The Impact of Security Trading on Corporate Restructurings

Abstract

Hedge funds are heavily involved in corporate restructurings. What makes their involvement distinct from other investors is that hedge funds can trade across the securities of a firm, holding either long or short positions in each security. We analyze the choice of a restructuring proposal by a firm's manager in the presence of a hedge fund as a potential investor in the firm. We show that, under certain market conditions, there is an equilibrium where the firm's manager makes a proposal for which a hedge fund finds it profitable to short-sell the equity of the firm, buy the debt of the firm, and via its debtholdings lead the firm to a value-reducing outcome to gain on its short equity position. The necessary and sufficient market conditions under which the aforementioned equilibrium occurs are that the debt and equity markets are segregated and that other traders in the equity market are net buyers on average.

Keywords: debt restructuring, short-selling, hedge funds, empty creditors, distressed investing

JEL Classification: G30, G32, G33, G34