Vulture funds and the fresh start accounting value of firms emerging from bankruptcy

• DOI: http://doi.org/10.1111/jbfa.12303
• Author: Ivana Raonic,Miles Gietzmann,Helena Isidro
• Published date: 01 March 2018
• Date: 01 March 2018

DOI: 10.1111/jbfa.12303

Vulture funds and the fresh start accounting value

of firms emerging from bankruptcy

Miles Gietzmann1Helena Isidro2Ivana Raonic3

1UniversitaBocconi Dipartimento di Accounting,

Milan,Italy

2ISCTE-IULInstituto Universitário de Lisboa,

Lisbon,Portugal

3CassBusiness School, City, University of

London,London, UK

Correspondence

IvanaRaonic, Cass Business School, City,

Universityof London, 106 Bunhill Row, London

EC1Y8TZ, UK.

Email:I.Raonic@city.ac.uk

Fundinginformation

Foundationfor Science and Technologyof

Portugal,PTDC/IIM-GES/3933/2012

JELClassification: G14, G23, G33, M41

Abstract

We study how distress-oriented hedge funds (vulture funds) play

an important role in the fresh start valuation of firms emerging

from Chapter 11 reorganization. We find that loan-to-own vultures

acquire debt positions of the distressed firm that grant dominant

power in the bankruptcy negotiations, and they then use the discre-

tion allowed by fresh start accounting to introduce valuation bias in

their favor.We show that the strategic influence over fresh start val-

ues can create opportunities to increase vulture investors’returns at

the expense of other claim holders.

KEYWORDS

bankruptcy, distress, hedge fund, reporting discretion, valuation

1INTRODUCTION

Active hedge funds have an important role in the resolution of Chapter 11 bankruptcies. Theycan influence the reor-

ganization negotiations and shift control rights in their favor (Hotchkiss & Mooradian, 1997; Ivashina, Iverson, &

Smith, 2016; Jiang, Li, & Wang, 2012; Kahan & Rock, 2009; Lim, 2015). However,how distress-oriented hedge funds

achieve that influence is unclear. While finance research underlines the positive effects of hedge fund involvement

(e.g., quick recovery from bankruptcy,greater debt reduction, and more efficient contracting; Lim, 2015), legal stud-

ies argue that distressed-oriented hedge funds (known as vulture funds) obtain excessive control at the expense of

other stakeholders (Baird & Rasmussen, 2010; Harner, 2011; Harner,Griffin, & Ivey-Crickenberger, 2014). We focus

on vulture funds that pursue a loan-to-own strategy,in which the fund purchases distressed debt with the intention of

converting it into equity of the emerging firm. We add to this debate by showing a particular accounting mechanism

that vulture investors are likely to use to preferentially influence the value of the firm at emergence from Chapter

11: fresh start (FS) accounting valuation.1The FS value is important for the allocation of rights because it determines

the value of the new firm to be divided among various stakeholders. The estimate of FS value affects the bankruptcy

negotiations on the amounts and form (i.e., cash, new debt, or new equity) of the distributions to the claimants,

1Fresh start accounting rules are defined by Statement of PositionNo. 90-7, Financial Reporting by Entities in Reorganization underBankruptcy Code,andthe

AmericanInstitute of Certified Public Accountants (AICPA) guidance on reorganizations included in the Accounting Standards Codification Topic 852 (Finan-

cial Accounting Standards Board, 2011). It requires that entities emerging from Chapter 11 must adopt fresh start accounting as of the effective date of the

reorganizationplan if both of the following conditions are met: (1) the reorganization value of the emerging entity is less than the total amount of all postpeti-

tionliabilities plus all allowed prepetition liabilities, and (2) prepetition voting shareholders receive less than 50% of the voting shares in the new entity.

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2017 John Wiley & Sons Ltd wileyonlinelibrary.com/journal/jbfa JBus Fin Acc. 2018;45:410–436.

GIETZMANN ET AL.411

which in turn determines the approval of the reorganization plan by the court and ultimately the success of the

reorganization.

Fresh start accounting rules require that all assets of the reorganized firm are measured based on estimates of fair

value, and recorded as opening balances in the firm's financial statements upon emergence from Chapter 11.2Because

most assets are not actively traded in liquid markets (e.g., intangible assets, property), their fair values are based on

forecasts rather than on arm's-length transactions,which gives rise to considerable reporting discretion. The forecasts

of fresh start values are produced by management with the help of experts and, as a result, incorporatemanagers’ pri-

vate information and the interests of influential claimants (Franks & Torous,1989; Gilson, Hotchkiss, & Ruback, 2000;

Lehavy,2002). Thus, the discretion facilitated by FS accounting rules opens the possibility for influence over valuation

by claimants with a significant say overthe restructuring process.

Vulture funds can obtain that significant influence by acquiring a critical position in the debt structure of the dis-

tressed firm: the fulcrum debt. The fulcrum is the point in the firm's capital structure at which the value of the firm

on exiting bankruptcy first fails to cover outstanding claims (Moyer,Martin, & Martin, 2012). Fulcrum creditors have

maximum voting power in the reorganization plan that defines the fresh start accounting value of the firm. The reason

for this power is that while the most senior (unimpaired) creditors are paid in full and hence their approval of the plan

is automatic, the intermediate fulcrum creditors which are only partially paid have a presumptiveright to the equityof

the newly organized firm. Any claims junior to the fulcrum get little or nothing in the new firm and so it is assumed

they will reject the plan, making their vote less critical. Thus the vote of the fulcrum creditors is the only one that

matters.

However, the exact fulcrum point is not known until the final reorganization plan is approvedby the court. This

uncertainty gives vulture investors incentives to influence the FS valuations so that the final value of the firm guar-

antees them increased control rights at exit from bankruptcy. Forexample, if their claim is of relatively high senior-

ity and the FS value is too high, they will only receive the honoring of the claim with no opportunity to convert it

into equity. Thus, we argue that a vulture fund acquiring a relatively high seniority claim has a strong preference

for lower FS values because the lower priority debtors then receive little or no share in the equity of the emerg-

ing firm, while the vulture fund ends up with a larger proportion of the equity. If in fact the firm value a short time

after bankruptcy is significantly higher than the FS value on the emerging date, then there is a potential windfall for

the owners of the emerging firm. An immediate consequence of this strategic influence over FS value is the cancella-

tion of the interests of the original shareholders and junior debtholders. On the other hand, if vulture funds acquire

debt of relatively low seniority, they will favor higher FS valuations to avoidthe risk of extinguishing the claim and

to ensure that the claim is partially rather than fully impaired. The case of Visteon, which filed for Chapter 11 in

May 2009, illustrates how vultures can strategically interfere with FS valuation. Some vulture investors bought a

large portion of unsecured junior debt with almost zero recovery value in the initial reorganization plan. They voted

against the initial plan and the court had to overrule it. The plan was amended five times, and the estimated FS value

changed from about $1 billion to about $2.5 billion in the final plan approved in October 2010. The emerging value

of the firm granted vulture investors 16% ownership. Three months later, Visteon's market value jumped to about

$3.5 billion.

We empirically test our conjectures for a hand-collected sample of Chapter 11 firms, in the period between 1994

and2011. We start by comparing the FS value of the firm's assets at exit from Chapter 11 bankruptcy (ve) with the value

of assets at filing for bankruptcy (vf). We find that when vulture funds enter the capital structure of the target firm at

relatively high seniority positions, the firm experiences a downward FS valuation in 67% of cases (i.e., ve−vf<0). In

contrast, when vulture investors holdl ow seniority claims,95% of the firms exit bankruptcy with upward FS valuation

(i.e., ve−vf>0). The upward (downward)FS valuation is mostly achieved through the increase in the fair value of intan-

gible assets (i.e., decrease in fair value ofproperty, plant and equipment, PPE). We also document the FS misvaluation at

2Underfresh start accounting rules, firms emerging from Chapter 11 are required to estimate and report the fair values of assets and liabilities of the reorga-

nizedentity. The amounts of the assets and liabilities of the predecessor firm are set to zero and the new fair values (i.e. fresh start values) are reported in the

successor'saccounts. For a comprehensive example of fresh start accounting, see Lehavy and Udpa (2011).