By Vincent S.J. Buccola (University of Pennsylvania – The Wharton School), Jameson K. Mah (Cyrus Capital Partners), Tai Yi Zhang (University of Pennsylvania – The Wharton School)
Bankruptcy scholars have worried about the potential for credit derivatives to frustrate sensible out-of-court reorganizations since such derivatives became widespread in the 2000s. The basic problem they saw was that derivative contracting could complicate dealmaking by disguising investors’ true interests vis-à-vis a distressed company. Most perniciously, derivatives could lead creditors to oppose value-maximizing restructuring plans that offer fair treatment—not just for the familiar purpose of furthering a holdout strategy, but with the very aim of opposing the general welfare. In particular, a creditor with a large derivative position betting against its debtor could actively use its rights as creditor to drive the debtor into a messy and value-destroying default.
Many debt-market observers are sure that a recent episode pitting the hedge fund Aurelius against Windstream was a case in point. That episode has only increased attention on the subject, and issuers are experimenting with contractual devices that purport to muffle the influence of net-short activists at the expense, presumably, of secondary-market liquidity.
Our recent article argues that commotion over net-short creditor activism is misplaced—indeed that such activism is implausible. The nub of our skepticism lies in the incentives and capacities of investors other than a hypothetical net-short activist to foil the activist’s plans. The objective of net-short tactics, according to the story’s logic, is to cause a liquidity crisis that will reduce a targeted company’s value and prompt default. This objective implies, however, as a matter of arithmetic, that others can make money supplying offsetting liquidity.
Our article explores some of the channels through which this responsive liquidity is most likely to flow. We conclude that in the ordinary case one should expect parties other than the would-be saboteur to undermine its plans. If we are right, then it is a puzzle why a sophisticated potential activist would think it could succeed. A net-short activist bets not just on debt prices falling, as all short investors do. It bets rather on its own ability to cause the prices to fall. But in placing such a bet, the activist must know it is daring rival investors to profit by punishing it. The whole approach seems misguided. Which brings us to Windstream. Why did Aurelius think it could prevail at sabotage? As the article explains, we don’t believe it did and don’t believe it tried. We can’t say for sure, because lack access to the fund’s books and records. But so do the many other commentators who have opined on the story.
To us, then, one of the most intriguing features net-short activism is its rhetorical appeal. We suggest that the appeal lies in a kind of mythological function—that net-short sabotage has, in particular, the cautionary form of a good urban legend.
The article is available here.