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.
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.
Despite such issues, nobody is betting hedge funds will move out of the debt market anytime soon. Their interests and those of the companies they fund are too closely aligned. Debt watchers say the real fireworks will erupt in a year or two as more companies that took such loans file for bankruptcy and hedge funds wrestle with other creditors for control of the highly leveraged assets. Of particular interest is how second-lien loans will be treated, bankruptcy lawyers say, noting that the covenants in these loans have been virtually untested in bankruptcy cases. "People will have to be more nimble going forward," says Steven Gross, chair of the Bankruptcy and Restructuring Practice Group at Debevoise & Plimpton.
Just how rough could it get? Take a look at the case of FiberMark, a Vermont-based specialty paper manufacturer. Last August, an independent, court-appointed examiner chastised three prominent firms that trade in distressed debt, including Silver Point Financial, for turning FiberMark's "simple, uncomplicated reorganization case" into a full-scale intercreditor war. Even the scheduling of meetings was fraught with "tension and recriminations," and good-faith efforts "broke down because of rigidity and intense self-interest fueled by individual rancor and distrust," the examiner found. Silver Point, which held most of the second-lien debt, won the war. But the protracted fight cost FiberMark about $60 million over the course of seven months.
FiberMark's management apparently didn't hold a grudge. Despite offers from others, the company snatched an additional $155 million in exit financing from Silver Point to ease its transition from bankruptcy back onto the market.
This story appears in the April 10, 2006 print edition of U.S. News & World Report.