Distressed / Capital Structure Arbitrage

2.Distressed / Capital Structure Arbitrage

Very often a hedge fund can have a team of ex-corporate lawyers who are experts on bankruptcies. This team might be very successful in assessing the probability of a firm filling for chapter 11 or even getting into some financial difficulties. The analysts would also be good at determining how much value a company has after it has released news of its financial difficulties. Based on this knowledge a distressed arbitrage fund might be able to take advantage of a miss priced low credit rated stock. Very often a hedge fund or investment management company will need to sell a troubled company at a discount to its true worth. Very often a distressed company which isn’t public will sell its stock as a private placement using regulation D.

Another common strategy is the relative value between a company’s common stock and bonds. Bond holders are usually the first to receive the recovery amount of a bankrupt company. This could create potential miss pricing in the market between a companies debt and equity. If the market place releases bad news on the credit of a company the equities could receive a disproportionate hit relative to the bonds because of the differences in risk. A trader can buy the common stock and short the bonds to profit from the miss valuation. This is known as capital structure arbitrage. York Capital made a fortune on acquiring Enron bonds when the company announced bankruptcy. They also acquired Adelphia Communications, Tyco International and WorldCom bonds. Distressed funds on average returned 14.6% annualized with 3.6% volatility according to Bloomberg magazine.

A typical long equity short bonds strategy is also known as convertible bond arbitrage. Here the holder of the convertible bond has the right to swap the bond for common stock. Most often than not convertible bond arbitrageurs enter into the trades more as a statistical arbitrage strategy rather than assessing the fundamental capital structure of the company. CB arb traders have sophisticated quantitative tools that are able to price convertible bonds better than the market does. A typical strategy includes long the convertible and short the common stock on a delta neutral level if they feel that the “call option” component of the bond is trading cheap.