considerations for hedge funds that invest in bankrupt companies

8/20/2019 Considerations for Hedge Funds That Invest in Bankrupt Companies

http://slidepdf.com/reader/full/considerations-for-hedge-funds-that-invest-in-bankrupt-companies 1/4

Vol. 3, No. 9 March 4, 2010

BANKRUPTCY

Due Diligence Considerations for Hedge Funds That Invest in the Equities of

Bankrupt Companies: Lessons of the Energy Partners, Ltd. Bankruptcy

By Gregory C. White

Hill Schwartz Spilker Keller LLC

Hedge funds are recognizing with increasing frequency that the common stock of bankrupt

companies or companies in the zone of insolvency may have post-reorganization value. See

“Interview with Mark Dalton, Alex Sorokin and Neil Wessan of Halsey Lane Holdings: Key

Considerations for Distressed Debt Hedge Funds that become ‘Unnatural Owners’ of EquityFollowing a Reorganization,” The Hedge Fund Law Report, Vol. 3, No. 6 (Feb. 11, 2010).

While investing in bankruptcy equities involves considerable risk – notably, the tangible

likelihood of a complete loss of value – such investments also, in the right circumstances,

offer the prospect of considerable upside. In particular, bankruptcy equities may be attractive

in at least three circumstances: (1) where creditors undervalue the assets of the debtor; (2)

when an event (such as a lawsuit in which the debtor is a plaintiff) can act as a catalyst for

value creation; and (3) were conditions in the relevant industry or credit markets may enable

a debtor to emerge from reorganization while its bankrupt competitors do not. See “Equities

of Bankrupt Companies Offer Hedge Funds a High Risk, Potentially High Return Method of

Investing in Restructurings,” The Hedge Fund Law Report, Vol. 2, No. 27 (Jul 8, 2009).

However, beyond the well-known financial risk of investing in bankruptcy equities, hedge

funds should be cognizant of additional legal and structural risks that can adversely affect

investment outcomes, or at least complicate the process of value creation. This article tells

the story of hedge funds’ participation on the equity committee in the Chapter 11 bankruptcy

of Energy Partners, Ltd. (EPL), a Louisiana-based exploration and production company. In

particular, this article outlines the facts of the case as they relate to the equity committee’s

involvement in the valuation of EPL, focusing on relevant terms of the debtor’s engagement

letter with its financial adviser. The article then discusses two key lessons highlighted by the

EPL case for hedge funds considering purchases of bankruptcy equities.

Background of the EPL Bankruptcy

In May of 2009, Louisiana-based exploration and production company Energy Partners, Ltd.

(EPL or the Debtor) filed a petition in the United States Bankruptcy Court for the Southern

District of Texas (Court) seeking relief under Chapter 11 of the United States Bankruptcy

Code. The bankruptcy announcement instantly sent the price of EPL’s common stock to record

lows; the stock reached five cents per share as investors liquidated their holdings. As recently

as September 30, 2008, EPL had one of the largest concentrations of hedge fund ownership

Hedge Fund Law Report - the definitive source of actionable intellige... http://www.hflawreport.com/print/a

3/8/2010 1



relative to other companies in the energy sector, with 16 hedge funds accounting for nearly

30 percent of EPL’s market capitalization, as illustrated in the following table:

Pre-Approved Restructuring

In conjunction with the bankruptcy, EPL filed a pre-negotiated plan of reorganization (Plan)

to: (1) convert all of its $473 million in senior notes (including accrued interest) outstanding

into essentially 100 percent of new EPL common stock (New EPL Common Stock); and (2)wipe out all existing equity interests. Rather than receive any payment on account of their

interests, holders of pre-petition EPL common stock would be given warrants granting them

the option to purchase a maximum of 12.5 percent of the fully diluted New EPL Common

Stock.

Valuation Dispute

In connection with the proposed Plan, the Debtor’s financial adviser (Debtor’s Adviser)

determined the enterprise value of EPL for the purpose of estimating the total value

potentially realizable by creditors and holders of equity interests. The valuation undertaken

by the Debtor’s Adviser concluded that no residual value would be available for holders of

equity interests. However, the valuation estimated an enterprise value realizable to EPL’s

creditors of $499 million, which implied that the senior creditors would be provided with an

unexplained $26 million premium over their claims. Soon after the Plan was filed,

representative EPL shareholders formed an official committee (Equity Committee), quickly

objected to the proposed treatment of the common stock and disputed the valuation that was

performed by the Debtor’s Adviser.

By June 2009, the month following the filing, the Equity Committee consisted of three


3/8/2010 1



members. One of the members was Daniel Bletzman from hedge fund Birch Run Capital

Partners, LP, who immediately expressed his disagreement with the results of the valuation

and began pressing for a more favorable outcome for shareholders. Mr. Bletzman reviewed

the initial valuation and noticed several material issues that significantly undervalued the

Debtor, which he quickly escalated to the court’s attention. The key issues identified by Mr.

Bletzman included the following:

The valuation performed by the Debtor’s Adviser used hydrocarbon prices as of March

31, 2009. By early June 2009, the spot price for oil had increased approximately 38

percent, and forward price curves for both oil and natural gas had increased

significantly. This fact alone, and without considering any of the other inputs and

assumptions used in the discounted cash flow analysis performed by the Debtor’s

Adviser, meant that the March 31, 2009 valuation was significantly lower than if it had

been determined using more current (i.e., June 2009) market prices.

The Debtor’s Adviser’s valuation also relied on a comparable public company method,

again using comparable company stock prices as of March 31, 2009. Mr. Bletzman

claimed that the dramatic increase in the stock prices of comparable companies from

March 31, 2009 to June 8, 2009 had a direct and significant effect on the value of the

Debtor and raised questions about the reasonableness and accuracy of the valuation

performed by the Debtor’s Adviser.

Favorable Settlement for EPL Shareholders

For the two reasons cited above, the Equity Committee withheld its approval of the Plan,

claiming that the Debtor’s Adviser’s valuation undervalued the Debtor. Shortly thereafter, the

Equity Committee and the holders of notes issued by the Debtor held discussions regarding

the valuation of EPL. Within a few weeks, the Equity Committee successfully negotiating amore favorable settlement with the Debtor and its Senior Creditors that allowed the equity

holders to retain five percent of the New EPL Common Stock (equivalent to approximately $30

million).

Practical Considerations

As the number of corporate bankruptcy cases continue to rise, hedge funds are likely to play

increasingly prominent and varying roles in the corporate reorganization process. In

particular, beyond their historic role as members of official or ad hoc creditor committees,

hedge funds are likely to play increasingly salient role on equity committees. With regard toequity committee participation, several observations can be drawn from the EPL case:

It is important to consider the motivation and incentive of each equity committee

member. While creditors and equity owners in EPL bankruptcy knew that there were

three members of the equity committee in the EPL case, each member’s individual

stake in EPL’s common stock was not made public. Hedge fund managers that serve on

equity committees should be aware of what other members stand to gain or lose in a

potential settlement. In many cases, equity committee members are mutual funds or


3/8/2010 1



© 2008 - 2010 The Hedge Fund Law Report. All rights reserved.

other large institutional investors that have held the debtor’s stock for several years

and are usually at risk of experiencing a complete investment loss. Hedge funds

typically find themselves on the other side of the spectrum by purchasing the debtor’s

stock at already distressed levels. This frequent difference in basis implies that the

motivations and incentives of equity committee members may diverge. In particular,

parties with lower bases may be amenable to lower settlements. On the topic of

disclosure of information with respect to the timing, quantity and other data on

distressed debt purchases in bankruptcies, see “Bankruptcy Court Denies PhiladelphiaNewspapers’ Motion to Force Disclosure from Steering Group Pursuant to Rule 2019,”

The Hedge Fund Law Report, Vol. 3, No. 6 (Feb. 11, 2010); “Delaware Bankruptcy

Court Bars Ad Hoc Noteholder Group from Participating in Accuride Chapter 11

Proceedings Until the Group Complies with Rule 2019,” The Hedge Fund Law Report,

Vol. 3, No. 4 (Jan. 27, 2010); “Delaware Bankruptcy Court Disagrees with WaMu

Decision, Finding that Rule 2019 Does Not Apply to Ad Hoc Committees in Six Flags

Chapter 11 Proceeding,” The Hedge Fund Law Report, Vol. 3, No. 4 (Jan. 27, 2010).

The decision to invest in the equity segment of a bankrupt debtor’s capital structure is

difficult and subject to a high degree of risk. While rigorous valuation techniques may

enable a manager to quantify and evaluate potential reorganization value, carefulattention must also be given to how a debtor has determined its own reorganization

value. According to the disclosure statement filed by EPL, the Debtor’s Adviser was

engaged to estimate the enterprise value of the reorganized Debtor. The engagement

letter between the Debtor and the Debtor’s Adviser, an energy investment banking firm

based in Houston, stated that in connection with any restructuring transaction (a

defined term in the engagement letter), the Debtor’s Adviser would receive a cash fee

equivalent to $2 million. At least in this case, and probably others in which debtor’s

financial advisers are engaged on similar terms, it may reasonably be presumed that

the debtor’s adviser has an incentive to enable the debtor consummate an exit from

bankruptcy or other restructuring transaction. Generally, a lower or more conservative

valuation of a debtor is more appealing to creditors (especially senior creditors)

because the dollar amounts of creditors’ claims will convert into higher percentages of

equity the reorganized debtors with lower valuations. By contrast, in the presence of a

low valuation, there may be no post-reorganization equity left over for

pre-organization equity holders. Accordingly, analysis of the terms of the engagement

between a debtor and its financial adviser may be a relevant to diligence item for a

hedge fund contemplating an investment in the equity of a debtor or company in the

zone of insolvency.

Gregory C. White is an Associate in the Valuation Group in the Dallas office of businessvaluation and litigation consulting firm Hill Schwartz Spilker Keller LLC. His background

includes serving as the primary contact for large institutional and corporate trust relationships

with total assets in excess of $30 billion. His clients have included public and corporate

pensions, foundations, endowments, investment managers, fund of funds and investment

consultants.


3/8/2010 1

considerations for hedge funds that invest in bankrupt companies

Documents