Hedge Funds Poised To Show Their True Colors

During the last five years, with debt plentiful and cheaply priced, Carl Thoma often sounded a note of caution.

Thoma, whose Chicago-based firm Thoma Cressey Bravo is about to begin raising its ninth fund, had been through a credit cycle or two. And he made a habit of shunning hedge-fund creditors for fear of how they would behave on the way down from the peak.

“I’ve never thought of hedge funds as being patient money,” Thoma said. “Hedge funds think of themselves as investors, not lenders. When things slow down, you want to do business with an investor who’s worked in a slowdown.”

Thoma Cressey isn’t alone in being wary of hedge funds. In recent years, many buyout shops signed credit agreements that prevented banks from syndicating loans to hedge funds that had proven to be unacceptably unforgiving lenders, or ones known for loan-to-own strategies.

“The practice of blacklisting certain potential lenders has become reasonably common in senior loan syndications,” said Lawrence Golub, president of Golub Capital Management, a New York mezzanine-fund manager. “There’s a solid core of players that have received multiple black balls.”

To be sure, hedge funds, with their thirst for bank loans and high-yield bonds, and willingness to back some deals that banks wouldn’t touch, played a leading part in fueling the recent buyout boom. The second-lien loan market, which is dominated by hedge funds and hardly existed before 2005, now accounts for more than $35 billion of outstanding debt, according to Standard & Poor’s Leveraged Commentary & Data.

Hedge funds have bought into mega-deals through syndicated second-lien loans and have been ust as active as debt originators in the middle market. Prominent among these syndicated buyers and primary lenders, all of which declined to comment, are Ableco, a lending arm of Cerberus Capital Management, DB Zwirn & Co., Perry Capital and Silver Point Capital. Hedge fund trading desks also swallow up big pieces of debt. According to Greenwich Associates, a research firm, hedge fund activity accounts for the trading volume of 30 percent of high-yield bonds, 26 percent of leveraged loans and 80 percent of distressed securities.

Along with providing leverage for deals, hedge funds have also proven useful to buyout shops in other ways. As stakeholders in under-performing public companies, their agitation for change has forced a number of companies onto the auction block, providing a steady of source of deal flow. In one of the more recent examples, two Dutch hedge funds earlier this year prodded conglomerate Ahold N.V. into auctioning off its U.S. Foodservice division, while activism by hedge fund Pirate Capital eventually delivered OSI Restaurant Group into the hands of two buyout firms. Hedge funds have also stepped up to co-invest in big buyouts as antitrust threats and tapped-out limited partners cut off supply for sponsors.

But with the credit markets in retreat, the big question on the minds of buyout shops is what kind of debt investors are hedge funds going to prove to be. Will they step forward in the credit crunch to continue financing buyouts on favorable terms? And what happens if portfolio companies start to struggle? Can LBO firms expect their hedge fund creditors to be partners or vultures? “Whether or not hedge funds deserve a bad rap or some negative bias remains to be seen,” said an executive at one large finance company. “There’s been so few defaults or work-outs.”


It’s tempting to view hedge funds as the “bogeyman,” said Terry Mullen, managing director of mid-market firm Arsenal Capital Partners. But at least for his firm, it’s simply not true. If other firms have “had a bad experience with hedge funds, it’s because they had a badly performing company,” Mullen said. “It’s not the lender’s fault. It’s the sponsor’s fault.”

New York-based Arsenal Capital counts among its regular pool of lenders several hedge funds that other sponsors have put on their black lists. Mullen said he’s found that hedge funds have many of the same attributes that others ascribe wistfully to the bank lenders of yore. They’re sophisticated, patient and supportive. “They’re people who can appreciate the inevitable volatility that will occur across an investment hold period,” Mullen said. “If a business underperforms for some reason, and we as a sponsor can explain it to them in a way that they understand it, they’ll be patient.”

Banks, moreover, lack the same flexibility that hedge funds can bring to bear on a deal, Mullen said. One Arsenal Capital portfolio company needed to boost capital expenditures in order to take advantage of an opportunity not envisioned when the deal was signed. Banks, Mullen contended, would have offered little help because they’re large organizations with multiple tiers, credit committees and rigid formulas. Hedge funds, however, were willing to inject more money into the company. Thanks to expanded capital expenditures, the portfolio company was able to meet the growing demand of an important customer and eventually generate more cash flow, Mullen said.

One more thing hedge funds have going for them right now is the ability to lend, Mullen said. Bulge-bracket banks are still choking on the paper from bridge loans and other credit commitments that they haven’t been able to syndicate off their books. Similarly, warehouse loans—primarily coordinated through collateralized loan obligation funds—have evaporated, taking a big chunk of liquidity along with them, several sources told Buyouts.

In the meantime, Mullen said, hedge funds, mezzanine funds and other lenders who can fall back on capital collected from limited partners are still open for business. Jeff Kilrea, co-president of corporate finance at mid-market lender CapitalSource, which relies on hedge funds as partners in debt underwriting and syndication, agreed: “In this constrained marketplace, they offer liquidity. I view that as a good thing.”


It remains to be seen how positively hedge funds will be viewed as the credit crisis drags on. Already many buyout firms have scars from previous encounters.

Many of the same hedge funds pushing public companies into sales, for example, don’t let up when the deal is signed. As a result, buyout firms have often been compelled to raise their prices or offer concessions such as stub equity. In the last year alone, Bain Capital twice raised its offer prices before completing two big deals, the buyouts of OSI Restaurant and Clear Channel Communications. In some cases, hedge funds have taken part in auctions as equity sponsors themselves, providing unwanted competition for buyout shops and forcing up prices.

“On any deal, they can be on the same side or the opposite side,” said Bob Profusek, partner at law firm Jones Day in New York. “Hedge funds and private equity firms are all participating in this new capital marketplace. It’s part of the overall fabric of the deal community today.”

Unlike banks, which have a reputation for being more forgiving lenders, some hedge-fund debt investors have been quick to swoop in on ailing companies. That’s true not just of hedge funds pursuing bankruptcy-related loan-to-own strategies, but also for more passive investors. Hedge funds are often reluctant to make amendments to debt agreements, and do so only after raising interest rates or taking a fee. And despite holding long positions on debt, they may not always work to protect those interests. Two years ago, when Michigan-based Tower Automotive filed for bankruptcy, bankers involved in the deal were convinced that hedge funds holding the company’s debt and pushing the auto-parts company into Chapter 11 stood to gain from short equity positions taken against Tower, according to The Wall Street Journal.

“I’d’ rather have a bank sitting across the table rather than a 28-year-old who’s only thinking about dollars and cents,” said an investment professional at one mid-market buyout shop. The firm blacklisted several hedge-fund lenders after one of its portfolio companies hit some turbulence and the lenders were unwilling to give the company temporary breathing room. “Banks are in the business of getting their money back. They have a long-term view. They have this thing called a relationship.”

Consider what happened to companies caught in the options-backdating morass of 2006. A year ago, when public companies sorted out their options-related accounting, forcing changes to financials that sometimes went back a decade, those companies frequently delayed filing quarterly reports with the Securities and Exchange Commission. Technically, delayed regulatory filings would result in broken covenants on their corporate bonds.

Banks, conditioned to expect small hiccups from their debtors, looked the other way. Hedge funds, however, pressed the companies. In one case, a group of bondholders told UnitedHealth Group Inc. that it expected to collect the entirety of an $800 million bond issuance due in 2036 if the health insurer didn’t meet the filing deadline for a quarterly report. UnitedHealth didn’t end up paying, but other companies forced into the same situation, such as Saks Inc. and Mercury Interactive, had to pay fees to hedge-fund creditors to get them to back down.

“I don’t think private equity sponsors like having hedge funds in their loans,” said Robert Polenberg, director of Standard & Poor’s Leveraged Commentary and Data. “Hedge funds tend to be very opportunistic. They don’t want to work with the companies.”