Hedging Their Debts
Hedge funds find there's money to be made in lending to distressed firms and start-ups
San Francisco start-up Pay By Touch didn't take venture-capital money when it sought $130 million in new financing for its biometric fingerprint-reading system. The battered baker Krispy Kreme Doughnuts shunned banks when it wanted to refinance its debt. And the management buyout of British clothier Peacock Group didn't tap private equity shops to do the deal.
Instead, all three turned to another group of investors who were both flush with cash and quick on the draw: the nation's hedge funds and their more than $1 trillion in assets. Many of these 8,000 or so funds have been eating their way up the lending food chain and are becoming increasingly powerful forces in U.S. debt markets.
Hedge funds are providing loans for everything from small outfits, like payday lenders and start-up technology firms, to large automotive companies, airlines, and retailers. They are snapping up securitized loan bundles tailored to sate their appetite for risk, scooping up higher-risk loans on the open market, and swooping in to provide companies with bailout funds.
"These guys have a ton of cash on their hands, and they are trying desperately to put it to work," explains Rob Polenberg, an associate director with Standard & Poor's. He adds that hedge fund participation in the debt markets "has just become huge."
Corporate default rates are near historic lows, and that means "pretty slim pickings" in the debt areas traditionally traveled by hedge funds, says Prof. Edward Altman, a debt expert with New York University's Stern School of Business. But at the same time, many companies want to retire higher-yielding bonds, make acquisitions, or shore up operating funds without giving up more equity to do it. With banks shedding some of their corporate loans and becoming tighter in their lending, yield-hungry hedge funds have rushed in to exploit other areas of the debt market.
Big yields. Some hedge fund companies, like Ritchie Capital Management, have formed new divisions that focus only on direct lending. Bill DeMars, who heads the Ritchie Technology & Life Sciences Finance Division, says that hedge funds are attracted to such loans because they help diversify their investments, have had low default rates, and offer "double digit" yields. He says it's a good deal for the companies, too. Many of the firms don't generate a lot of cash flow, so traditional bankers "avoid getting involved."
Hedge funds are also continuing to take ground in the public debt markets. Standard & Poor's data show that hedge funds accounted for 12 percent of all loans allocated to institutional investors last year, compared with less than 1 percent in 2001. Some experts estimate that they now account for 70 to 80 percent of the entire volume in one popular product, a loan called the second lien, which is squeezed out of the equity left between first-lien creditors and bondholders.
The use of second-lien loans, which are seen as transitional loans and usually carry variable interest rates and shorter terms than bonds, has ballooned in recent years. They now account for $16 billion in trades, up from only $600 million in 2002. The size of individual loans has also risen dramatically. Among the beneficiaries: embattled Krispy Kreme, which took a $225 million loan backed by Credit Suisse First Boston and the hedge fund Silver Point Financial. The company said the cash would be used to pay down $90 million in other debt and provide a cash cushion.
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