Hedge funds' existence and activity have a dramatic impact on both financial markets and the real economy. The first chapter of this thesis analyzes the tradeoff between access to financing and disclosure of valuable trading information hedge funds are facing when interacting with their brokers. The next two chapters model how entering innovative financial contracts distorts hedge funds' incentives while voting on the creditor board of a financially distressed company. The first chapter studies competition in the financial service market for large hedge funds. Hedge funds have to be secretive about their asset strategies since these strategies are their sole source of profit. They need to implement their strategy through trading brokers, which might front-run and decrease the hedge funds' profit. Hedge funds also interact with prime brokers, which provide loans. We compare two institutionally-different situations. In the first institutional framework, all prime brokers are dedicated. We define dedicated prime brokers as prime brokers that do not have a trading desk. In the second case, all prime brokers are dual. Dual prime brokers have their own trading desk; good examples are investment banks. Dual prime brokers can serve as trading brokers for hedge funds, partially internalizing the competition effect of front-running. We find that both ex-ante and interim, hedge funds prefer a monopolist dedicated prime broker to a monopolist dual prime broker. In a monopolistic situation, a dedicated prime broker can make more money from a profitable hedge fund than a non profitable one as it extracts some of the hedge fund profits by charging for credit services. A monopolist dual prime broker internalizes the competition effect of front-running and the relationship generates a higher surplus, which accumulates to the dual prime broker. We then allow for ex-ante competition among prime brokers, which is equivalent to assuming long term prime brokerage relations. Under ex-ante competition, hedge funds receive a proportion of the ex-ante relationship surplus, which we define as the sum of expected ex-ante hedge funds' and prime brokers' profits. In this case hedge funds prefer dual prime brokers to dedicated prime brokers. We alternatively assume interim direct competition between the two types of prime brokers. We prove that there exists an equilibrium when hedge funds have to interact with both types. We then conjecture that there exist an equilibrium in which both types of prime brokers are active, although hedge funds do not have to contract with both types. We conclude that hedge funds need not worry about the effectiveness of the "Chinese wall" for investment banks if they can have long term relationships with investment banks. The second chapter analyze the implications of hedge funds' involvement in the creditors board of financially distressed companies. We do so by creating a novel model of corporate structure and governance. If a company defaults on its debt obligations the manager, who wants to maximize the payoff to shareholders and has no agency problems, proposes a new promised payment to creditors, based on her knowledge of their positions in the company. Voting occurs by creditors who choose either to accept the new payment and allow the firm to continue with its operations or to reject it, and file for bankruptcy. We assume that it is beneficial for the firm to continue its operations. The crux is that hedge funds can short the equity of their borrowers and moreover are not required to report their exposure in a distressed company's equity. We show that if the manager knows everyone's positions there is a promised payment that secures continuation but the presence of creditors with short equity positions lowers the continuation payoff to shareholders. If there is some uncertainty, however, then there are contingencies where the creditors' board rejects the restructuring plan. This "contrarian" voting can occur since a (unregulated) hedge fund may have different incentives from those of the rest of the (regulated) creditors. We show that the uncertainty is always in the benefit of the hedge fund and the detriment of the shareholders. So requiring creditors to report their aggregate exposure to the company's securities prior to voting leads to a better outcome for the firm. The third chapter studies the efficiency of the voting process for the restructuring of a company for which there is an active credit default swap market. As the restructuring value of the company is unknown, the voting process is analyzed through its ability to guarantee continuation only in the efficient state. If the restructuring value of the company is high, it is efficient to continue and if low, it is efficient to liquidate. We extend the framework suggested by Bond and Eraslan (2005) to allow for two types of creditors: those with credit default swap contracts and those without any such contract. We analyze how this creditor heterogeneity influences the outcome of the restructuring process. We conclude that the voting process efficiency is negatively affected by the existence of a CDS market. Even when we allow for a large number of creditors, although the information gets aggregated efficiently, the existence of creditors with different outside options might cause companies to continue even when it is efficient to liquidate.

Last modified

• 09/10/2018

Creator

• Ioan Florian I. Olaru

DOI

• https://doi.org/10.21985/N27737

Subject

• Finance

Keyword

• Prime Brokers
• Credit Default Swap
• Hedge Fund
• Creditor Board
• Voting
• Capital Structure Strategy

Date created

• 2008-05-09

Resource type

• Dissertation

Rights statement

• In Copyright