Can someone explain to me how hedge funds bankrupt companies?
In: Economics
There are many ways. The answer is a long one – please bear – will try to share the most common way,
Most companies take loans from banks and pledge their shares as security (apart from physical assets). Banks are happy with it as long as the share price keeps going up (as their risk exposure reduces because they can claim (and report to statutory authorities) that they have x times more security against the y amount of loan given).
Due to poor economy or poor management of the company leading to poor performance of the company (basically valid economical / business reasons) – **(#A)** the share price drops in the market. **(#B)** Then the bank approaches the company asking it to increase the security it has pledged to the bank. If the company does not do so – then the bank threatens to withdraw its loan and demand an immediate payment. This will force the company to raise more funds immediately. It may go to another bank (who will ask for more security – which the company does not have) or go to a private equity player (who will demand a % stake in the company) or sell some of its physical (real estate etc.) and non-physical assets (Patents etc.) – if such assets are not pledged as security already. Once funds are generated the first bank is paid off and the business can continue to recover. If the funds are not generated then the company has to file for bankruptcy – where a third party administrator takes over the company and liquidates all its assets and returns whatever money is generated from the proceedings to the banks (and other creditors). Then the company is wiped out (no intangible or tangible assets, employees are sacked, offices and factories closed etc.).
This is how normal, ideal world is supposed to function.
Hedge funds identify a underperforming company in an outdated / soon to be outdated sector and start to short sell its stock. Short selling is of 2 types – naked and covered. When the intent of the HF is to drive a company to its bankruptcy – they normally engage in naked shorting. Naked shorting means HF’s sell shares in the market at lower and lower prices without owning or having these shares in its possession. So this is like selling a share which they dont own (yes the SEC allows this legally). I wont get into the details of how its done.
By doing so – the price of the share goes down (because there are more sellers than buyers or the selling pressure is more). This leads to a situation where the company’s share price falls for reasons other than those mentioned at point **(#A)** above. And the further course of actions by the bank begins (refer **(#B)** onwards above). So effectively a HF can keep shorting the stock – seemingly endlessly – to force a company into raising more and more capital for collateral security and eventually face bankruptcy. There are other effects of the created “bearish” sentiment – business may not get working capital loans but need more working capital, suppliers may reduce credit terms and demand payments upfront etc.
Along with the naked shorting – other tactics are also used to justify the drop in stock price – where “bearish” news about the company is spread in the mainstream media or analysts downgrade the stock rating, someone files class action suits against owners / company etc.
All of the above creates “a new problem” for the company management to handle – instead of focusing on building the business, they need to devote substantial time and resources to fight this nonsense. This leads to lower than peak performance for any business – which reinforces the bearish sentiment being created by the HFs.
Did you know – that if the company bankrupts the HFs dont have to bother about the “non-owned or borrowed” shares they sold. The shares dissappear too. So HF’s got money from retail investors for “non-owned or borrowed” shares they sold (shorted) – and never have to buy them or repay for them. Its a win win win for the HFs if the company they shorted gets bankrupted.
And this is how the real world operates…
There are many instances this has happened in the past and the HF’s have gotten away with it…
And sometimes – once in a blue moon – the HF’s get caught with their pants down – wink, wink GME.
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