Distressed Securities

Cerbero, fiera crudele e diversa, con tre gole caninamente latra sovra la gente che quivi e sommersa. Li occhi ha vermigli, la barba unta e atra, e 'l ventre largo, e unghiate le mani; graffia li spirti ed iscoia ed isquatra. Dante Alighieri, Inferno, Canto VI, verse 13-18 Translation by H.W. Longfellow

Cerberus, monster cruel and uncouth, With his three gullets like a dog is barking Over the people that are there submerged. Red eyes he has, and unctuous beard and black, And belly large, and armed with claws his hands; He rends the spirits, flays, and quarters them.

Cerberus is the name of a hedge fund well known for its restructuring feats in companies going bust. The fund's name, taken from Greek mythology, evokes memories of the Divine Comedy in which the Florentine poet Dante meets the three-headed, red-eyed dog Cerberus who guards the gates of hell and barks and rends the spirits of the damned. In the same way, the hedge fund Cerberus feeds insatiably on companies that have been caught by a downdraft and driven to the hell of bankruptcy, and through a creative destruction process seeks to restructure them and sell them out again to make a profit.

The distressed securities market has been a rather obscure area in the last twenty years, and only recently it has been under the spotlight of the press due to the Enron, Adelphia, WorldCom and Parmalat scandals. Certainly, the fact that distressed securities trade mainly over-the-counter contributed to building this image.

In Europe, bankruptcy regulations are complex and differ from country to country, so that settlement procedures call for local expertise and presence. Also, in Europe, bankruptcies tend to turn into negotiated reorganizations. Many reorganization processes in Continental Europe are still relatively new and untested compared to the United States.

In 2002, the number of companies worldwide filing for bankruptcy or whose debt securities were traded under distress conditions was at an all time high, due to the spate of defaults involving the telecommunication, high-tech and energy industries. In 2003, in the United States the default rate1 of high-yield bonds stood at 4.7 %, well below the 12.8 % rate reported in 2002, or 9.8% in 2001. And in December 2003, the most flagrant case of default ever experienced on European bond markets occurred: the default of Parmalat and its subsidiaries, which led to a total volume of insolvent bonds issued by the Parmalat group of about €6 billion.

In the United States in 2002 there were 122 bankruptcy filings by publicly held companies2 with $337.5 billion worth of liabilities before the bankruptcy procedure, whereas in 2003 there were 95 filings associated with liabilities for $337.5 billion.

1 Altman, E.I. and Fanjul, G. (2004) "Special Report On Defaults and Returns on High Yield Bonds: First Quarter 2004," Leonard N. Stern School of Business, New York University Salomon Center; National Bureau of Economic Research Data.

2 With liabilities of at least $100 million.

In Europe recovery percentages are still rather low (20 % in 2003), about half the amount as in the United States.

For most investors a default is generally a harbinger of bad news. Yet for some hedge funds, which invest only in highly depressed debt securities of distressed companies in the expectation of a price rebound, this represents a great investment opportunity. These funds earned the nickname of "vulture funds", because they pick the bones of underperforming companies clean.

Obviously their role in corporate reorganizations is still controversial. Many observers are philosophically against the idea that some investors may step in during a distressed situation to make a profit, while the company's original shareholders and lenders must suffer material financial losses. This hostility, however, fails to consider the critical role distressed investors may play in the creation of value during a corporate reorganization. After all, even though they might have a repulsive appearance, vultures are appreciated for their useful role as scavengers.

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