A group of analysts from a distressed debt hedge fund were working through Hertz’s capital structure on whiteboards in a midtown Manhattan conference room sometime in early 2020. They were mapping out debt tranches, calculating enterprise value under different reorganization scenarios, and estimating the potential value of a pre-bankruptcy bond trading at thirty cents on the dollar once the company exited Chapter 11 with its lease obligations shed and its balance sheet cleaned.
People were losing their jobs outside. The bankruptcy was being covered by the media as a catastrophe. There was a purchasing opportunity in that conference room. One of the more hidden and continuously lucrative areas of institutional finance is bankruptcy arbitrage, which is centered on this tension—the difference between what corporate failure looks like from the outside and what it looks like from inside a sophisticated distressed debt operation.
The fundamental tactic opposes a predictable process. When a business files for Chapter 11, its bonds and loans usually trade at sharp discounts, often as low as 40 cents on the dollar, as banks and mutual funds sell positions they are ill-equipped to handle throughout a protracted legal process. In contrast, distressed debt specialists purchase that reduced paper from vendors who prefer assurance to waiting. The entry point is the discount.
The real leverage comes from what you can do once you have a sizable enough portion of a certain debt class. For example, if a hedge fund owns more than one-third of a particular tranche, it has what practitioners refer to as a blocking position, which allows it to effectively sit at the table where the company’s new ownership structure is being designed, veto restructuring plans that don’t serve its interests, and force renegotiations. The hedge fund is one of the principals in the negotiation that results from the legal procedure.
The debt-to-equity swap is the most sophisticated form of the transaction. Senior secured bonds are purchased for fifty cents. Your debt is converted to equity in a reformed corporation with significantly less leverage than the original organization, the company restructures, and shareholders are eliminated. That stock frequently trades at a significant premium to the amount you paid for the initial financing if the underlying firm is viable and the balance sheet rather than the business model was the issue.
The most recent example is Hertz, when equity interests were obtained through the bankruptcy process by distressed investors such as Knighthead Capital and Certares. After coming out of Chapter 11 in June 2021, the firm traded far higher than what the restructuring suggested. The equity held by the investors who purchased thirty-cent bonds was significantly more valuable. Nothing was given to the former stock investors who had held shares in a car rental company that was operating flawlessly.
This approach is still a specialized rather than a popular trade in part because of the actual and particular hazards involved. The absolute priority rule in bankruptcy, which states that junior creditors are paid before equity and senior creditors are paid before junior ones, is both what makes the strategy work and what might ruin it. Even though you completed the legal analysis correctly, you may lose everything if you purchase the incorrect debt class, hold subordinated bonds, and the reorganization value falls short of your level.
The Toys R Us bankruptcy serves as a warning: while secured creditors emerged unscathed, the company’s operational flexibility was destroyed by the leveraged buyout debt structure that initially caused the bankruptcy, and 33,000 American workers lost their jobs during the US liquidation. For the most part, the hedge funds that held senior secured paper were doing well. The capital structure analysis that generated the human cost was not visible.
It is difficult to ignore the growing complexity of these creditor groupings when observing how bankruptcy arbitrage has changed over the past ten years. Major bondholder ad hoc committees now frequently employ litigation teams, hire their own restructuring experts, and coordinate strategy across holdings before a business even files, putting themselves in a position to influence outcomes rather than merely react to them.
It’s likely that this growing sophistication results in better-run reformed businesses that emerge leaner and reduce unmanageable debt. It’s also feasible that the hedge funds that knew the game ahead of time and positioned themselves appropriately benefit the most from it. Most likely, both are true simultaneously.
