position of an activist investor could enhance tunnelling. In this situation, the activist investor is the “insider” that opts for liquidation by blocking a healthy restructuring plan. The activist investor could have a large interest to liquidate viable but
95 Section 1.3.2.2.
96 David Peress and Thomas C. Prinzhorn, 'Nontraditional Lenders And The Impact Of Loan-To-Own Strategies
On Restructuring Process' (2006) 48 American Bankruptcy Institute Law Review, p. 57 and 58.
97 Ibid 48, p. 494 – 497. 98 Ibid 44, p. 193.
financially distressed business assets or divisions, by means of buying the sold assets through another investment or daughter firm for a price which is under the real value. An activist investor will opt for this strategy, if the value increase of its investment on the daughter firm is higher than the value decrease on its investment in the distressed firm. As with any kind of tunnelling, the value increase of the insider arises at the expense of other stakeholders. In this situation, the other creditors.
Third, some academics argue that activist investors make the restructuring procedure more management neutral.99 When reorganization starts, activist investors sometimes replace a part
of the management board. As discussed Chapter 2, employees and creditors are the prominent parties within restructuring. Management has to be neutral to all these parties. However, one point can be made. The activist investor is (possibly) the new employer of the management board.100
Last and perhaps most importantly, empirical research shows that activist investor involvement in Chapter 11 filings creditors receive a higher recovery rate and debtors are more likely to realize a successful reorganization.101 In fact, empirical research states that activist investors
contribute to the reorganization process, partly through capital injections, financial insight and expertise.102
To conclude, longer restructuring proceedings and tunnelling by the activist investor leads to value minimization which lead to higher costs and on its turn to both a lower recovery rate for creditors and lower probability of rehabilitation of the distressed firm. As well as the incentive divergence of activist investors, longer restructuring proceedings has to be limited by regulation. There is, however, no significant evidence that activist investors lengthen restructuring procedures or tunnel. Meanwhile, there is empirical evidence that distressed debt investor activism in Chapter 11 procedures has a positive impact on both the creditor recovery rate and probability of firm rehabilitation.
99 Ibid 39, p. 760.
100 Ibid 39, p. 764.
101 Ibid 70, p. 240. & Edward I. Altman, Tushar Kant and Thongchai Rattanaruengyot, 'Post-Chapter 11
Bankruptcy Performance: Avoiding Chapter 22' (2009) 21 Journal of Applied Corporate Finance, p. 48-52.
5.3 Different Investment Incentives
Sometimes, activist investors have different interests than the debtor itself. Obviously, the activist investor has an interest for a shorter period relative to the debtor and other creditors. When the activist investors made their profits and sold their stake in the company, they would no longer be concerned with the viability of the target firm. As discussed at the beginning of the chapter, activist investors might use their controlling creditor position not for reclaiming the outstanding contractual principal amount borrowed by the debtor but for the purpose to realize a debt-to-equity swap. The examples make clear that there is a high probability that activist investors have different investment incentives which may hurt both the debtor and creditor. Because of this, activist investor’s acting in their best interest does not necessarily mean acting in the best interest of all creditors. These issues could cause harmful conflicts between different investors and the debtor.103 Conflicts between different activists investors
within one distressed firm will be discussed paragraph 5.4.
One more point to worry about is the variety in investment horizons between the activist investor, other creditors and the debtor. While activist investors have a relatively short-term investment horizon (0,5-3 years), the debtor and the creditors generally have a much longer investment horizon.104 The short-term horizon encourages activist Distressed Debt investors to
focus on a quick realization of value rather than organic long-term growth of the firm. Quick short-term growth can come at the expense of gradual long-term growth, which can come at the expense of maximizing the firm value.
Conclusive, there could be a large divergence of incentives which might decrease both the recovery rate of creditor claims and the probability of firm rehabilitation. The different investment incentives could cause undesirable value destruction in the restructuring process.
5.4 The War Between Activist Distressed Debt Investors
Now we have discussed different possible positive and negative externalities of the divergence in strategies and incentives between activist investors and the other creditors, this paragraph will discuss the possible costs of having two different activist investors within one distressed firm’s reorganization proceeding.
103 Ibid 89, p. 104.
