Having it both ways

Private equity investing relies on the tenets of free market economics. It thrives in economic, fiscal and regulatory environments that project flexibility and a laissez-faire approach to entrepreneurialism. It is most perverse, therefore, that buyout firms should be pushing to have their banks create documentation preventing the transfer of assets in portfolio companies to hedge funds.

Hedge funds have very quickly become the bêtes noires of financial sponsors. Is the paranoia they’ve been exhibiting around the whole issue turning to some sort of industry-wide psychosis? Why on earth would banks want to exclude hedge funds from secondary-market sales? Such rigidity would impose ridiculous controls on liquidity and asset values.

The essence of open-market economics is that the market sets the price. As value investors themselves, buyout shops intimately understand this concept. Could they possibly be supporting the notion of price controls or artificial prices by introducing implausible market rigidities?

More chillingly, could they possibly be contemplating withholding future business from banks, in effect blackmailing them into sitting on assets if there is no bid from real money or non-fast money accounts?

If nothing else, transfer restrictions in documentation can easily be circumvented, and policing it would be close to impossible. Trading sub-participations in the loan market has been going on for years; agent banks and companies rarely know what’s really going on because no-one needs to request formal assignments.

The reality is that hedge funds dominate the global credit markets in the current cycle. They represent a huge source of liquidity, and the price discipline they introduce can’t be ignored. In deteriorating, distressed or restructuring situations, they are invariably the only bid. They take the time to understand credit situations, capital structures and recovery values. And their risk parameters are set much wider than mainstream institutional players.

Buyout firms have had it their way for far too long. Leveraged finance bankers routinely acknowledge they’re being taken for a ride and are powerless to retain any real upside value in dealing with sponsors. The question is: how long will it be before the banks run out of patience?

Here’s the ultimate reality: hedge funds pay banks multiple times the amount of fees paid by buyout firms. Some of the more progressive investment banks are starting to structure themselves around the requirements of their hedge fund clients.

If financial sponsors insist on transfer restrictions, there is every sign that the market could be headed for a major confrontation. And at this juncture, it’s hard to say how it will turn out.