Hedge Fund

bankruptcy because the securities are undervalued even in light of the risk
of default. Typically, hedge funds buy debt securities at deep discounts
from face value. Upon entering bankruptcy, these debt holders frequently
become the de facto shareholders, and the return on the hedge fund invest-
ment is determined by the liquidation value of the assets and the skill of the
debt holders at renegotiating other obligations.
Bankruptcy trades rely very little on the credit risk analysis described
in the risk management chapter (Chapter 11). Instead, the analysis hinges
on estimating the current liquidation value of all the assets plus the ex-
pected value of other liabilities after negotiation. Performance is best
when investors are concerned about credit risks (because the funds have
the chance to buy bonds at attractive spreads) and when the economy is
improving (because the prospects of the borrowers improve). Perfor-
mance is worst when defaults rise and the value of the assets supporting
the debt falls.
Event Driven--Divestiture
One of the unique strategies surrounding change of control involves di-
vestitures. Companies sell divisions for a variety of reasons. Often, a divi-
sion will fall out of favor because it doesn't fit into a revised corporate
strategy. When that occurs, the company often finds that the highest price
for the division can be realized by selling the unit to the managers currently
in charge of that division.
When the transactions are not completely arm's-length, there is no
pressure to get the highest possible price for the assets. In fact, when the di-
vision is spun off as shares given to shareholders, there is little harm to in-
vestors, because they are given shares, not cash. However, many investors
immediately sell shares of spin-offs. For example, a mutual fund that in-
vests only in companies in the S&P 500 index often must sell shares of a
division distributed to shareholders if the new company is not part of the
S&P 500 and hence is not consistent with the investment strategy of the
fund. In fact, many portfolio managers will sell shares of spin-offs simply
because the daily volume of trading is too small for the liquidity require-
ments of the portfolio.
As a result, many assets are spun off at low prices and often shares de-
cline further in value. Hedge funds invest in these securities knowing that
managers of the newly separated company are highly motivated to im-
prove results.
Hedge funds may invest in a completely different type of spin-off.
Sometimes, a larger company will spin off a hot new product as an initial
public offering (for example, the sale of Palm, Inc., by 3Com). Here, the
Hedge Fund Investment Techniques
63
ccc_mccrary_ch04_59-72.qxd 10/6/04 1:42 PM Page 63