Hedging Their Debts
Hedge funds find there's money to be made in lending to distressed firms and start-ups
Hedge funds have helped bring liquidity to these debt markets while driving down lending costs for some companies and giving others in a rough patch a chance to breathe. But it's not always clear that these companies should have been kept afloat, says David Feldman, a partner at the law firm Kramer Levin Naftalis & Frankel, which has many hedge funds as clients. While default rates have remained low, he says that easy access to debt, particularly second liens, "has really been a band-aid" for many companies, forestalling an eventual and inevitable fall into bankruptcy.
Even for those companies that stay afloat, owing money to a hedge fund can be trying. Salton Inc. is most famous for its George Foreman line of grills. But in the financial world, it is also famous for its contentious relationship with one of its debt holders, the hedge fund Third Point Management Co.
Traditional lenders usually don't write and then publish angry screeds about CEOs. But Daniel Loeb, Third Point's chief executive, did just that, repeatedly, when dealing with Salton's CEO, Leonhard Dreimann. In one, sent in April 2005 (and copied to the Securities and Exchange Commission, on whose website it is posted), Loeb wrote that while he was aware of Dreimann's "reputation for extravagance, poor judgment, and ... overall limitations as a manager ... it was only over time that we came to recognize the magnitude of your incompetence." Loeb then added that he looked forward to "personally dedicating my considerable energy to serving on the creditors' committee and seeking your ouster at that time."
Calpine's case. Dreimann is lucky compared with some; he's still at the helm. Executives at Calpine turned to hedge funds to prop the company up as its vast electricity-generation plans went awry. When the company began using some of the money in a way that the hedge funds believed skirted covenants written in its loan agreements, they sued. Later, two of Calpine's top executives were ousted, and Calpine was forced into bankruptcy. "Taking aggressive litigation positions, being aggressive with the company, and having the company move in the direction the hedge fund wants happens fairly routinely," notes Feldman.
Regulators see another problem: insider trading. Hedge funds, by definition, often play both sides of the fence. In these debt plays, that sometimes means they are buying a company's debt at the same time they are making a financial bet against the company's stock. Over the past few months, several hedge funds have been accused of profiting from confidential borrower information or information gained during private placements. Regulators in France, Britain, and the United States are pursuing investigations.
One U.S.-based hedge fund has already settled regulatory charges. Last year, the Securities and Exchange Commission censured Van Greenfield of the hedge fund Blue River Capital for failing to protect insider information he gained while serving on several bankruptcy committees--including WorldCom's, in the largest bankruptcy case in American history. The SEC also alleged that Greenfield had backdated two trades to gain access to the WorldCom creditors' committee and then canceled those trades once he was assured a seat. Greenfield and Blue River Capital, without admitting guilt, paid a $150,000 fine to the SEC to settle the charges.
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