Abstract:

Historically creditors of firms filing for Chapter 11 Bankruptcy adopted strategies to try and maximize the probability of return of their initial (often pre-Chapter 11) positions. However more recently Vulture funds that specifically seek out the purchase of the debt of distressed firms at a discount, have taken a more activist approach. If they succeed in purchasing the fulcrum debt of distressed firms (often during Chapter 11) they can find themselves in a position to do far more than simply get their initial investment refunded with interest. Purchasing the fulcrum debt may allow them to take control of the distressed firm and swap their original debt for securities such as new equity in an emerged firm. This can be sold for a large capital gain far in excess of any reasonably imputed interest rates on the original debt. One hypothesis for why such returns are possible assumes that the Vulture funds are simply earning a return for their expertise at strategic restructuring of the operational and financing problems of distressed firms. Put simply they weed out weak management and put things right. However a competing hypothesis is that when they take control of fulcrum debt they may disenfranchise existing equity holders by exploiting how fresh start accounting valuations are used to determine residual allocations between various claimants. Put simply this competing hypothesis assumes they gain control on the cheap. This research is the first systematic study of a comprehensive sample of fresh start accounting reports. An analysis of fresh start, book to market performance and a new ratio, return on old and new equity (ROONE) is conducted to simulate the returns if original equity holders had not been disenfranchised. In addition, another bank of tests looks at how reliable fresh start valuations are when Vulture funds are present. Particular attention is paid to fresh start valuation practices which decrease values leading up to emergence only for them to subsequently increase shortly afterwards. We comment on one high profile case in which the application of “market based” fresh start accounting resulted in the firm’s property portfolio being downgraded in value to such an extent that existing equity holders were left with zero claims (since remaining assets only covered a fraction of debt holders claims) but that upon emergence the same property portfolio was re-valued significantly upwards generating huge returns for the Vulture fund loan to own equity holders.