Hedge fund investments in bankruptcy.

Branch, Ben ; Xu, Min

To those unfamiliar with hedge funds, linking them. with bankruptcy may seem strange. In reality, distressed securities investment is one of the largest hedge fund strategies. Research has focused on hedge fund return, risk, and influence on the portfolio performance of other institutional investors. An increasing number of studies have investigated hedge fund activism as it relates to corporate governance, active and passive, intense and non-intense. The debate is centered on whether hedge funds can effectively monitor the performance of their target firms and whether hedge fund involvement can. help the target firms enhance their operating performances. Herein we seek to extend that literature by investigating the impact of hedge funds investing in bankrupt firms.

Hedge fund involvement in the bankruptcy process can be categorized as either financial or strategic. The major objective of financial players is to advantageously acquire assets that throw off cash without putting up much cash of their own. Strategic players, in contrast, seek to acquire control of the bankrupt firm, and then achieve synergies by combining it with other related holdings. Hedge funds usually act as financial players in the bankruptcy process.

According to. Bray et al. [2008], hedge funds rarely seek control of their target firms; their average holding percentage is about 5.4% to 8.8%. They point out that hedge funds try to enhance shareholders' value through facilitating value-enhancing changes, without taking on management responsibility for the target firms. This is not limited to bankruptcy but occurs in other areas as well.

Rosenberg and Riela [2008] point out that investment and participation by hedge funds can create benefits for distressed companies, creditors, and shareholders. For example, investments by hedge funds may enable a troubled company to correct its problems and avoid bankruptcy altogether. DIP financing from hedge funds may be critical to a successful Chapter 1.1. case, if bankruptcy becomes necessary. In addition, hedge fund purchases of secured and unsecured debt permit other creditors to quickly realize some recovery on the pre-petition credit they had extended to the bankrupt companies. Thus creditors could benefit from the ability to sell their claims to hedge funds for cash.

In this article, we find hedge funds can help troubled companies by providing liquidity and improvements to their profitability through financial restructuring. The investment interest of hedge funds who buy the securities of bankrupt firms can not only create a more liquid market for those same securities, but also be a reliable source of capital when more traditional lenders are unwilling to lend, especially during a crisis period. However, because hedge funds rarely intend to acquire controlling stakes in the troubled firms and are generally organized as short-run return-oriented entities, they typically only help the bankrupt firms improve their near-term performance, usually limited to the initial post-bankruptcy year.

These improvements are often not sustainable. Therefore, the involvement of hedge funds in the bankruptcy process, as vulture investors who attempt to earn profit from investing in bankrupt or credit-impaired companies, usually only helps with balance-sheet issues, not strategic problems. Our conclusion is supported by both the accounting and stock performances of hedge fund invested firms.

Our paper extends the existing literature in several respects. First, most of the current literature that explores activism from the hedge fund perspective excludes bankruptcy cases. As pointed out in Bray et al. [2008], the motivation, financing, and outcomes of hedge funds in bankruptcy cases are typically quite different from those of non-bankruptcy cases. However, bankruptcy filings are important economic events (Coelho and Taffler (2008b). As active players in the market, hedge funds play a role in bankruptcy or distressed investment that should not be ignored.

Second, previous bankruptcy literature (Hotchkiss and Mooradian [1997]) documents that vulture investors do impact post-bankruptcy performance. However, the literature does not differentiate the various types of vulture investors, such as private equity and hedge funds. This is an important issue, as the different types of vulture investors may have different motivations and investment strategies, and face different regulations.

Hedge funds are characterized as highly secretive investment vehicles that offer or at least seek to offer high returns, are open to very limited qualified investors, and are loosely regulated. Private equity investors, while similar in many of these respects, tend to have a longer-term perspective and take larger positions. Whether these differences impact their roles in troubled firms is an interesting question.

Finally, the current literature demonstrates that hedge funds can actually help the targeted firms increase payout, operating performance, and stock performance. However, when they turn to distressed investment, our results show they do not perform as favorably as we might hope. Their roles are focused on providing liquidity and improving short-term profitability. Therefore, we should not be over-optimistic about the impact when hedge funds invest in bankruptcies.

HYPOTHESIS AND DATA

Hypothesis

Following Hotckkiss and Mooradian [1997], we focus on groups of vulture investors. Compared to non-vulture investors, vulture investors specialize in purchasing assets or other financial instrument from distressed entities. Hedge funds and private equities are active participants, as vulture investors, although they may differ in motivation and in other ways. Our sample includes hedge-fund companies such as Glenview Capital Management, LLC, and Gotham Partners, L.P, and private equities companies such as Invista Capital Management, LLC.

Rosenberg and Riela [2008] point out the major differences between hedge funds and other groups of vulture investors. One is that hedge funds generally have short-term investment horizons. They may not be designed to build value in the long run, and this could create conflicting interests with other interest holders. While hedge funds can absolutely pursue long-term investment philosophies, the permissive redemption policies offered by most hedge funds require their managers to dive in with more short-term strategies in order to maintain sufficient fund performance and liquidity.

Casa et al. [2008] note that the key difference between hedge funds and private equities is that private equity investors usually work with the management on a day-to-day basis. Hedge funds are less involved in the operative leadership of the company; instead, they focus on trading opportunities surrounding the company's outstanding stock and bond securities. Again, this does not completely eliminate the possibility that distressed hedge fund strategy can overlap with private equity strategy. Even though the majority of hedge funds have short-term investment horizons, some do pursue a private equity--style strategy, in which they hold large blocks and focus on a two- to three-year investment horizon.

We test the impact of hedge fund investment on bankrupt firm performance. If hedge funds are able to provide useful strategic, operational, and financial assistance, they should be able to help these firms achieve sustainable improvements after their emergence from bankruptcy. Other types of vulture investors, such as private equity or venture capital funds, may also be players in the area of bankrupt firms. Their motivations and roles may vary compared to hedge funds. Therefore, we test the following two hypotheses:

 Hypothesis 1: Bankrupt firms with hedge fund investments during
 Chapter 11 perform better after emergence than those without
 any vulture investment.

 Hypothesis 2: Bankrupt firms with hedge fund investments during
 Chapter 11 perform better after emergence than those with other
 types of vulture investors, such as private equity or venture
 capital funds.

Data

Our sample collection process is described in Exhibit 1. We obtained our initial sample of 1,117 firms that filed for bankruptcy between January 197.8 and December 2006 from Professor Edward Altman of New York University. It contains bankruptcy filing firms with liabilities at default of$1.00 million or greater. We added 99 filings in 2007 and 237 filings in 2008 from bankruptcydata.com. Therefore, we begin with 1,453 bankruptcy filing cases from 1978 to 2008.

EXHIBIT 1 Data Sample

 Number of Percentage
 Firms

Initial total 1453

-Pre-1986 cases 68 4.7%

- Acquired/Purchased 110 7.6%

- Liquidated/Convert to Ch 7 286 19.7%

- Dismissed 42 2.9%

- Undetermined 266 18.3%

- Reorganized

- public firms 254 17.5%

- private firms 139 9.6%

- others 288 19.8%

Reorganized public firms 254

- CRSP & Compustat available 172

- CRSP & Compustat not available 82

Reorganized public firms with CRSP & 172
Compustat Data

- with hedge fund investment during 16
Ch 11

- without hedge fund investment 156
during Ch 11

Next we determined the bankruptcy outcome, filing date, confirmation date, and emergence date (if any from Lexis-Nexis, New Generation Research, and Form 10-K filings with the SEC. We restricted our smple to the 1986-2008 period, as the New Generation Research database begins with 1986, thereby excluding 68 firms that filed previously. In addition, we excluded 110 firms that were acquired or purchased, and 286 firms that were either liquidated during their bankruptcy process or converted to Chapter 7. We also dropped 42 dismissed cases and 266 undetermined cases.

From the remaining 681 reorganized firms, we obtained a sample of 254 firms that successfully emerged as public companies listed for trading in NYSE, NASDAQ, AMEX, or OTC markets. We require members of our sample to have trading information in CRSP and accounting information in Compustat both before filing and after emergence from Chapter 11. We identified 172 companies with the required data.

Next, we manually checked the 13D/13G filings of the 172 firms during their Chapter 11 process in order to obtain a list of involved parties. The SEC requires 13D and 13G filings when an investor acquires more than 5% of any class of securities of a publicly traded company. If a firm reports that it intends to try to influence, change the management, or seek control of the target firms, a Schedule 13D filing is required. Otherwise, a Schedule 13G may be filed.

After this step, we filter a hedge fund, either at the advisor or fund level, if it satisfies one of the following: 1) the name matches the ones in CISDM or TASS database; 2) the party is featured by news articles in Factiva or Lexis-Nexis as a hedge fund or hedge fund advisor; 3) the party's own website identifies it as hedge fund management company or hedge fund is one of its major lines of business. Of our 172-firm sample, we identify 16 with hedge fund involvement. They include both "pure" hedge funds, such as Loeb Partners Corp., and investment firms with hedge funds as their major line of business, such as D.E. Shaw. Following Agarwal et al. [2011], we further exclude four cases with full-service banks who also engage in hedge fund business, such as Goldman Sachs Asset Management, so that our final sample drops to 12 firms.

Of our 12 firms with hedge fund investment, six filed 13Ds, and the remaining six filed 13Gs. Ten of the hedge funds acquired common stock, whereas one acquired preferred stocks

and one debenture. The average percentage is 8.1%, with the highest at 23.8% and lowest at 5.1%.

The six with 13D filings are required to disclose the purpose of the transactions. They can be categorized into "maximize shareholders' wealth," "investment purpose," and "capital structure." The average holding period of these 12 hedge fund--targeted firms is 869 days, with a median of 652 days, or approximately 1.7 to 2.3 years. Clearly this hedge fund investment is not short-term oriented.

Of our 20 .firms with other vulture investors, three filed 13Ds, and the remaining 17 filed 13Gs. All the asset classes they purchased are common stock. The average holding is 11.7%, with the highest at 33.3% and lowest at 0.7%. The purposes disclosed in the 13D filing include purely investment, or to become involved in the restructuring and to try to acquire the target firm.. The average holding period is 433 days, with a median of 371 days, shorter than for hedge fund investors.

RESULTS AND DISCUSSIONS

Characteristics Comparison Between with-HF and No-Vulture Investors

We first investigate absolute values in the accounting performances between firms with hedge fund investment (12 with-HF investors) and Firms without any vulture investment (122 no-vulture firms). Since the bankrupt companies might experience a huge change in their capital structure, we normalize all our variables. We report both t-tests for differences in means and Wilcoxon rank-sum tests for differences in medians. Ten variables are used to represent different performance aspects.

The Z-scores in Exhibit 2, Panel A, reveal that in the post-bankruptcy years, the overall level of bankruptcy risk is comparable between the two groups, in both mean and median. The mean and median Z-scores are not significantly different between the two groups for one year, two years, and three years after emergence from bankruptcy. The with-HF group shows stronger performance in three profitability measures, EBIT/Sales, ROE, and NI/Sales, one year after emergence. The median differences are 0.054, 0.185, and 0.064, respectively, which are significant at least at the 10% level.

EXHIBIT 2

Characteristics Comparison Between with-HF Firms
and No-Vulture Firms

WC/TA is working capital divided by total assets, which is
a liquidity measure. Sales/TA is sales divided total assets,
which is a turnover measure. TL/TA is total liabilities
divided by total assets, which is a leverage measure.
EBIT/TA is earnings before interest and taxes divided by
total assets, which is a profitability measure. Equity/TA
is shareholder's equity divided by total assets, which is
a solvency measure. ROA is net income divided by total
assets, ROE is net income divided by shareholder's equity,
NI/sales is net income divided sales, which are three
measures of profitability. Book/Market is a firm's book
value of equity divided by its market value. Z-score is
Altman's Z-score model, which is bankruptcy risk measure.
Diff is calculated as the difference between with-HF and
no-vulture firms. A t-test for means and Wilcoxon signed
rank test for median differences are performed.
Differences with ***, **, and * are significant at 1%,
5%, and 10% level respectively.

Panel A: Absolute Values After Chapter 11

 WC/TA Sales/TA TL/TA EBIT/Sales Equity/TA

Post-1
Mean

W HF 0.126** 1,076*** 0.719*** 0.054 0.262***

No -0.140 1.471*** 0.954*** -10.944 0.040
Vulture

Diff 0.266 0.394 -0.234 10.998 0.222

Post-1
Median

W HF 0.128* 1,083*** 0.670*** 0.064 0.304**

No 0.094*** 1.178*** 0.716*** 0.010 0.277***
Vulture

Diff 0.034 -0.095 -0.047 0.054** 0,027

Post-2
Mean

W HF 0.103 0.906*** 0.862*** -0.086 0.122

No 0.050 1,372*** 0.750*** -1.136 0.244***
Vulture

Diff 0.053 -0.466 0.112 1.050 -0.121

Post-2
Median

W HF 0,090 0.801*** 0.874*** 0.007 0.112

No 0.092*** 1.185*** 0.717*** 0.010 0,264***
Vulture

Diff -0.002 -0.384 0.157* 0.002 -0.152*

Post-3
Mean

W HF 0.091 1.081** 0.925*** -0.931 0.058

No 0.048 1.410*** 0.773*** -1.561 0.220***
Vulture

Diff 0.044 -0.330 0.152 0.630 -0.161

Post-3
Median

W HF 0.016 1.391** 0,863** 0.002 0.089

No 0.125*** 1.199*** 0.712*** 0.026 0.269***
Vulture

Diff -0.108 0.193 0,150 -0,024 -0.181

 ROA ROE NI/Sales B/M Z-score

Post-1
Mean

W HF 0.038 0.313 0,018 16.432 1.665

No -0.228** 0.238 -11.335 21.426 -6.367***
Vulture

Diff 0.266 0.075 11.353 -4.995 8.033

Post-1
Median

W HF 0.017 0.188 0.039 0.522 0.646

No -0.029*** 0.003 -0.025*** 0.455*** 0.461
Vulture

Diff 0.047 0,185* 0.064** 0.067 0.185

Post-2
Mean

W HF -0.053 -0,344 -0.051 62.022 -0.052

No -0.129*** -0,088 -0.947* 3.668 -1.690
Vulture

Diff 0.076 -0.256 0.896 58.354** 1.637

Post-2
Median

W HF -0.059 0.017 -0.050 0.929 -0.326

No -0.028*** -0.012 -0.023*** 0.455 0.751
Vulture

Diff -0.031 0.029 -0.027 0.473 -1.078

Post-3
Mean

W HF -0.015 0.119 1.135 39.629 -0.575

No -0.095*** -0.155 -2.035 0.849 -2.062
Vulture

Diff 0.080 0,274 3.170 38.779 1.487

Post-3
Median

W HF -0.031 0.159 -0.021 0.067 -1.320

No 0.009* 0.047 -0.006 0.532*** 1.190
Vulture

Diff 0,022 0,112 -0.015 -0,465 -2.510

Panel B: Change in Values After Chapter 11, Post-t vs. Pre-1

 [DELTA]WC/TA [DELTA]Sales/TA [DELTA]TL/TA

(Post 1 -
Prel)

Mean W HF 1.592 -1.767 -0.220

No Vulture 0.347** 0.196** -0.367**

Diff 1.245* -1.963*** 0.147

Median W HF 0.146** 0.092 -0.329*

No Vulture 0.220*** 0.186*** -0.360***

Diff -0.075 -0.094 0.031

Reg Coef. 1.486** -2.265*** 0.118

F-value 3.95** 3.22** 5.75***

R-squared 13% 11% 18%

(Post2-Pre1)

Mean W HF 2.220 -2.792 -0.135

No Vulture 0.470*** 0.154** -0.489***

Diff 1.750*** -2.946*** 0.355

Median W HF 0.077 0.047 -0.349

No Vulture 0.263*** 0.207*** -0.337***

Diff -0.186 -0.159 -0.011

Reg Coef. 2.031** -3.298*** 0.231

F-value 3.38** 4.63*** 2.20*

R-squared 14% 18% 9%

(Post3-Prel)

Mean W HF 3.045 -3.934 -0.116

No Vulture 0.438*** 0.271** -0.423***

Diff 2.607*** -4.205*** 0.307

Median W HF 0.074 0.183 -0.354

No Vulture 0.323*** 0.213*** -0.372***

Diff -0.249 -0.030 0.017

Reg Coef. 2.803*** -1.445*** 0.282

F-value 3.58** 5.13*** 1.81

R-squared 16% 22% 9%

 [DELTA]EBIT/Sales [DELTA]Equity/TA [DELTA]ROA

(Post 1 -
Prel)

Mean W HF 0.127 0.204 0.232**

No Vulture -9.918 0.370** 0.530**

Diff 10.045 -0.166 -0.298

Median W HF 0.037 0.291* 0.247**

No Vulture 0.041*** 0.360*** 0.186***

Diff -0.003 -0.069 0.061

Reg Coef. 0,077 -0.129 -0.040

F-value 2.65* 5.83*** 1.75

R-squared 9% 18% 6%

(Post2-Pre1)

Mean W HF 0.001 0.115 0.170

No Vulture 1.069 0.495*** 0.534**

Diff -1.067 -0,380 -0.364

Median W HF -0.002 0.330 0.087

No Vulture 0.063*** 0.337*** 0.152***

Diff -0.066 -0.007 0.065

Reg Coef. -0.576 -0.250 -0.080

F-value 3.55** 2.27* 2.10

R-squared 14% 10% 9%

(Post3-Prel)

Mean W HF -0.984 0.093 0.228

No Vulture 0,589 0.429*** 0.339***

Diff -1.573 -0.335 -0.111

Median W HF -0,009 0.168 0.240

No Vulture 0.046*** 0.372*** 0.156***

Diff -0.055* -0.204 0.084

Reg Coef. -0.738 -0.313 -0.074

F-value 1.56 1.81 0.67

R-squared 8% 9% 4%

 [DELTA]ROE [DELTA]NI/Sales [DELTA]B/M [DELTA]Z-Score

(Post 1 -
Prel)

Mean W HF 2.151 0.529** 21.400 0.114

No Vulture 0.630 -9.485 31.077 9.473

Diff 1.521 10.014 -9.676 -9.359

Median W HF 0.782** 0.109** -0.218 1.638*

No Vulture -0.058 0.165*** 0.933*** 4.725***

Diff 0.840** -0.055 1.151 -3.088*

Reg Coef. 2.175 0.144 -7.633 -4.047

F-value 1.63 2.74** 0.67 2.83**

R-squared 6% 9% 3% 10%

(Post2-Pre1)

Mean W HF 1.884 0.463 77.744 -1.976

No Vulture 0.320 2.172 5.100** 11.608***

Diff 1.564 -1.710 72.644*** -13.584**

Median W HF 0.278 0.056 0.949 1.049

No Vulture -0.261 0.146*** 0.594*** 5.571***

Diff 0.539 -0.090 0.355 -4.522

Reg Coef. 1.879 -0.513 73.011*** -7.165

F-value 1.76 3.56** 5.19*** 2.83**

R-squared 8% 14% 20% 12%

(Post3-Prel)

Mean W HF 0.029 1.800 75.335 -3.671

No Vulture 0.543 0.283 4.409* 7.290***

Diff -0.514 1.517 70.926*** -10.961

Median W HF 0.275 0.036 0.617 1.433

No Vulture 0.008 0.159*** 0.863*** 5.573***

Diff 0.266 -0.124 -0.246 -4.140**

Reg Coef. 0.081 2.227 70.450*** -9.686

F-value 2.49** 0.72 4.22*** 1.16

R-squared 12% 4% 19% 6%

However, the advantage disappears two and three years after emergence. In TL/TA and Equity/TA, the with-HF group exhibits. a certain level of higher leverage and solvency risk. Other variables show no significant performance differences. These results suggest that hedge funds, which are generally short-term return-driven, may help the reorganized firms improve their profitability in order to achieve the highest holding period return. In the longer run, however, these hedge fund investors are inclined to take their profits and move on. This conclusion is also suggested by the reported purpose of their transaction contained in their 13D files. The major goal identified is "investment purpose."

In order to capture the dynamics of those characteristics, we track the change in the 10 variables and compare them across two. groups. We also undertake a regression analysis using. the following equation:

[DELTA]variable = [alpha] + [[beta].sub.1]HF + [[beta].sub.2]LogSize + [[beta].sub.3]Book/Market + [epsilon] (1)

where [DELTA]variable is the change in the 10 performance measures. HF is a dummy variable set to 1 if a firm has hedge fund investment and (1 if a firm does not have any investment greater than 5% during its bankruptcy process. We also control for size and book-to-market with LogSize, which is the demeaned natural log of a firm's total assets, and Book/Market, which is the demeaned book to market ratio of the firm. Following Petersen [2009], to control for autocorrelation and heteroskedas-ticity, standard errors are clustered at the firm level.

In Panel B we take a look at the performance in different years after emergence compared to the pre-bankruptcy level. Comparing the post-1 to pre-1 level, both groups enjoy significant improvements in a majority of the aspects, such as liquidity, leverage, solvency risk, profitability, and overall distress risk. The with-HF group has 0.146 in [DELTA]WC/TA, -0.329 in [DELTA]TL/TA, 0.291 in [DELTA]Equity/TA, 0.247 in [DELTA]ROA, 0.782 in [DELTA]ROE, 0.109 in [DELTA]NI/Sales, and 1.638 in [DELTA]Z-scores. The no-vulture group enjoys 0.220 in [DELTA]liquidity, -0.360 in [DELTA]leverage, and different amounts of increase in various profitability measures.

But comparing post-2 to pre-1, the scenarios start to change. We find that the significant increases come only from the no-vulture group. Two years after emergence, this group still enjoys substantial improvements in liquidity, leverage, solvency risk, profitability, and overall bankruptcy risk. However, the with-HF group's performance level two years after emergence seems no different compared to the level at one year before bankruptcy.

This scenario remains the same when we compare the performances between three years after emergence and one year before bankruptcy filing. The three regressions reveal similar results when comparing post-bankruptcy with pre-bankruptcy performance. That is, hedge funds seem to play a significant role in increasing the liquidity of the bankrupt firms, with coefficients of 1.486 for post-1 to pre-1; 2.301 for post-2 to pre-1; and 2.803 for post-3 to pre-1 periods.

Another interesting result we obtain from the regressions is that the involvement of hedge funds tends to be associated with a decrease in the turnover ratio of the bankrupt firms, with -2.265 for the post-1 to pre-1; -3.298 for the post-2 to pre-1; and--4.445 for the post-3 to pre-1 periods. These results also imply that the improvements in the with-HF firms tend to take place in the short term, even though the hedge fund investment period may not be short. The major role of hedge funds in the bankruptcy process tends to be to provide liquidity.

Combining all of the results above, after emergence from bankruptcy, both groups make significant progress during the restructuring process, and exhibit comparable levels of overall risks. However, the increase is significant in the with-HF group in the short run, one year after bankruptcy, but not in the long run. Therefore, hedge funds seem to be more of financial players, providing liquidity for the troubled company, rather than strategic players in the bankruptcy process.

Characteristics Comparison between with-HF and Other-Vulture Firms

Other vulture investors, such as private equity and venture capital funds, are also active players in the distressed-firm arena. In this section, we explore whether their involvements have different impacts on bankrupt firms.

Panel A in Exhibit 3 shows the levels of different characteristics between hedge funds and other vulture investors after Chapter 11. The Z-scores show no significant difference between the two groups, indicating that both hedge fund and other vulture investors tend to target firms with similar distress levels. Based on TL/TA and Equity/TA, with-HF firms still have higher levels of leverage and solvency risk compared to the other-vulture firms, in both means and medians. Hedge fund targeted firms enjoy better short-term performance in one profitability measure, EBIT/Sales. They outperform other-vulture firms by 0.068 one year after emergence, but the advantage disappears in the following years.

EXHIBIT 3 Characteristics Comparison between with-HF Firms
and Other-Vulture Firms

Panel A: Absolute Values After Chapter 11

 WC/TA Sales/TA TL/TA EBIT/Sales Equity/TA ROA

Post-1
Mean

W HF 0.126** 1.076*** 0.719*** 0.054 0.262*** 0.038

Other 0.258*** 1.077*** 0,434*** -0.548 0.560*** -0,077

Diff -0.132 0.000 0.285** 0.602 0.298** 0.115

Post-1
Median

W HF 0.128* 1.083*** 0.670*** 0.064 0.304** 0.017

Other 0.129*** 0.717*** 0.474*** -0.004 0.524*** 0.031

Diff -0.001 0.366 0.195** 0.068** -0,220** -0.014

Post-2
Mean

W HF 0.103 0.906*** 0.862*** -0,086 0,122 -0.053

Other 0.260*** 1.098** 0.521*** -1.073 0,479*** -0,443*

Diff -0,157 -0.192 0.342** 0.987 -0.357** 0.390

Post-2
Median

W HF 0.090 0.801*** 0.874*** 0.007 0.112 -0.059

Other 0.227*** 0.735*** 0.533*** 0.006 0.467*** -0.091

Diff -0.137* 0.065 0.340** 0.001 -0.355** 0.032

Post-3
Mean

W HF 0.091 1.08.1** 0.925*** -0.93 1 0.058 -0.015

Other 0.234*** 0.686** 0.447*** -3.306 0,553*** -0,339

Diff -0.143 0.395 0.477** 2.375 -0.494** 0.325

Post-3
Median

W HF 0.016 1.391** 0.863** 0.002 0.0H9 -0.031

Other 0.314** 0.131** 0.405*** 0.025 0,595*** -0.022

Diff -0.297 1.260 0.458** 0.024 -0.506** 0,009

 ROE NI/Sales B/M Z-score

Post-1
Mean

W HF 0.313 0.018 16.432 1.665

Other -0,177 -0.312 0.945*** 2.104

Diff 0,491 0.330 15.487 -0.439

Post-1
Median

W HF 0.188 0.039 0.522 0.646

Other 0,052 0.033 0.669*** 1.807

Diff 0.136 0.006 -0.147 -1.161

Post-2
Mean

W HF -0.344 -0.051 62.022 -0.052

Other -2.279 -1.313 0.506*** 5.430**

Diff 1.935 1.262 61.516 5.378

Post-2
Median

W HF 0,017 -0.050 0.929 -0.326

Other -0.198 0.000 0.574*** -2.656

Diff 0.215 -0.050 0.355 2.329

Post-3
Mean

W HF 0,119 1.135 75.335 -0.575

Other -0.445 -3.294 4.409* -7.654

Diff 0.564* 4.429 70.926*** 7.079

Post-3
Median

W HF 0.159 -0.021 0.067 -1.320

Other -0.037 -0.003 0.524*** -1.198

Diff 0.196** -0.017 -0.457 -0,123

Panel B: Change in Values After Chapter 11 Post-t vs. Pre-1

 [DELTA]WC/TA [DELTA]Sales/TA [DELTA]TL/TA

(Post1 Prel)

Mean W HF 1.592 -1.767 -0.220

 Other 0.243*** 0.197 -0.305***

 Diff 1.349 -1.964 0.085

Median W HF 0.146** 0.092 -0.329*

 Other 0.130*** 0.051 -0.270***

 Diff 0.016 0.041 -0.059

Reg Coef. 1.575 -2.097 0,139

F-Value 3.72** 3.26** 2,21

R-Squared 40% 36% 28%

(Post2-Prel)

Mean W HF 2.220 -2.792 -0,135

 Other 0.291** 0.094 -0.178***

 Diff 1.929 2.886 0.043

Median W HF 0.077 0.047 -0.349

 Other 0.270** 0.093 -0.169***

 Diff -0.192 -0,046 -0.179*

Reg Coef. 2.757 -3.895 0.098

F-Value 2.89* 3.04* 1.42

R-Squared 46% 48% 30%

(Post3-Prel)

Mean W HF 3.045 -3.934 -0.116

 Other 0.288** -0.095 0.226***

 Diff 2.757 -3.839 0.110

Median W HF 0.074 0.183 -0.354

 Other 0.243** 0.000 -0.201**

 Diff -0.170 0.183 -0.153

Reg Coef. 5.120* -6.917* 0.236

F-Value 2.88 3.11 1.28

R-Squared 59% 61% 39%

 [DELTA]EBIT/Sales [DELTA]Equity/TA [DELTA]ROA

(Post1 Prel)

Mean W HF 0.127 0,204 0.232**

 Other -0,381 0,325*** 0.197**

 Diff 0.509 -0.120 0.035

Median W HF 0.037 0.291* 0.247**

 Other 0.044 0.354*** 0.191**

 Diff -0,007 -0.062 0.056

Reg Coef. 0.570 -0.184 0.110

F-Value 2.51* 2.53* 1.27

R-Squared 31% 31% 18%

(Post2-Prel)

Mean W HF 0.001 0.115 0.170

 Other -1,017 0.178*** -0.084

 Diff 1.019 -0.063 0.254

Median W HF -0.002 0,330 0.087

 Other 0.023 0.169*** 0.033

 Diff -0.026 0.160 0.053

Reg Coef. 1.117 -0.123 0.270

F-Value 1.72 1.51 0.35

R-Squared 34% 31% 10%

(Post3-Prel)

Mean W HF -0.984 0.093 0.228

 Other -2.996 0.226*** 0.115

 Diff 2.013 -0.133 0.113

Median W HF -0.009 0.168 0.240

 Other 0.026 0.201** 0.126

 Diff -0.035 -0.033 0.114

Reg Coef. 1.164 -0.262 0.419

F-Value 0.42 1.28 0.44

R-Squared 18% 39% 18%

 [DELTA]ROE [DELTA]NI/Sales [DELTA]B/M

(Post1 Prel)

Mean W HF 2.151 0.529** 21.400

 Other 2.240 -0.039 0.262

 Diff -0.089 0.568 21.662

Median W HF 0.782** 0.109** -0,218

 Other 0.851** 0.255* -0.063

 Diff -0,069 -0.145 -0.155

Reg Coef. -0.219 0.656 13.224

F-Value 0.07 2.36 1.25

R-Squared 1% 29% 18%

(Post2-Prel)

Mean W HF 1.884 0.463 77.744

 Other -0.795 -0.768 0.895

 Diff 2.679 1.231 78.638

Median W HF 0.278 0.056 0.949

 Other 0.075 0.092 0.659

 Diff 0.203 -0.036 1.607*

Reg Coef. 3.889 1.368 62.198

F-Value 0.50 2.37 0.44

R-Squared 13% 42% 12%

(Post3-Prel)

Mean W HF 0.029 1.800 75.335

 Other 0.528 -2.905 -0.930

 Diff 0.498 4.706 76.265

Median W HF 0.275 0.036 0.617

 Other 0.194 0.039 -0.700

 Diff 0.081 -0.004 1.317

Reg Coef. 0.107 4.352 14.034

F-Value 0.04 3.87* 0.26

R-Squared 2% 66% 12%

 [DELTA]Z-Score

(Post1 Prel)

Mean W HF 0.114

 Other 14.630

 Diff -14.516

Median W HF 1.638*

 Other 3,014***

 Diff -1.376

Reg Coef. -5.330

F-Value 0.71

R-Squared 11%

(Post2-Prel)

Mean W HF -1.976

 Other 7.740

 Diff -9.716

Median W HF 1.049

 Other 1.656*

 Diff -0.607

Reg Coef. -0.774

F-Value 6.96***

R-Squared 68%

(Post3-Prel)

Mean W HF -3.671

 Other 14.197

 Diff -17.869

Median W HF 1.433

 Other 2.058

 Diff -0.626

Reg Coef. -2.049

F-Value 6.67**

R-Squared 77%

Panel B contains .the results in the change of all the characteristics over time. We run a similar regression in Panel B as the one on Exhibit 2, which is,

[DELTA]variable = [alpha] + [[beta].sub.1]HF + [[beta].sub.2]LogSize + [[beta].sub.3]Book/Market + [epsilon] (2)

All the variables remain the same except for HF, which is set to 1 if a firm has hedge fund investment and 0 if it has other vulture investment.

We investigate the long-term performances in Panel B. When comparing the post-bankruptcy performance to pre-bankruptcy level, in post-01 to pre-1, we find significant improvement for both groups in a majority of the aspects. The with-HF group enjoys a 1.638 increase in median [DELTA]Z-score and 3.014 for other-vulture firms. Besides Z-score, it also shows better performance in liquidity, leverage, solvency, and profitability measures. Both groups make comparable improvements.

Next, when we compare two years after emergence with pre-bankruptcy level, again, the with-HF group does not show significant differences, while the other-vulture-participant firms show improvements in liquidity, leverage, and solvency that can even continue for three years after emergence. The comparison between the with-HF and other-vulture firms is quite similar to the comparison between with-HF and no-vulture firms. We find that other-vulture-participant firms exhibit long-term improvement that can last for three years after emergence. The regressions only generate significant results for post-3 to pre-1, in which the HF firms enjoy higher liquidity and lower turnover ratios. However, we need to be cautious about the regression results here, as the sample size for both the with-HF (12) and other-vulture firms (20) are small in the comparison.

The most obvious result is that both hedge funds and other investors facilitate the turnaround process for the distressed companies, as most of the characteristics improve from their pre-Chapter 11 levels to their one-year post-Chapter 11 levels, and results are equally favorable for the two groups. However, the improvements are more sustainable in the other-vulture firms, where they can last up to three years, after emergence, while those of with-HF firms usually last only up to one year.

Short-Term and Long-Term Stock Performance between the with-HF and Other Two Groups

In this section, we explore the impact of these players on the stock performance of bankrupt firms. We show the average holding period for the with-HF and other-vulture firms in Panel A of Exhibit 4. While most of the existing literature identifies hedge funds as short-term investors when focusing on non-bankrupt cases, we find it is not the case in Chapter 11 bankruptcy. The holding period of hedge funds is actually longer than that of other vulture investors. Hedge funds hold their position in the bankrupt firms for an average of 869 days, median of 652 days, or about two years. Other vulture investors hold their positions for an average of 433 days, and a median of 371 days. These holding period numbers show that hedge fund investment in bankrupt firms is not short-term driven.

EXHIBIT 4

Stock Returns for with-HF and Other-Vulture Firms

Panel A: Length of Holding Period in Target Firms

 Mean Median Max Min Std Dev

W HF 869 652 1694 32 628
Other 433 371 704 156 224

Panel B: w-HF and No-Vulture Firms After Chapter 11

 Annual
 Return

 Mean Median

 W HF No Diff W HF No Diff W HF
 Vulture Vulture

Post+1 0.145 0.361* -0.216 0.190 -0.077 0.267 0.019

Post+2 -0.375 0.446 -0.822 -0,741 -0.016 -0.725** -0.365

Post+3 0.430 0.128 -0.558 -0.744 -0.128 -0.617** -0.289

Post+4 0.988 0.378* 0.610 0.988 0.048 0.940 0.903

Post+5 0.458 0.058 0.400 0.458 -0.172 0.630* 0.633

 Excess
 Return

 Mean Median

 No Diff W HF No Diff
 Vulture Vulture

Post+1 0.275 -0.256 0,054 -0.062 0.115

Post+2 0.359 -0.725 -0.593 -0.075 -0.519*

Post+3 0.026 -0.315 -0.541 -0.186** -0.355

Post+4 0.303 0.599 0.903 0.029 0.874

Post+5 0.065 0.567 0.633 -0.090 0.722*

Panel C: w-HF and Other-Vulture Firms After Chapter 11

 Annual
 Return

 Mean Median

 W HF Other Diff W HF Other Diff W HF

Post+1 0.145 0.231 -0.086 0.190 -0.079 0.269 0.019

Post+2 -0.375 0.368* -0.744** -0.741 0.147 -0.887** -0.365

Post+3 -0.430 0.182 -0.612 -0.744 0.329 -1.073 -0.289

Post+4 0.988 0.206 0.782 0.988 -0.028 1.016 0.903

Post+5 0.458 0.217 0.241 0.458 0.221 0.237 0.633

 Excess
 Return

 Mean Median

 Other Diff W HF Other Diff

Post+1 0.113 -0.093 0.054 -0.075 0.128

Post+2 0.299 -0.664** -0.593 0.158 -0.751**

Post+3 0.110 -0.399 -0.541 0.239 -0.780

Post+4 0.185 0.717 0.903 -0.060 0.962

Post+5 0.237 0.396 0.633 0.085 0.548

Panel B contains the stock performance between the with-HF and no-vulture firms after emergence from Chapter 11. We calculate both absolute annual return and excess annual return compared to S&P 500. In the first year after emergence, we do not see a significant difference between these two groups. Surprisingly, we see that the with-HF firms actually underperform the no-vulture group two and three years after emergence. The difference is--0.725 in median annual return, and--0.519 in median excess return in post-2, and -0.617 in median annual return in post-3.

We find similar results in Panel C. The with-HF firms are comparable to the other-vulture firms one year after leaving Chapter 11; however, they underperform the other group two years after emergence. For annual returns the mean difference is--0.744 and median is--0.887; for excess returns the mean difference is--0.664 and the median difference is--0.751, all of which are significant at 5%. Therefore, the with-HF group is comparable with both the no-vulture and other-vulture firms one year after emergence, but is the worst-performing group two to three years after Chapter 11.

CONCLUSION

We investigate the role of hedge funds in the bankruptcy process. We are interested in their impact after they acquire more than 5% of the stock in targeted troubled firms, compared with those with no vulture investments and those with investments from vulture funds other than hedge funds.

Using accounting performance measures, we find that liquidity and profitability are the major working areas for hedge funds during the bankruptcy process, as we observe significant improvements in these two aspects after emergence from Chapter II However, hedge funds do not seem to help the bankrupt firms through a systematic restructuring, and improvements are only obtained in the short run. Taking an average 8.1% stake in bankrupt Firms, hedge funds tend to be more financial players, rather than strategic ones.

The above results are also suggested by the stock performances. Even though hedge funds are not short-term investors, with an average 869-day holding period, the with-HF group underperforms the no-vulture and other-vulture-firm groups after emergence.

Overall, the major benefit of hedge fund investment in bankruptcy cases is to provide liquidity for the troubled firms, and help them improve profitability in the short term. This orientation is understandable, as short- to medium-term. return is the primary goal of most hedge funds. Without acquiring a significant controlling stake in the firms, it may be difficult to play a systematic role in restructuring the distresed firms.

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To order reprints of this article, please contact Dewey Palmieri at dpalmieri@iijournals.com or 212-224-3675.

BEN BRANCH is a professor of finance at the University of Massachusetts, Amherst's Isenberg School of Management in Amherst. MA. branchb@isenberg.umass.edu

MIN XU is an assistant professor of finance at the University of Detroit Mercy College of Business Administration in Detroit, MI.

xumi@udinercy.edu

Variables Characteristics

WC/TA = Working Capital/Total Assets Liquidity

Sales/TA = Sales/Total Assets Turnover

TL/TA - Total Liabilities/Total Assets Leverage

EBIT/Sales = Earnings before Interest and Profitability
Taxes/Sales

Equity/TA = Shareholders' Equity/Total Solvency
Assets

ROA = Net Income/Total Assets Profitability

ROE = Net Income/Shareholders' Equity Profitability

N1/Sales Net Income/Sales Profitability

Book/Market = Book Value of Equity/Market
Value of Equity

Z-score = 6.56 * WC/TA + 3.26 * RE/TA +
6.72 * EBIT/TA * 1.05

* Book Equity/TL Overall Bankruptcy Risk