Meet Your New Bankers

Trident Exploration Corp. needed money last year, and lots of it. Based in Calgary, Canada, the privately held company extracts natural gas from coal, but its business is too early-stage for most commercial bankers. So Trident turned to a new breed of lender, a group that includes several hedge funds, for a second-lien loan, an expensive but flexible form of subordinated debt.

"These deals have allowed us to tap a much larger amount of capital from the debt markets than we would have been able to otherwise," says Trident CFO Randy Neely. Trident says it will use the $450 million it borrowed for two huge development projects in western Canada.

As commercial bankers tighten the purse strings, more and more companies are turning to a vast and volatile source of financing: hedge funds. Over the past five years, in fact, hedge funds have become a key player in capital markets, specializing in high-risk loans to the financially distressed. Consider one measure of their power: hedge funds dominated the $15 billion market for second-lien loans in 2005. Standard & Poor's LCD estimates that market has grown more than 10-fold since 2002. Hedge funds also are broadening their portfolios with first-lien loans and revolving lines of credit. Some are even lending to start-ups whose founders don't want to dilute their ownership by seeking money from venture capitalists.

With $1 trillion in assets, hedge funds see high-risk lending as a profitable new line of business. Frustrated by low returns in equity markets and eager for new places to invest their cash, they first began dabbling in distressed debt in the late 1990s and early 2000s. New York hedge-fund giant Cerberus Capital Partners was one of the first to get into banking when it opened a lending unit in 1998. Now, dozens of hedge funds are plying the trade. Among the largest are Silver Point Capital LP, Fortress Investment Group LLC, and Golden Tree Asset Management LP, based in Greenwich, Connecticut, New York, and New York, respectively.

Lightning Speed
Hedge funds have one clear advantage over commercial banks: they process and approve loans with lightning speed. That was an important factor for DMX Music Inc., of Austin, Texas, which recently borrowed $62.5 million from Silver Point. "We had a window of opportunity to buy a key asset," says Paul Stone, CFO of DMX, which provides digital music programming to businesses. "We needed fast and certain execution for the financing." Silver Point agreed to the loan in only two weeks.

Hedge funds may charge borrowers interest rates of 14 percent or more, double the rate banks charge their better corporate customers. But most borrowers don't balk. That's because the lightly regulated hedge funds are more willing to take chances on risky ventures and structure deals creatively. In Texas, for instance, hedge funds are providing millions in loans to the oil and gas industry; the deals typically come with an equity kicker that could pay off big if the company goes public or gets bought. Banks get nervous when borrowers have debt levels that exceed three times cash flow; hedge funds are used to high-risk action. "Banks have grown more risk-averse," says Charles Gradante, managing director of The Hennessee Group in New York, which advises clients on their investments in hedge funds. "Now we're seeing the hedge funds replacing banks" in the high-risk loan market.

For companies shunned by commercial bankers, this is welcome news. Indeed, among the most prominent borrowers have been Krispy Kreme, Calpine, and Goodyear. But borrowers have reason to be wary, too. Unlike banks, which presumably have a vested interest in their clients' financial health, hedge funds may have other motives, such as profiting from a forced restructuring if the borrower falls behind on its loan. In recent months, several funds have been accused of conflicts of interest because they were privy to confidential information about their borrowers yet continued to trade their securities.

Loan-to-Own?
Such trading may be benign — hedging a loan with credit default swaps, for example. But other times, the trading may be more worrisome to a CFO, as in cases in which the hedge fund is shorting its borrower's stock or engaging in convertible-bond arbitrage, a strategy that can push stock prices lower. "I never see a hedge fund simply go into a deal as lender without something else going on behind the scenes," says Steven Adelkoff, a complex finance partner in the New York and Pittsburgh offices of Kirkpatrick & Lockhart Nicholson Graham LLP, which represents hedge funds and other investment managers. The reason, he says, is that the margins from lending are too slim for hedge funds; thus the funds have great incentives to seek better returns by trading in the company's debt or equity.

In November, the Securities and Exchange Commission said it was investigating possible insider trading by hedge funds in instances in which representatives had secured seats on creditors' committees during bankruptcies. In 2004, the SEC accused Blue River Capital LLC of using confidential information to trade in shares of WorldCom, Adelphia, and Globalstar. The SEC said the hedge fund obtained the information while sitting on the bankrupt companies' creditors' committees. Regulators fined Blue River $150,000 and barred it from trading for six months. The hedge fund, which had been operating out of a basement in Manhattan, is now defunct.

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