(Bloomberg) — It was the type of master stroke that could make a Wall Street career. Jason Mudrick’s financing of AMC Entertainment Holdings Inc. at the height of the pandemic netted his hedge fund hundreds of millions of dollars in just a few months.
Then, in the blink of an eye, it was gone. Options contracts meant to hedge the bullish wager went haywire as retail traders flocked to AMC’s stock, pushing shares to once unimaginable heights and costing Mudrick Capital Management all of its gains — and more.
Distressed investors have long had to have thick skins — taking criticism as predators, even as they sometimes rescue firms no one else will touch and generate returns for pensions, endowments and foundations. But life in the business is getting even harder, as they can no longer count on a predictable stock market to hedge massive, multipronged bets.
With equities swept up in the whims of exuberant day traders, some funds are now being forced to rethink their business models.
“It’s become a much harder calculus to even consider,” said Scott Hartman, the global co-head of corporate credit and trading at $14 billion investment firm Varde Partners. “Frankly, many funds have decided to stay away from shorting these stocks altogether.”
Granted, there are other investment opportunities — some distressed funds are pivoting to private lending and emerging-market plays — and often other ways that money managers can hedge their exposures or engage in forms of capital-structure arbitrage (plenty of their targets, after all, have no public equity.)
But fiscal and monetary stimulus have greased markets so thoroughly that many of the riskiest companies are now breezing through debt walls with cheap new financing, rather than running into the kind of dead-ends and defaults that generate restructurings or profitable loan-to-own plays.
Indeed, many fund managers say that beyond disrupting their ability to hedge, retail traders are increasingly propping up troubled firms, further limiting the universe of investment opportunities.
Clothing chain Express Inc., prison operator Geo Group Inc., coal miner Peabody Energy Corp. and others have, like AMC, seized on their popularity among day traders to seek equity financing — an option historically out of reach for firms with their debt loads.
That’s a problem for distressed-credit funds, where corporate failure is a key part of the investment thesis.
Their strategies often center on identifying companies that are out of options, providing last-resort financing and calling the shots throughout the workout process. Their controversial tactics — in which workers are often left bearing the brunt of the pain — can lead to huge payoffs, including outright ownership of the cleaned-up corporations.
Yet opportunities are dwindling.
“It’s eerily quiet out there,” said Colin Adams, a senior managing director at corporate advisory firm M3 Partners, where he focuses on debt restructuring. “You have the twin monsters of fiscal stimulus and low interest rates, and this phenomenon with meme stocks adds a whole new dynamic.”
Even companies careening toward default are no longer reliable targets for funds that use short equity bets to hedge or enhance their credit plays.
Investors confronted this reality with a trio of mall owners that filed for bankruptcy over the past year — CBL & Associates, Pennsylvania Real Estate Investment Trust and Washington Prime Group Inc.
All three saw their stock prices fluctuate — often surging on little underlying news — as they approached and then entered Chapter 11, where shareholder value gets wiped out almost as a rule.
Brian Sheehy, the founder of IsZo Capital Management, which takes long and short positions across firms’ capital structures, started shorting the mall owners as they began to buckle under the weight of unpaid rent and monthslong store closures.
“I predicted they would go bankrupt, and I was right — but I still lost money,” Sheehy said. “This stuff now will go straight up into your face until the day they file,” he said, adding that “the incentives are all thrown off.”
The irony is that achieving meme-stock status can sometimes be a boon not only for companies, but also their creditors.
Mudrick was initially one of the big winners of the Reddit-driven rally in AMC’s shares. After buying up the company’s battered bonds, his fund late last year provided $100 million in financing via complex pay-in-kind toggle notes, while receiving about 22 million shares. Those netted a handsome paper profit after the stock surged as much as 839% in January.
At the same time AMC was able to target retail demand for more than $1 billion in equity financing via so-called at-the-market offerings, which it used in part to pay down debt.
Yet what starts out as a stroke of good fortune can quickly turn into a burden for sophisticated hedge funds, which rely on markets staying rational to support their complex bets.
Call options Mudrick sold to protect the firm’s holdings from a market plunge — most of which gave other investors the right to buy shares from him at $40 or more, well above any price at which they had ever traded — would suddenly turn into massive liabilities by early June, as the company’s stock surged above $60.
Mudrick — whose firm last month exited its AMC debt and derivative positions — declined to comment when contacted by Bloomberg.
The theater chain’s shares closed Wednesday at $33.43, part of a wider retreat in so-called meme stocks in recent days.
AMC didn’t respond to a request seeking comment.
As for the few companies that do default or enter bankruptcy these days, retail traders are disrupting outcomes for credit funds there, too. More than once this year, money managers deep into monthslong restructuring negotiations have had to essentially start from scratch as company fortunes changed.
“The volatility makes it harder for the parties to coalesce around a restructuring plan,” said Dominique Mielle, a former partner at Canyon Capital Advisors and the author of an upcoming book on distressed debt. “One day the equity of the company has no value and the next it does — that upends the previous day’s work.”
Washington Prime entered Chapter 11 last month with a bankruptcy plan crafted with its largest lender, distressed fund SVPGlobal. The money manager was set to be rewarded for its risk-taking and diligence with a swift court process and ownership of the restructured company.
Now it’s facing objections and delays from equity holders who — emboldened by Washington Prime’s relatively healthy $2 stock price as well as the successes of firms like Hertz Global Holdings Inc. in preserving shareholder value — are demanding a larger payout.
“As investors, we can’t just say these are punks and they’re bidding up a stock for no reason,” Mielle said. “That may be so individually, but collectively they’re a market power and you’ve got to take that into account.”