On the wide horizon of investment vehicles in the financial markets, hedge funds play an important and unique role. While most investors are betting that the companies they invest in will grow and progress. Hedge funds between others utilize approaches that are betting on the company's failures. From there the next question comes - how do hedge funds make money from failing companies?
Among strategies that are directed at winning companies, specific tactics like short selling, activist approaches, and investing in distressed debt aim to generate gains from failing companies. Depending on the strategy hedge funds can make a straight profit from a distressed firm, or an attempt to make a failing firm an outperformer that can generate gains.
The topic of profiting off failing companies is often considered a controversial topic, due to its ethical dilemma. By the end of the article, we will go through the basics of hedge funds, and then we will dive into strategies that make profit from companies on the decline. Stay with us till the end to understand this topic and be able to make your judgment of it.
Key Takeaways
- Hedge funds use several strategies to benefit from failing companies - short selling, activist investing, and focus on distressed assets are the most prominent ones.
- Identifying and understanding the value of securities is the cornerstone of reaping success from almost certain market failures.
- Profits can be pulled off even from bankruptcy, a debt instrument, or a liquidation.
How Hedge Funds Work
What sets hedge funds apart from other types of investment vehicles is the constant goal of generating excess alpha. While mutual and other types of funds often try to replicate gains of competitive benchmarks, hedge funds aim to beat them.
To achieve this managers can resort to investing in winning or losing companies. By employing fundamental and technical analysis they evaluate both the current state of the assets and its parameters in the past.
Depending on the strategy funds can prefer to invest in the winning or losing side of the market. In any case, managers must mind the risk around every investment choice, and prepare a risk mitigation approach.
To minimize risk and diversify their gains, hedge funds tend to have a highly diversified portfolio composed of different asset classes spread out over different geographies. When you put into the mix various strategies an investor can allocate their investments into a unique portfolio that is adjusted to his needs.
How Hedge Funds Identify Failing Companies
Hedge funds identify failing companies by in-depth fundamental analysis. Through it, they aim to find declining revenues or profits, debt that is on the rise, low or negative cash flow, and decreasing gross or operating margins. All these parameters can point out to a company in distress. While a company can pull through, a good analysis should show what is a chance for it to go down under.
Another criterion that is a sure sign of a company's distress is losing its market share. If the competition is taking its customer base, and pushing the company out of the market, hedge funds can profit from it.
Often entire sectors are undergoing downturns due to changes in market sentiment, or industry disruption. These factors have a wider impact and can result in long-term damage to the companies if they are vulnerable to these shifts.
As a proven strategy, hedge funds are on the lookout for credit ratings and regularly conduct debt analysis. If a specific company gets its credit rating downgraded, or its bond prices are on the decline, that is a telltale sign of a struggling company.
Watching what competition is doing can result in finding companies that do not have a strong present or future. If a large contingent of a company's stocks are being shorted that means that someone else already found out about the weaknesses of the company and decided to profit from it. A fund can try to jump aboard and earn a part of the profit.
As a last indicator, a fund can look out for major corporate events that can point to a bad scenario unveiling in front of their eyes. A company that is selling parts of its operations, or is making a desperate merger, is almost always a sure sign of a company going down. Further analysis can provide more insights into how the fund can position itself in the individual case.
Ways To Invest In Failing Companies
Short Selling
When a hedge fund identifies a company on the downturn they aim to profit from it if it is a part of their strategy. Short selling is one of the options to achieve that. Essentially it is an investment process in which the manager borrows the stock from the broker for a fee.
Once the stock is borrowed the manager sells it at a current price. If the investment thesis is correct, the stock price will decline, and when it happens the manager buys it. The stock bought for a discount is returned to the borrower, earning a manager a difference between the borrowing and buying price. If the stock makes a recovery, hedge funds fail in their attempt and lose money.
Short selling was often criticized because through it speculators try to artificially deflate the stock price of already vulnerable assets. It is one of the strategies that brought a bad name to institutional investors, particularly in the hedge fund industry. During the 2008 global financial crisis, short-sellers targeted distressed firms like Lehman Brothers and Bear Stearns resulting in their stock prices losing much of their value. This triggered a series of events that had a global impact.
Distressed Assets
Investing in distressed assets is one of the riskiest approaches conducted by hedge funds. In the process, hedge fund managers buy securities of firms nearing bankruptcy. Stocks or bonds of these companies are traded at significant discounts. Essentially managers are betting that these companies will make a turnaround and the value of these securities will rise.
Another option is to negotiate a debt restructuring. Hedge funds can attempt to change the status of the debt by extending maturity or reducing interest rates. If the restructure ends as a success it can raise the value of the debt or even convert the debt into equity.
If the distressed companies opt to declare bankruptcy, hedge funds can play an active role in it. Depending on the amount of capital they invest, funds can impact the way the distressed firm will restructure.
In situations when hedge funds own a substantial portion of distressed debt, in case of a debt-for-equity swap they may end up owning a major part of the company. This can easily lead to a takeover opportunity, and a chance to restart operations in a different way.
Activist Approach
The cornerstone of the activist approach is to identify firms that are performing badly due to poor decision-making from the management. Strategic missteps, plans that have little to no chance of succeeding, or bad allocation of assets are just a couple of examples.
Once hedge funds detect these companies they aim to acquire a big chunk of their stakes. That brings them a possibility to enter the board of the company, allowing them to make operating decisions.
After the fund manages to break into the decision-making structure, it can implement its ideas into the company's plans. This approach can turn a ruined company into an overperformer with direct help from the hedge fund.
Although this strategy carries unique sets of risks, funds with enough experience can earn a hefty sum from these deals. It is crucial that the funds find economic interest to attempt to save these companies. If they are bad from their foundations, earning big returns from them is impossible.
Some of the best examples of activist hedge funds are Elliott Management (led by Paul Singer), Pershing Square (Bill Ackman), and Third Point LLC (led by Daniel Loeb).
Role Of Ethics In Activist And Distressed Investing
Attempting to earn more money from distressed firms is an ethical issue from the start. In case the hedge fund invests in a company and wants to make a breakthrough it can demand making difficult choices, including laying off employees, reducing salaries, or closing entire plants. If a hedge fund manager wants to make an ethical decision he should think about the long-term implications of his decisions.
Another scenario is when hedge funds invest in distressed companies aiming to further exploit their weaknesses. Activist hedge funds can attempt to push for decisions that can bring them solid gains, but as a result, the companies become weaker in the long run.
Closing Remarks
The investing market is a wide and diverse place. Investors can find vehicles that can earn from almost anything, and even from the demise of others. While it can be easily pushed into a grey ethical area, for those with a strong stomach it can bring a lot of good.
Before you decide to pursue gains in this way assess your risk tolerance, because betting on other failures is usually a highly risky endeavor.