Secrets of Top Hedge Funds

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Hedge funds such as Appaloosa Management and Cerberus Capital Management made a fortune buying the debt of WorldCom when it was in bankruptcy. Both funds had positions on WorldCom's creditors committee, allowing them to influence the case's outcome. WorldCom eventually was sold to Verizon Communications (VZ), in a deal that's widely believed to have generated enormous profits for the hedge funds. As WorldCom went into bankruptcy in 2002, its debt was trading in the neighborhood of 47¢ on the dollar. Verizon's acquisition of the company ensured payback of the debt and allowed credit investors to double a well-timed bet.

Creditor Bets

Sowing discord in a bankruptcy case is another profitable approach. Why bring all parties together and settle things fairly when you can grab as much money as possible for yourself? A capital-structure arbitrage is a bet on which creditors will make out best in a bankruptcy reorganization. The strategy hasn't been in favor during the last few years, but there are indications that it could be useful in certain situations.

In the Northwest Airlines (NWACQ) bankruptcy, hedge funds such as Owl Creek Asset Management have bought Northwest equity and shorted the bonds, a reversal of the common assumption that equity holders are the losers in bankruptcy cases. Owl Creek is betting that Northwest, which filed for bankruptcy protection in 2005, will be acquired, giving it another shot at life and boosting the value of its stock. The shares, which now trade over-the-counter, once traded above $50. Last week, they hit a low of 8¢, and finished at 16¢ on May 7. Owl Creek declined comment.

Suing for Fun and Profit

Many people argue that the U.S. economy is burdened by too many lawyers and lawsuits. If so, why is that? Because it's profitable! In the bankruptcy of the former Adelphia Cable, hedge funds including W. R. Huff Asset Management and Appaloosa bought the company's bonds on the assumption that Adelphia would be able to recover money by suing former auditor Deloitte & Touche. Deloitte and a group of banks agreed in December, 2006, to pay Adelphia investors $455 million to settle the case. Deloitte was responsible for $210 million of the agreement.

The pursuit of alpha isn't for the faint of heart: An estimated 83 U.S. hedge funds went under in 2006, eliminating $35 billion in assets, according to Absolute Return magazine, which tracks the sector. "To produce alpha, you have to take risks," says Discolo of AIG Global Investment.

Wipeouts notwithstanding, the outlook remains strong. The U.S. hedge fund sector crossed the $1 trillion mark in 2006 for the first time, according to Absolute Return. It looks like this poker party is set to last a while.

Click here for a roundup of the U.S.'s 10 top hedge funds.

Rosenbush is a senior writer for BusinessWeek.com in New York.