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This column was originally published on RealMoney on Sept. 13 at 10:40 a.m. EDT. It's being republished as a bonus for readers.

The activist battle against

Bally's Fitness


is going to another level as Pardus Capital Management appears to be joining Liberation's effort.

I first wrote about Liberation and Bally's on

July 25 when the stock was at $3.25. Piggybacking on top of Liberation's efforts has proved successful, with the stock closing Monday at $4.06, a full 25% higher. Pardus revealed that it owned 12% of the company (4 million shares) in a

Securities and Exchange Commission

filing last week, with a block of 1 million shares being bought last week at $3.93 per share.

In Pardus's (PCM's) filing it stated:

"PCM has communicated with management of the Company, and expects to continue to communicate with management of the Company." Pardus also threw in the line that funds do when they want to start talking with the other activists: "Depending upon such factors that PCM may from time to time deem relevant, PCM may, among other things, (i) communicate with other shareholders of the Company..."

Pardus's confidence, and Liberation's bet, achieved a substantial boon in the past two weeks as Bally's reworked some of its debt agreements with its bondholders. Let me just state that when a company defaults on its bonds, that is often the best time to buy its stock. Why? Because the hedge funds that own the bonds will do anything they can to avoid reporting a writedown on that debt to their investors.

In Bally's case, the "writedown avoidance efforts" began on Aug. 5, when two bondholders sent notice that Bally's was in default of their bonds because of earnings restatements that Bally's was in the process of filing. Bondholders typically have covenants in their loan agreements which trigger a default if the company does not file financial statements on time. Bally's has been under an SEC investigation for its earnings and is restating from 2000 to 2004. Bally's was given 30 days to either get a waiver extending its deadline or to file the restatements. Once the company defaults, even if it's a default based on a financial reporting covenant, bankruptcy is often a short hop away.

On Aug. 31, Bally's announced that the bondholders who had previously notified them they were in default had sent the company a waiver extending the deadline of the Financial Reporting Covenant (the line item in the loan agreement that said the company was in default unless it filed financial statements on a regular basis) until Nov. 30, 2005.

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For taking on this additional risk, the bondholders got paid handsomely. One group of bondholders received $15 cash for every $1,000 invested (effectively raising their already high interest rate of 9.875% by another 1.50% on the year) and the other group of bondholders got the choice between $20 or 9.2 shares of stock for every $1,000 invested. They also changed slightly the terms of the loan agreement, making it more difficult for Bally's to default.

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Why do this? For one thing, nobody wins in a default:

Shareholders lose, because their equity is wiped out. Debtholders get paid back first in a bankruptcy.

The management team loses, because sooner or later they will be fired by whoever steps in to restructure the company in a bankruptcy.

Since most of the debtholders are hedge funds, they lose too -- even if they get paid first. Hedge funds are reporting monthly results to their investors. When everything is going fine, the debtholders report great results to their shareholders (the interest rate divided by 12) and at extremely low volatility. When debt is impaired (i.e., there is a default), the dreaded word "writedown" is used. Nobody wants to see or hear that word. So both the company and the debtholders will do anything they can to avoid the writedown word.

In effect, the bondholders extended the runway to Bally's and changed the terms so that it would actually be harder for the company to default. In exchange, Bally's gave them some money. It's win-win -- unless Bally's doesn't work through its financial reporting problems by Nov. 30.

Bally's has at least temporarily solved the problems with debtholders. And equity holders have now seen that the debtholders will do whatever it takes to avoid bankruptcy. My guess is sometime soon we'll hear the next word from Liberation as to how they suggest the company modify its operations now that the issue with the debtholders has been resolved. And with Pardus talking to Liberation and accumulating shares as high as $3.93, my guess is they're expecting more than a gain of 13 cents.

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James Altucher is a managing partner at Formula Capital, an alternative asset management firm that runs several quantitative-based hedge funds as well as a fund of hedge funds. He is also the author of

Trade Like a Hedge Fund


Trade Like Warren Buffett. At the time of publication, neither Altucher nor his fund had a position in any of the securities mentioned in this column, although positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Altucher appreciates your feedback;

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