Hedge Funds and Collective Action
The standard justification for bankruptcy is that exists to solve a collective action problem. The various investors in the business are dispersed, and, left to their own devices, they will take action that is invididually rational but will fail to put the assets of the corporation to the highest-valued use. For over a decade we have known that it is possible, in theory, to solve the collective action problem ex ante. Still, many companies have capital structures that result in thousands of parties making investements in the business.
The collective action problem is much less severe today, however, than it has been it the past. This has happened not through contracting ex ante but rather through the actions of hedge funds ex psot. In most bankruptcies, there is an active market in claims (though in some cases there are restrictions due to valid tax considerations). Anyone with a claim who does not want to participate in the bankruptcy proceeding can cash out with ease. There are negotiations in Chapter 11, but it is among professional investors who want to be there. Also, it often makes little sense to classify the investors by the type of claims. It is common for a hedge fund to hold various types of claims. It can have senior secured bonds, trade debt, and subordinated bonds. The image of various classes of investors negotiating among themselves does not capture this dynamic.
This development in bankruptcy suggesst that views of bankruptcy law predicated on the conflict between debt and equity need to be broadened. While these conflicts still exist and should not be ignored, they fail to capture the dynamics in many companies. What also matters is the extent to which the investors are dispersed. With few investors, issues of control may loom larger than the current configuration of cash-flow rights.
Stated somewhat differently, one benefit of the liquidity provided by hedge funds and private equity funds (to the extent that one wants to draw a difference between the two) is to place a cap on the costs of collective action. Dispersed investments can be gathered together. While it obviously costs time and money to do so, it does place an upper limit on the cost of dispersed investments.
Of course, there is always the risk that hedge fund activism has their cost. There may be situations where hedge funds can use their cash so that they can extract rents from the reorganization process. At other times, it may be that conflicts between hedge funds dissipate value. While hedge funds have changed the bankruptcy landscape, it is still an open question as to what their overall impact will be.