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The impact of security trading on corporate restructurings

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The involvement of hedge funds in corporate restructurings has received considerable attention lately. In the context of debt restructurings the concern is that hedge funds might short the equity of their debtors and reject beneficial proposals to the detriment of both the firm and some of its claimholders. What is missing, however, from the existing narratives is the effect the cost of acquiring these positions (short equity, long debt) can have on the overall profitability of such strategies. We show that there is rejection of beneficial proposals when (i) a fund is a prevalent debtholder that can trade in the firm's equity or when (ii) even if the fund has to build both positions markets are disconnected, i.e., there is no exchange of order flow information between the debt and equity markets. In both cases rejection occurs only when other, non-strategic investors' trading is positively skewed. In particular, when others' trading is not skewed or markets are connected there is no deadweight loss to firm value from the fund's presence. Regardless of the effect on firm value, it is the firm's debtholders who benefit by the fund's presence, while equity holders get a lower expected value than if there are only pure debtholders, i.e., debt holders who only have debt but no equity position in the firm.

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