Lehman's Carcass Has Handed Huge Profits to Distressed Funds

(Bloomberg) -- It was a bold move: buy at Lehman Brothers’s darkest hour. But a decade after Lehman’s collapse, a handful of hedge funds that bought up the bank’s debt for pennies on the dollar have made even more money than seemed possible.

More than $124.6 billion has flowed to Lehman creditors, and another $1.4 billion may yet be coming. At least $92.2 billion has gone to those last in line: unsecured creditors. Some of the largest and earliest buyers, according to people familiar with the case, were distressed debt hedge funds Elliott Management Corp., Paulson & Co., Baupost Group LLC, and Varde Partners.

Expected to recover just 21 cents on the dollar when the reorganization came together in 2011, they’ve so far received 45 cents. In Lehman’s U.K. unit, senior claims have gotten 140 cents on the dollar.

While Lehman’s bankruptcy, the largest in history, with $613 billion in debt, was a boon to the funds, it’s not unprecedented. After Enron Corp.’s 2001 bankruptcy, unsecured creditors eventually got returns of 53 cents on the dollar, triple that projected by the plan.

“Lehman was a catastrophe,” said James Peck, who presided over the early years of its bankruptcy. But reaching a resolution in 2011 went relatively smoothly. The big reason: Hedge funds had a strong incentive to resolve issues because they had bought claims at a deep discount and wanted to see them gain value, he said.

‘Fog of Lehman’

The original investors, such as pension funds or Lehman’s business partners, walked away with immediate money but with less than they would have if they’d held on.

The recoveries since defy early expectations amid what was known as the “fog of Lehman.” Banks like Goldman Sachs Group Inc. and Citigroup Inc. had huge derivatives-related claims with Lehman that would prove nightmares to quantify. At first, some thought there would be nothing for unsecured creditors.

“We had no information, literally,” recalled Shai Waisman, an initial lawyer on the case.

Then, the hedge funds came, racing to figure out where assets were, even before Lehman’s advisers at Alvarez & Marsal did so. Elliott bought Lehman bonds within days, one of the people said. Soon after, it began buying claims on the secondary market at a deep discount.

Price Appreciation

The bonds had traded at around 8.625 cents on the dollar at the outset. They have now appreciated to 47.5 cents. Claims traded anywhere from 10 cents to 30 cents in the early years, a person familiar with the prices said.

One of the biggest legal fights was over whether to view Lehman’s assets and debts as pooled at the holding company or belonging to its warren of subsidiaries and foreign affiliates. Dan Kamensky, who had just joined Paulson from Lehman, giving him insights into how the company ran itself, pushed the consolidated position. His view was eventually echoed by Bryan Marsal, the restructuring officer in charge of Lehman, and Pacific Investment Management Co. and the California Public Employees’ Retirement System, which also had claims against the holding company.

Two Camps

“The marketplace was trying to analyze each box within the Lehman complex,” recalls Kamensky, who now runs Marble Ridge Capital. “But the math became simple when you started thinking about it as a consolidated entity.”

That view pitted it against hedge funds that were more diversified in their Lehman holdings. These funds included Elliott, Baupost, King Street Capital Management, Davidson Kempner Capital Management and CarVal Investors. The people familiar spoke on condition of anonymity because the claims trades are private. Elliott, Varde, CarVal and Baupost declined to comment on the performance of their claims. King Street, Davidson Kempner and Paulson didn’t return calls for comment.

By January 2011, a rough deal was reached carving up the Lehman pie, avoiding a more protracted court battle. Both sides fared well, and the compromises reached then allowed the payouts that continue today, as the estate, run by 77 people, continues to marshal and distribute them. Paulson, Calpers and Pimco ended up with around 93 percent of the value they sought, by one person’s calculation.

“Everyone involved was right in thinking this was so complicated that if there wasn’t a deal to cut, everyone was worse off, and it could be caught up many more years in court, so reasonable heads prevailed,” said Scott Hartman, a partner at Varde.

To Waisman, who left Lehman’s bankruptcy adviser Weil Gotshal & Manges to become chief executive at Prime Clerk, this success came at a cost. An orderly wind-down would have preserved more value -- and it would have changed who the winners were.

“It would have returned that money to the initial holders, like pension funds, rather than the opportunistic buyers,” Waisman said.

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