Can someone explain to me how hedge funds bankrupt companies?

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Can someone explain to me how hedge funds bankrupt companies?

In: Economics

They don’t. At least not directly. And of course, “hedge fund” is too wide a term – there are many types of hedge funds all with different ways of investing.

But to take what is the more common idea. There are companies that do poorly in their business area. There could be a variety of reasons for this (not relevant). Some hedge funds are very good at finding these companies and what the hedge fund will do is to “short” that company’s shares. In effect the hedge fund is saying “this company isn’t doing well and their share prices will fall soon”.

Of course, the hedge funds are not always right. But what some people believe is that the actions of the hedge fund “causes” the fall in the share price.

Shareholders of a company the hedge fund bets against are, of course, angered. Their argument might be “the company has a recovery plan”, “the company needs time”, “this is just an unusual situation” etc etc. These shareholders don’t want the market to know how badly the company is performing because they want to preserve their assets. And, to an extent, they might have a point – perhaps hedge funds force management to be short term focused. Another argument is that hedge funds might cause “self fulfilling prophecies” – by betting against a company, other investors panic and rush to sell thereby causing the share prices to fall.

Hedge fund supporters argue that the hedge funds provide useful information to the market (ie in effect telling everyone about problem companies). And, of course, hedge funds are investing their money – so they are not simply pundits. The argument is that they make share values align to company performance quicker.

If a company share price falls (a lot), then it becomes vulnerable to takeovers and to be broken up for assets. It might also become harder to borrow money. Since top executives are also paid in shares – this also causes their top executives to resign/retire and/or look for new jobs – thus making a difficult situation even worse.

Hedge funds exist to mitigate (hedge) risk in other investments. Given that most investments involve holding some asset (called a long position) which is effectively a bet that the asset will go up in value, it is common for hedge funds to bet the opposite way (called a short position). Given that a short position is betting that a company’s value will go down, lots of people shorting a company is a sign that it is in trouble or at least overvalued. This may lead to people who hold that company’s stock selling, which results in the price going down.

If the price goes down too far then the company will need to take drastic action or face bankruptcy.

Additionally some particularly aggressive funds will take out short positions on a company and then publish data which shows that the company is overvalued (e.g. analysis showing that the company’s forecasting is overoptimistic).

You gather loads of money, take loans on that money to get more money, buy stocks of a company let’s say for 100 and options to sell the stocks of that company for a fixed price idk let’s say 100. By buying the stocks you pumped it’s value as people will see that this company is “in demand”, so it must be valuable let’s say it rises to 200. And then sell off all your stocks in that company for the pumped price. Afterwards, the company will drop in value because people see that investors are fleeing the company, so there must be something wrong with them, let’s say it drops to 50. And when they hit the low point you buy back your stocks full fill your trade option, so you buy it for 50 and sell it for 100. So the result is:

result = -100 (to buy it) + 200 (for selling it) – 50 (to buy it back) +100 (to fulfill the option) = +150

So you get +150 for each share for essentially nothing. Now if you hit the company really low on their way down, they might not be able to get loans anymore, their suppliers might want to see money upfront and don’t trust their credit score and whatnot and so they might not be able to fulfill their contracts and if the company didn’t have the means to sit it out and have the market realize that this was all a scam and that the value of the company never actually changed from 100, then they might go bankrupt before they would “miraculously” recover from that.

There are many ways. The answer is a long one – please bear – will try to share the most common way,

Most companies take loans from banks and pledge their shares as security (apart from physical assets). Banks are happy with it as long as the share price keeps going up (as their risk exposure reduces because they can claim (and report to statutory authorities) that they have x times more security against the y amount of loan given).

Due to poor economy or poor management of the company leading to poor performance of the company (basically valid economical / business reasons) – **(#A)** the share price drops in the market. **(#B)** Then the bank approaches the company asking it to increase the security it has pledged to the bank. If the company does not do so – then the bank threatens to withdraw its loan and demand an immediate payment. This will force the company to raise more funds immediately. It may go to another bank (who will ask for more security – which the company does not have) or go to a private equity player (who will demand a % stake in the company) or sell some of its physical (real estate etc.) and non-physical assets (Patents etc.) – if such assets are not pledged as security already. Once funds are generated the first bank is paid off and the business can continue to recover. If the funds are not generated then the company has to file for bankruptcy – where a third party administrator takes over the company and liquidates all its assets and returns whatever money is generated from the proceedings to the banks (and other creditors). Then the company is wiped out (no intangible or tangible assets, employees are sacked, offices and factories closed etc.).

This is how normal, ideal world is supposed to function.

Hedge funds identify a underperforming company in an outdated / soon to be outdated sector and start to short sell its stock. Short selling is of 2 types – naked and covered. When the intent of the HF is to drive a company to its bankruptcy – they normally engage in naked shorting. Naked shorting means HF’s sell shares in the market at lower and lower prices without owning or having these shares in its possession. So this is like selling a share which they dont own (yes the SEC allows this legally). I wont get into the details of how its done.

By doing so – the price of the share goes down (because there are more sellers than buyers or the selling pressure is more). This leads to a situation where the company’s share price falls for reasons other than those mentioned at point **(#A)** above. And the further course of actions by the bank begins (refer **(#B)** onwards above). So effectively a HF can keep shorting the stock – seemingly endlessly – to force a company into raising more and more capital for collateral security and eventually face bankruptcy. There are other effects of the created “bearish” sentiment – business may not get working capital loans but need more working capital, suppliers may reduce credit terms and demand payments upfront etc.

Along with the naked shorting – other tactics are also used to justify the drop in stock price – where “bearish” news about the company is spread in the mainstream media or analysts downgrade the stock rating, someone files class action suits against owners / company etc.

All of the above creates “a new problem” for the company management to handle – instead of focusing on building the business, they need to devote substantial time and resources to fight this nonsense. This leads to lower than peak performance for any business – which reinforces the bearish sentiment being created by the HFs.

Did you know – that if the company bankrupts the HFs dont have to bother about the “non-owned or borrowed” shares they sold. The shares dissappear too. So HF’s got money from retail investors for “non-owned or borrowed” shares they sold (shorted) – and never have to buy them or repay for them. Its a win win win for the HFs if the company they shorted gets bankrupted.

And this is how the real world operates…

There are many instances this has happened in the past and the HF’s have gotten away with it…

And sometimes – once in a blue moon – the HF’s get caught with their pants down – wink, wink GME.

Here’s a basic ELI5 way… hedge fund buys XYZ company, which it thinks is underperforming. They spend $1b in hedge fund money buying up the company’s shares to take it private. Then XYZ company borrows $1b to pay back the hedge fund, leaving newly private XYZ company with $1b in new debt to pay back. if hedge fund can actually grow XYZ corp as it believes it can, they additional revenues will allow the company to grow, pay back debt, and eventually be a more profitable company with new growth once debt is repaid. If the company doesn’t see the anticipated growth, however, the debt burden becomes too much and the company ends up in bankruptcy. Maybe it’s a recession, delay in major product launch, growth projections or quick fixes were too optimistic.

Toys R Us, for example, was still cash flow positive as far as selling toys went, but because they couldn’t grow their online sales fast enough, kids were spending fewer years playing toys before moving on to sports or video games, more competition from Amazon, Target, Wal-Mart, people having fewer babies meaning less demand for all the baby products Babies R Us sold, etc. prevented the growth needed to pay down all the hedge fund debt the company was saddled with.

To keep it super high level, the most common method (there are PLENTY) is what is called a leveraged buyout. It’s when the buyer of a company uses the companies assets to get a loan to buy the company.

Dumb example: You want to buy a lemonade stand. It is worth $10. The owner want’s $30 to sell it to you. So you go to a bank and the ask to borrow $30 to buy the stand. The bank asks what collateral you have for a $30 loan. You say “If you lend me the money, I will own a lemonade stand, so that will be my collateral”. The bank agrees, gives you the $30, you pay the former owner, and take over the lemonade stand. You now own a lemonade stand worth $10, with $30 of debt attached to it, so now it’s worth -$20 dollars.

Since you leveraged the value of the lemonade stand to secure a loan to purchase the lemonade stand, the lemonade stand now has to carrier that debt, so a business that used to be worth $10 is now worth -$20. If the buyer can’t grow that business and pay off that debt, the stand goes bankrupt.

Now you may ask, why would anyone do this? Want to buy a lemonade stand that will be worth -$20? Well, your boss told you if you buy a lemonade stand, you get a bonus of $5. So you go through the leveraged buyout, you didn’t spend any of your money, you collect your $5 bonus, and let the stand fail. You don’t care because you keep your $5.

That’s basically it except replace “lemonade stand” with “Toys R Us” and replace $10 with “$1.86 billion” and replace $30 with “$5 billion” and replace $5 with “$15 million” and replace “boss” with “KKR Investments”


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