Due Diligence Considerations for Hedge Funds That Invest in the Equities of Bankrupt Companies: Lessons of the Energy Partners, Ltd. Bankruptcy

Hedge funds are recognizing with increasing frequency that the common stock of bankrupt companies or companies in the zone of insolvency may have post-reorganization value.  See “Interview with Mark Dalton, Alex Sorokin and Neil Wessan of Halsey Lane Holdings: Key Considerations for Distressed Debt Hedge Funds that become ‘Unnatural Owners’ of Equity Following a Reorganization,” Hedge Fund Law Report, Vol. 3, No. 6 (Feb. 11, 2010).  While investing in bankruptcy equities involves considerable risk – notably, the tangible likelihood of a complete loss of value – such investments also, in the right circumstances, offer the prospect of considerable upside.  In particular, bankruptcy equities may be attractive in at least three circumstances: (1) where creditors undervalue the assets of the debtor; (2) when an event (such as a lawsuit in which the debtor is a plaintiff) can act as a catalyst for value creation; and (3) where conditions in the relevant industry or credit markets may enable a debtor to emerge from reorganization while its bankrupt competitors do not.  See “Equities of Bankrupt Companies Offer Hedge Funds a High Risk, Potentially High Return Method of Investing in Restructurings,” Hedge Fund Law Report, Vol. 2, No. 27 (Jul 8, 2009).  However, beyond the well-known financial risk of investing in bankruptcy equities, hedge funds should be cognizant of additional legal and structural risks that can adversely affect investment outcomes, or at least complicate the process of value creation.  In this article, Gregory C. White, an Associate at business valuation and litigation consulting firm Hill Schwartz Spilker Keller LLC, tells the story of hedge funds’ participation on the equity committee in the Chapter 11 bankruptcy of Energy Partners, Ltd. (EPL), a Louisiana-based exploration and production company.  In particular, this article outlines the facts of the case as they relate to the equity committee’s involvement in the valuation of EPL, focusing on relevant terms of the debtor’s engagement letter with its financial adviser.  The article then discusses two key lessons highlighted by the EPL case for hedge funds considering purchases of bankruptcy equities.

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