The early 2000s rocked the financial world with the dot-com bubble, interest rate hikes and of course 9/11 wiping billions of dollars off net asset values. The resulting recession inspired Warren Buffet to famously state that “you only find out who is swimming naked when the tide goes out”. Roll the clock forward 10 years and the tide has receded again with many investments being exposed in all their glory. 

This recession was of course cradled in the credit markets which led to unprecedented levels of illiquidity in what were previously considered liquid asset classes. It resulted in the creation of some frustrated, opaque and often decentralised market segments. Such illiquidity has extended to elements of the MBS, ABS, CDO, auction rate notes and many other asset classes, each of which justify their own article. This article focuses on opportunities for funds and their investors exposed to illiquid assets in financial sector bankruptcies such as Madoff, Lehman, Bear Stearns ABS funds, Sphinx and Refco. However, the solutions are equally applicable to the numerous suspended fund of funds, residual private equity portfolios and, indeed, most distressed illiquid asset classes.

It would be remiss to fail point out that, of course, not all illiquid assets are as a result of distress. Many illiquid opportunities include exciting (but illiquid) equity in private companies such as Facebook or LinkedIn as well as public companies that have restricted stock, employee stock options, warrants, convertible debt and Rule 144 securities. Again, the market has evolved and there are buyers that will provide a liquidity solution. 

So turning to investors’ exposure to bankruptcies, there are now a growing number of sophisticated market participants with an appetite and willingness to acquire this class of “investment” and their existence and growth has been an important contributor to unlocking capital, creating liquidity and ultimately a more efficient market. The estimated market value for bankruptcy claims is often quoted to be in the region of $500 billion with increasing year on year trade volumes suggesting a growing asset class. At its heart the market is about exchanging claims against insolvent debtors be they seeking protection under the US Bankruptcy Code, UK Insolvency Act or, in the case of offshore funds, under the relevant company and fund legislation in Cayman, BVI and beyond. 

Evidence suggests that the more complex bankruptcies can last for over a decade to be finally resolved and financial sector bankruptcies are always complex. Take the creditors of Enron who are still to this day receiving distributions on their claims that were filed shortly after the company entered into insolvency proceedings in 2001. Or Lehman, my former colleague Tony Lomas of PwC in the UK and an administrator of the Europe assets of Lehman explained to The Telegraph that he expects to be donning a pipe and slippers in retirement before final resolution of Lehman, one of the most complex insolvencies of all time and that is expected to take up to 20 years to fully unravel. 

Of course the collapse of Bernard L Madoff Investment Securities LLC, of such staggering proportion and complexity as to give Carlos Ponzi a headache, has already passed its second anniversary and will likely be another lengthy affair. I will use Madoff as an example to explore the bankruptcy claims market further. 

Benefits for the seller

The benefits of selling a trade or bankruptcy claim are numerous and the motivations of sellers can vary broadly. 

• Liquidity – First and foremost, immediate cash is of course the primary objective. A cents on the dollar or pennies on the pound price today that reflects the underlying value and risk and allows a seller to convert the claim back to cash and utilise the proceeds. 
• Certainty of timing – A sale provides certainty as to timing of recovery and allows a seller to benefit from the time value of money, avoid the long and uncertain wait for the full unravelling of a complex estate and avoid the hidden opportunity cost of doing nothing. 
• Certainty of value – A seller gets certainty as to value and does not have to carry the risk on the uncertain outcome of what maybe a highly complex, multi-jurisdictional bankruptcy outside of their strategy and expertise. 
• Return to strategy – In a scenario like Madoff, the investors’ chosen investment asset class was effectively converted from what they believed was a highly liquid equity strategy investment into in to an illiquid, hard to value, often unregulated asset class that they are unlikely to have expertise or even the mandate to invest in. One consistent, if perhaps unsubtle, observation is that of the many investors exposed to such a bankruptcy, none are there willingly and all would benefit from a return to their strategy of choice. 
• Distributions in kind – Illiquid assets are often distributed in kind to investors at the end of the wind down of a fund be it through bankruptcy, liquidation or having simply been economically run off by the manager. Such assets may include bankruptcy claims but more typically consist of the flotsam and jetsam of residual illiquid assets at the end of a funds life. Whilst there are structures to house such assets at low cost, it is more common for funds to simple distribute them in kind and move on leaving individual investors with self management of their pro rata proportion of the asset. Again, a cash sale eliminates this risk and inconvenience for investors. 
• Stigma – Motivations to sell can vary significantly from the purely economical to the emotive depending on the fact pattern and situational need of the seller. In the case of contentious bankruptcies often investors simply want to be dissociated from the bad experience or CIOs do not like to be reminded of bad decisions from the past at every month’s portfolio review for the rest of their careers. 

Risks for the buyer

Buyer’s intentions are purely economic whether intending to hold a claim for the short or long term. The price is broadly a product of the assessment of the potential assets and liabilities of the bankrupt estate (normally based upon very limited and far from perfect information), the time value of money and risk analysis of what is typically a complex, multi-faceted and multi-jurisdictional affair. Further, the Madoff bankruptcy has already created new legal precedents and will likely continue to do so adding a further layer of uncertainty. Complexity, uncertainty and delayed distributions amplify risk for a buyer and price is, of course, inversely correlated to risk. That said, it is helpful for potential sellers to understand the risks they are exposed to and transfer to a buyer when selling.  

In the case of Madoff, the structure and pricing of the sale of a direct claim is dependent on a complex matrix of facts relating to the seller, the status of their claim and even their past relationship with Madoff. Some considerations include: the type of claim (private or institutional, customer fund or general estate, etc), the jurisdiction of the claimant and, of course, the timing and value of past subscriptions and redemptions. The later issue often needs to be resolved with the Madoff trustee and his approach towards seeking claw backs and settlements under US Law and specifically the US Bankruptcy Code’s 90 day preferential payment rules. The good news is that the Trustee has stated a preference to reach settlement rather than litigate where he can. As a buyer you can provide the capital and resource to settle such claw backs and reach a mutually beneficial tripartite solution for trustee, seller and buyer.

Acquiring a shareholder’s interest in a Madoff feeder fund adds an additional level of complexity and uncertainty given the shareholding is a further and significant step removed from the feeder fund’s direct claim in the Madoff estate. To give some colour on the additional uncertainties these may include: the introduction of often conflicting multiple jurisdictions and bankruptcy regimes (eg Cayman, BVI, UK, Swiss feeder funds into the US Madoff); the feeder funds exposure to litigation risk such as indemnity claims from service providers; uncertainty on the basis for allowing and valuing claims (on a money in/money out basis per the US or on another basis depending on the feeder fund’s jurisdiction); preference period and pre-preference period claw back demands on subsequent transferees; the cost and uncertainty of possible recoveries from rights of action against service providers; timing of distributions many years into the future; the costs of managing all the above, etc. It is a complicated affair.

Of course there are also benefits to the investment manager, board of directors or liquidator of a collapsed fund in encouraging the sale of such shareholders claims. The numerous, typically disgruntled, investors are consolidated into those that have a risk appetite, understanding and willingness to be in the asset class and can even, where merited, source complementary capital such as funding litigation. 

Both direct and indirect claims are further impacted by issues the Madoff estate itself faces. For example the basis upon which distributions will be calculated (the denominator). The US courts have ruled that victim’s losses will be calculated on a money in/money out methodology rather than a last statement methodology. However, this is subject to appeal, the outcome of which could have a very material impact such as increasing the denominator upon which distributions are calculated by several multiples. 

In summary there is a growing appetite for the acquisition of illiquid assets of all classes be they bankruptcy claims, suspended fund of funds, credit securities or residual private equity or other asset portfolios. Adam Levitin of the Georgetown University Law Centre views “the creation of a market in bankruptcy claims is the single most important development in the bankruptcy world since the Bankruptcy Code’s enactment in 1978”. Each such transaction contributes to the healing of the market by unlocking capital, creating liquidity and ultimately a more efficient world.