Equities of Bankrupt Companies Offer Hedge Funds a High Risk, Potentially High Return Method of Investing in Restructurings

Common wisdom holds that common stock is invariably wiped out in a chapter 11 reorganization.  Experience, however, has taught that sometimes common stock retains some value in a reorganization, and in light of the perception that equity will have no value, equities of companies in or near bankruptcy can often be picked up at a major discount.  Even a little recovery, therefore, can yield a lot of return (with, of course, a lot of risk).  Indeed, hedge funds of various stripes, including historic bankruptcy investors and others, have been purchasing bankruptcy equities in the conviction that the issuer will survive a chapter 11 reorganization, and emerge stronger than when it entered.  Many such investments are predicated on one or more of three ideas: (1) that the debt investors are greatly undervaluing the assets of the company; (2) that a major event, such as a lawsuit, will significantly expand the value of the estate; or (3) that industry-wide conditions will improve dramatically (e.g., that many players went into bankruptcy but only few, including the issuer of the subject equity, will emerge).  On the second point, see “Should Hedge Funds Purchase Unsecured Debt of Lehman Brothers Holdings Inc.? Key Legal Issues Impacting Returns,” Hedge Fund Law Report, Vol. 2, No. 26 (Jul. 2, 2009).  We discuss the risks inherent in such investments; reasons (some of which may be surprising) why equity may not be wiped out in a bankruptcy; ways to mitigate the risk of investments in bankruptcy equities; and the formation, purpose and downside of equity committees.

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