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FRM Part II · FRM Exam Part II · Hedge Fund Investment Strategies

A distressed debt fund holds a bond bought at 40 that it expects to be converted to equity in a Chapter 11 reorganization. The fund wants to influence the plan and obtain control of the reorganized company. Which approach is most consistent with this objective?

The fund should accumulate a large, blocking position in the fulcrum security, the class expected to convert into the reorganized company's equity. This gives influence over the plan and control, though it may impose trading restrictions from insider information obtained in creditor committees.

  1. AAccumulate a blocking position in the fulcrum security class, the class expected to receive the equity, accepting restrictions on tradingCorrect
  2. BBuy only the most senior secured debt, which is repaid in full, and sell before the plan vote
  3. CShort the junior bonds and avoid participating in creditor committees
  4. DBuy the equity of the distressed firm because equity holders vote first on the plan

Explanation

The fulcrum security is the class that is partially impaired and expected to convert into equity, so owning enough of it (often a blocking position of one-third in amount) gives control influence. Senior debt paid in full has little say, and equity typically is wiped out. Active involvement brings information restrictions on trading.

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