Hedge funds: Vultures or guardian angels?

Contrary to popular belief, hedge funds aren't company killers, they act as stabilizers to help an entity on the brink of bankruptcy return to financial health.

So suggests a joint study conducted by researchers at the University of British Columbia (UBC) in Vancouver, Queens University in Kingston, Ont., and Columbia University in New York City.

The study, published in the April edition of the Journal of Finance, states hedge funds have a positive influence when investing in U.S. companies filing for Chapter 11 bankruptcy.

UBC professor Kai Li, one of the study's co-authors, tells Yahoo! Canada Finance that when a hedge fund invests in a distressed company other creditors in the transaction fare better and the chance for a company to emerge from bankruptcy increases.

"Hedge funds are not homogenous, they have different styles," she explains. "What we uncovered is the proactive activist [movement] helps struggling firms in financial distress that are still economically sound to go through a reorganization process."

Hedge fund manager Peter Ackman of New York-based Perishing Square Capital Management, and his efforts to overhaul Canadian Pacific Railway Ltd.'s fortunes, immediately comes to mind.

"(CP Rail) isn't in distress but it is underperforming," she says. "Perishing Square wants to change CP's top management and its board of directors.

"That's one of the key findings of our paper: hedge funds provide incentives for other key employees to stay on to help them with the reorganization process."

Popular opinion that hedge funds are 'vulture investors' who dismantle companies to maximizing profits in the shortest time-frame possible persists, Li acknowledges, but she says the data she and her colleagues compiled show the opposite to be true.

"Our data shows that hedge funds strategically invest in troubled companies with the intention of becoming major shareholders after they emerge from bankruptcy," she says. "For instance, CP is underperforming but Ackman sees value and creation opportunities. Given his track record in the U.S., he's confident he can change things and make a profit for his firm."

The report also argues hedge funds are much more likely to wait while companies successfully restructure under new management than other private investors.

The researchers analyzed 474 Chapter 11 filings in the United States between 1996 and 2007. Looking at firms with assets worth more than US$100 million, the researchers examined bankruptcy filings from a wide variety of angles, including the presence of hedge fund investment, CEO turnover, key employee retention, asset liquidation, debt recovery and emergence.

They found that 87 per cent of these bankruptcies had observable hedge fund involvement. The data shows such companies had improved chances of surviving the bankruptcy process. The results also reveal that the presence of hedge funds increased the likelihood of failed CEOs being fired and reduced the liquidation pressure from other stakeholders clamouring for a payout.

Hedge funds as the largest unsecured creditors had a favourable effect on stock price, and positive influence on the overall debt recovery for other lenders, the data showed. Where hedge funds were involved, companies had a reduction in leveraged debt one year after emergence from bankruptcy.

"Instead of vultures it is better to see them as guardian angels of distressed companies, overseeing their transition into healthier entities," she adds. "That's in the U.S. where we found systematic evidence to support that. I couldn't find any evidence of that in Canada."

Canada's hedge fund space

Hedge funds don't figure as prominently in Canada as they do stateside. By comparison, Canada's hedge fund industry is quite small. According to the Scotia Capital Canadian Hedge Fund Performance Index, Canadian hedge funds took a beating in 2011 and performance expectations for this calendar year aren't stellar.

"Hedge funds are very much a U.S. phenomenon," Li continues. "Canadian hedge funds are perhaps in the range of C$30 billion whereas mutual funds may be $700 billion … that's the magnitude, it's really tiny. Also in Canada, a unique feature of hedge funds is they're institutional -- especially in pension funds. In the U.S., it's really for value creation like excessive returns and so they can take a lot more risk."