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Hedge funds have a pile of cash to lend. Should you take it?
Don Durfee, CFO Magazine
February 1, 2006
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.
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.
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.
Hedge funds' dual role as lender and trader is also becoming a point of contention among lenders. Last year, Silver Point was accused — and later cleared — of trading on confidential information it had obtained as a member of the creditors' committee of FiberMark, a specialty-materials manufacturer in Brattleboro, Vermont, which had filed for Chapter 11. According to a court-appointed examiner, two other creditors, AIG Global Investment and Post Advisory Group, had made the accusation to gain the upper hand in a scuffle over who would control FiberMark after bankruptcy.
There is another risk for companies: that a hedge fund could use a loan as a back door to an eventual takeover, a tactic known as "loan-to-own." During a bankruptcy, a creditor holding a lien can typically negotiate to swap debt for a stake in the company. If the company retires its existing equity — typically worthless by the time of bankruptcy — the creditors become the new owners. "They can basically kick out the shareholders and take over the company," says Bill Lenhart, national director of financial recovery services for BDO Seidman LLP, an accounting and consulting firm based in Chicago.
No Loan Sharks Here
Hedge funds may be more ruthless taskmasters than banks when borrowers run into financial difficulties. That's the case with Calpine, one of the nation's largest power producers, which declared Chapter 11 bankruptcy in late 2005. Earlier that year, Harbert Distressed Investment Master Fund, a New York–based hedge fund, sued Calpine twice for violating its debt covenants.
Some hedge funds are taking steps to reassure potential borrowers that they are not, in fact, loan sharks. Silver Point promises its clients that it does not engage in "loan-to-own" deals, and its policy is not to use loans to benefit a position in a public security. Even so, "you need to have your eyes open" when borrowing from hedge funds, cautions Chuck Bralver, executive director of Mercer Oliver Wyman, a financial consultancy in New York. He suggests CFOs investigate whether a fund has a position in the company's stock before borrowing. He also advises borrowers to investigate funds' lending histories and ask for references from other CFOs.
Tough negotiating may help protect a borrower's interests. Rob Rosenblum, of the Washington, D.C., office of Kirkpatrick & Lockhart Nicholson Graham, says in some cases a borrower can convince a hedge fund not to short its stock during the life of the loan. But many of these borrowers are in no position to be choosy. "Most of the companies turning to hedge funds are starved for cash," says Lenhart. "The problem is, most borrowers don't realize that when things go wrong, it's not going to be like dealing with traditional lenders."
Still, hedge-fund money may fit neatly into a company's capital structure at a crucial moment, providing a bridge to the next stage of development. This is how CFO Neely views Trident's $450 million in second-tier loans from a syndicate of hedge funds and other investment groups. "This allows us to have a floating structure," he says. "Although there are penalties to pay off the debt early, we can do that as things improve."
Don Durfee is research editor of CFO.
Reining In Hedge Funds
The SEC imposes new rules on the booming hedge-fund industry.
Ever since hedge funds first appeared in the 1950s, the business has been the untamed frontier of the financial industry. But as with most frontiers, it was only a matter of time before the federal marshals rode in to impose some order.
February 1 marks the official start of the crackdown. That's when the Securities and Exchange Commission will require hedge funds to register as investment advisers. Under the SEC's new rules, funds will have to establish policies and procedures, hire chief compliance officers, and open their books for inspection by the agency, if asked.
It's not hard to understand why regulators want to pry open this secretive business. With an estimated $1 trillion in assets, hedge funds are a powerful, if lightly regulated, force in financial markets. Recently, they've been jumping into new lines of business such as commercial loans and credit derivatives. A series of scandals last year seemed to confirm the worry that light oversight breeds mischief. "The SEC was embarrassed by the mutual-fund market timing scandal, and can't afford a blowup on this side of the industry," says Michael Caccese, a securities lawyer with Kirkpatrick & Lockhart Nicholson Graham LLP in Boston.
Will regulation have an impact on the freewheeling funds? That's debatable. The rules leave at least one yawning loophole: any fund with a two-year lockup period can avoid registering. (A lockup bars investors from withdrawing their money from the fund for two years.) Several of the most prominent firms have said they will take advantage of the loophole, among them Cerberus Capital Management in New York, Citadel Investment Group in Chicago, and SAC Capital in Stamford, Connecticut.
Indeed, critics say the main effect of the rules will be to increase costs for the industry. Those costs are likely to fall mainly on new funds that haven't established a successful track record and thus can't afford to impose a lockup period on investors.
But Janaya Moscony, president of SEC Compliance Consultants in Philadelphia, argues that the new requirements will force hedge-fund managers to get serious about internal controls. "There are clearly advisers out there who just don't know the rules," she says. A former SEC staff accountant, Moscony believes the agency will intensify oversight if it finds that many funds are avoiding registration. — D.D.