Providing theoretical and practical insight Distressed Debt. Vulture Funds and Fresh Start Accounting of Firms Emerging from Chapter 1. Bankruptcy. 1 Vulture Funds and Fresh Start Accounting of Firms Emerging from Chapter 1. Bankruptcy Miles Gietzmann* University of Bocconi Via Roentgen 1, Milano, 2. Milano, Italy Telephone: Fax: Helena Isidro Instituto Universit. Unusually all previous accounting valuations are cancelled and replaced with these updated synthetic market value estimates in order to give the firm a fresh start. Lehavy (Review of Accounting Studies 7, 5. For our sample we find a similar first day reaction but go further and show that a post emergence announcement drift exists and that critically the magnitude of the emergence drift depends on the presence of vulture funds on the firms debt register during Chapter 1. We explain how the drift arises because of fundamental asymmetries of information that arise during the court controlled Chapter 1. We find evidence to support the hypothesis that the presence of vulture funds on the debt register makes it more likely that firm values are subject to whiplash values being driven down during Chapter 1. We explain how this maximizes returns to a vulture fund trading strategy of loan to own. Keywords: financial distress, bankruptcy, debt trading, market values. JEL: G1. 4, G2. 3, G3. M4. 1 2. 3 1. Introduction This research looks at the role of accounting valuation in the settlements of claims during Chapter 1. The strategy of loan to own employed by vulture funds 1 is explained and critically how Fresh Start Accounting (FSA) valuations facilitate such a strategy in practice. It is shown how vulture funds can have widely divergent interests from the original shareholders and that the lower FSA values are the more likely original shareholders will receive no claims on assets in the firm that emerges from Chapter 1. Thus for the vulture funds this lowers the cost of gaining control over the assets of the financially distressed firms. Hence a natural question to ask is whether self- interested vulture funds are able to introduce bias into the FSA valuation process to improve returns. In order to address this question this paper introduces a new measure to the literature whiplash accounting revaluation. The research design to detect when vulture funds introduce bias into FSA is based on identifying when balance sheet values are reduced during the Chapter 1. FSA revaluation only for them subsequently to increase (in the opposite direction) shortly after the original shareholders are disenfranchised and the new firm emerges with the vulture funds controlling the equity. The whiplash movement in accounting valuations maximizes the returns to vulture funds and is suspicious because if FSA values in the presence of vulture funds were unbiased why would the subsequent market valuation go in completely the opposite direction? Stephen Moyer Distressed Debt Pdf Merge FreewareThis research does not just look at changes in the directions of revaluation but also focuses upon the magnitudes of these changes. Statistical evidence is provided which shows the magnitude of whiplash when it occurs is significantly positively related to the presence of vulture funds holding the debt of troubled firms during Chapter 1. To test formally whether Fresh Start valuation decisions are consistent with such selfinterested bias we consider the properties of Fresh Start Accounting valuations at three key dates. Date f(ile); the date at which a firm files for Chapter 1.
Moyer, Great Leaders of the Christian Church. Chicago, Ill.: Moody Press, 1951. Dogmatic statements and emphasis upon minor details of the faith distressed him. He was a man born in the wrong century. Date e(merge); the date at which a firm reports Fresh Start Accounting valuations upon emergence from Chapter 1. Date m(arket)t(periods) after emergence which is referred to as the market value t periods after emergence. This differentiates our study from Lehavy (2. Consider the following three valuation events: v f = Predecessor valuation at f(iling) date. Value entering Chapter 1. FSA value emerging from Chapter 1. Market valuation t periods after emergence. In the case when hedge funds purchase debt (typically at a discount) of troubled firms they are referred to as vulture investors. Vultures often follow a loan to own strategy buying debt that becomes converted into the equity. In order to identify potential strategic incentives for vulture funds we will explain below that when a vulture fund successfully follows a loan to own strategy, returns to the fund increase: (i) the larger is v f - v e ; which we refer to as the downward bias on Fresh Start valuations during Chapter 1. We refer to this as the whiplash revaluation effect because when it exists, Fresh Start Accounting forces values down only for subsequent open market trading to force values back up in the opposite direction. Place Figure 1 Here Consistent with Figure 1 we introduce a new measure to the restructuring literature called whiplash revaluation defined as follows: Whiplash revaluation measure: If v f > v e (downward FSA revaluation) is followed by v m,t > v e (upward Market revaluation) the whiplash magnitude is defined as: v f - v e ) + (v m,t - v e ) In other words provided they hold the appropriate debt instruments it is in the interests of vulture funds following a loan to own strategy to have Fresh Start values v e as low as possible. As we shall see below the major issue with low v e values is that predecessor equity holders are more likely to lose all their investment in the firm as they become legally disenfranchised during the Chapter 1. To intuitively explain our contention that whiplash revaluation movements are consistent with vulture encouraged bias 2 we note that in the first instance one would not be surprised a- priori in many cases to find that v f - v e > 0. However what would be surprising is for those firms that see the largest downward pressure by Fresh Start revaluation, to also be the firms that are most likely to then see the largest positive change in market values following emergence. This is notable because it seems like the market based Fresh Start Accounting valuations are subsequently found to have gone in the wrong direction as evidenced by subsequent actual market reactions. In this respect the empirical analysis presented below shows that the magnitude of whiplash around Fresh Start Accounting values varies systematically depending on the presence of vulture funds following a loan to own strategy when they invest in the distressed debt of Chapter 1. This whiplash effect maximizes the post- emergence returns to vulture funds. The Enron case illustrates particularly starkly how so called independent outside experts tasked with identifying market values may align their valuations with the interests of senior management. When vulture funds successfully follow a loan to own strategy they will have considerable influence on senior management for instance their appointment and compensation levels in a newly emerging firm. The paper is now organised as follows. In section 2 we present the literature review. We also provide Appendix A which gives an overview of the mechanics of FSA and explains why potentially this method of accounting facilitates vulture funds gaining control at low cost. We review in detail one specific prominent case which illustrates the issues particularly clearly. We note that to date the finance literature on the subject of hedge fund returns has largely missed the role of accounting choices in determining returns from this class of investment strategy. In section 3 we provide information on our sample of Fresh Start reporting companies and our database of vulture investors. Section 4 provides the empirical results. Section 5 provides conclusions. The key finding of this paper is that the properties of Fresh Start Accounting valuations for firms emerging from Chapter 1. Vulture funds on the loan register. This arises because Vulture funds have strong economic incentives to affect FSA values and since during Court controlled Chapter 1. Literature Review and Hypotheses Development 2. Literature In his survey of the market for distressed debt investing Gilson (1. One of the most important and enduring legacies of this period has been the development of an active secondary market for trading in the financial claims of these companies. When companies prepare to emerge from bankruptcy, accounting valuation takes centre stage in determining how claims are settled. The principal accounting rule that governs valuation of firms emerging from Chapter 1. Fresh Start Accounting rules of SOP 9. FASB ASC 8. 52. At the time of development of SOP 9. Before reviewing the small sample of previous papers that have looked explicitly at Fresh Start Accounting we provide an overview of the literature on distressed debt investing as this provides enhanced motivation for our primary hypotheses. Jiang, Li and Wang (2. Chapter 1. 1 cases. It is an important paper for at least two reasons. It is the first systematic study of hedge fund involvement in Chapter 1. We note that simply asserting that values should be market based does not remove the possibility of bias when in fact marking to model is being used to value a basket of illiquid assets (as is typically the case for Chapter 1. In the literature review we comment on the apparent enthusiasm Enron had for replacing historic cost accounting for marking to market. It is now commonly agreed that this was so they could introduce bias into the valuation process for assets and claims. They look at hedge funds which encompasses a larger set of institutions than vulture funds that focus specifically on distressed debt investing. They argue that their most salient finding is that there is publicly observable hedge fund involvement in 8. Chapter 1. 1 cases. In addition they find that in 6. DIP financing) the hedge funds followed a loan to own strategy. Predominantly their findings are suggestive of hedge funds having a favourable effect. They find that hedge fund presence is associated with an increased likelihood of emergence, more favourable distributions of claims, greater CEO turnover, and more frequent adoption of KERPS 5.
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