Almost six years after Lehman Brothers Holdings Inc. filed for the largest bankruptcy in history, triggering a global market meltdown, hedge funds are still feeding on its remains.
A small group of firms that waded into the morass in the aftermath of the financial crisis, including Paulson & Co., King Street Capital Management LP, Varde Partners Inc., Halcyon Asset Management LLC and Solus Alternative Asset Management LP have made billions of dollars trading in the debt. As claims are being paid out, often at a multiple of initial estimates, investors that have spent years analyzing the bankruptcy are ploughing money back into newly available loans, such as those between the investment bank’s Hong Kong and U.S. units, fueling a rally unmatched by stocks and high-risk bonds.
“A little of a surprising aspect is that there’s still this much return left in it this far along,” according to Marcia Page, co-chief investment officer of Varde, which oversees $8.5 billion and has been buying Lehman claims since 2008. “There’s just so much debt.”
The investments have been a bright spot in a world of increasingly expensive securities because they are complicated to analyze, partly hinge on decisions made by judges and may take a long time to pay out, which reduces the pool of buyers to those who have adequate resources and available capital.
The assets meanwhile have surged in value after the bank’s trustees settled litigation at better-than-anticipated terms, and as central banks’ unprecedented stimulus to rescue the financial system from the global credit seizure caused by the bank’s failure pushed up prices of everything from real estate to derivatives.
Lehman has been “the trade that keeps on giving,” John Paulson, whose firm has made more than $1 billion on its investment, told clients on a conference call last month. Lehman debt has risen about 11 percent this year through the first quarter and 45 percent since the beginning of 2013, Paulson & Co. said in a first-quarter letter to investors, a copy of which was obtained by Bloomberg News.
High-yield, high-risk bonds have returned 12 percent since the end of 2012, according to Bank of America Merrill Lynch index data. Stocks, as measured by the Standard & Poor’s 500 Index of U.S. equities, have gained more than 30 percent.
Lehman filed for Chapter 11 in September 2008 listing $613 billion in debt after it couldn’t get U.S. government aid or attract a buyer, 158 years after its founding as a cotton brokerage in Alabama. The investment bank, based in New York and run at the time by former bond trader Richard Fuld, failed after taking on too much debt and making risky real-estate investments, according to the bankruptcy examiner’s report.
The first big sellers of Lehman claims were trading counterparties such as Morgan Stanley, which unloaded its holdings in 2009 and 2010, according to two people with direct knowledge of the matter, who asked not to be named because the information is private.
Paulson and Varde were some of the earliest buyers of the claims, which give investors the right to collect any income tied to an estate’s assets. Lehman debt started trading shortly after the filing at about 8 cents on the dollar for the parent company and the mid-teens for the broker-dealer unit.
Lehman estimated in 2011 that the average creditor would get about 18 cents on the dollar for an estimated $370 billion in allowed claims payable by 2016. John Suckow, an executive at restructuring firm Alvarez & Marsal and Lehman’s president, and the defunct bank’s other directors had an incentive to maximize payouts: The more money they raised beyond the target the bigger the bonus they would get.
Lehman made its first payment to creditors of $22.5 billion in April 2012, 53 percent more than the company had said was likely in previous filings. Last July, the estate estimated it would recover $80.6 billion, compared with the $65 billion recovery projected in the company’s liquidation plan approved in December 2011. In total, it has distributed more than $56 billion to third-party creditors, and a sixth payment is scheduled for the end of September.
Harvey Miller, Lehman’s bankruptcy lawyer, and his team have added value to the estate through litigation and settlements. In February, the bank reached an accord with the founder of software maker SAP AG, a step that freed up about $1.8 billion for creditors. That same month, Lehman reached a settlement to pay $767 million to Freddie Mac to satisfy a $1.2 billion bankruptcy claim, one of the biggest remaining in the case.
Some parts of Lehman have been particularly lucrative. Debt of Lehman’s specialty finance unit started trading in late 2009 at about 29 cents and, with distributions, is now at about 65 cents, Scott Hartman, a managing director who focuses on the bankruptcy at Minneapolis-based Varde, said in a telephone interview. Claims against the firm’s U.K. unit initially traded at 20 cents on the dollar in mid-2009 and is currently at the equivalent of about 150 cents, he said.
The debt has been especially attractive because the amount of U.S. notes considered distressed has dwindled to $55.1 billion, less than a tenth of what it was during the crisis, according to Bank of America Merrill Lynch index data.
“One of the reasons I still like seasoned liquidations at this point in the cycle is that we’ve had a 30-year bull market in bonds, and spreads associated with most credit instruments, especially high yield, are pretty tight,” said John Bader, chief investment officer of $12.6 billion New York-based Halcyon, which has been buying the majority of its Lehman claims since late 2011. “When the economy troughs or perhaps before, there may be a lot more traditional corporate distressed opportunities.”
There are at most about 20 hedge funds that have bought Lehman debt consistently since its collapse, Hartman estimated. The investment, which comprises a percentage of Varde’s holdings that is in the “low double digits,” has been one of its top-performing positions in the past few years, he said.
“Returns have been very attractive, a huge generator of profit over the last five years,” he said. “When you get that money back the market has tended to reinvest it in the Lehman structure; that’s been a recycling-of-capital effect.”
Solus, the $4.3 billion event-driven distressed hedge fund-firm run by Christopher Pucillo, accelerated its purchases of bankruptcy claims in 2012 after hiring Scott Martin and C.J. Lanktree from Deutsche Bank AG, where they ran a distressed-debt group. Along with King Street, which oversees $19.8 billion, the firms are reinvesting profits.
King Street is finding “numerous attractive possibilities for ongoing investment in Lehman,” including purchasing intercompany claims, the New York-based firm wrote in a February letter to investors. Spokesmen from King Street and Solus declined to comment.
Paulson & Co., which held more than $750 million worth of the claims across all of its funds at the end of 2013 and at one point was was the largest creditor in the case, anticipates returns will keep coming.
“We expect incremental returns will be driven by litigation recoveries and highest asset realizations versus management estimates,” the $22.8 billion New York-based hedge-fund wrote in a first-quarter letter. A spokesman for the fund declined to comment on the investments.
Lehman in its reorganized state will exist until the estate’s assets are liquidated. Hedge funds say the distributions, still the best large U.S. distressed opportunity in a barren market apart from Energy Future Holdings Corp., may continue for up to three years. Some hedge funds, including Varde, have shifted the bulk of their distressed dollars to Europe, where the firm has been buying holdings of performing and non-performing loans.
“There’s still opportunity in the Lehman structure but if we look at three to four years later and if there’s still no defaults, everybody will have a bit less to do than they do today,” Hartman said.