New barbarians at the gates

When Bryan Burrough and John Helyar wrote their classic tale of 1980s corporate excess, eyes were on the private equity investors. While they still ostensibly drive the buyout market, their activities have been heavily shaped by the sheer volume of cheap debt backing their bids. But who is behind this wall of money and what their motivations are ought to concern institutional investors backing these bids. Whether that knowledge will cause them to shift uncomfortably in their seats, given that they are backing the equity, or the tail-end of the financial structure and so are the first to go home empty-handed if things get rocky, is a matter of conjecture. Joanna Hickey reports.

Hedge funds have stormed into European leveraged finance in the past 18 months. Yet although they are driving pricing down and boosting liquidity, some sponsors are wary of their short-term investment reputation and have banned them from their financings. However, with the growth of secondary trading and the dawn of leveraged loan credit default swaps (CDS), not only is it hard to keep hedge funds out, but traditional lenders are also now adopting a more trading-orientated approach to the market.

While hedge funds’ activities in private equity have been somewhat overstated in Europe, given the relative paucity of buyouts they have actually completed, the reverse is the case regarding their inroads into Europe’s leveraged debt markets.

In the past 18 months, hedge funds have veritably charged into par and near-par leveraged finance. Lured by the market’s huge growth over the past few years and the attractive returns on offer compared with the flat equity market, they entered high-yield first, in early 2004. Having discovered the risk-return profile of leveraged finance has considerable attractions, by mid-2004 they were buying omnivorously across the entire market, including senior debt, PIK loans and notes, second lien and mezzanine.

At least 50 hedge funds are now in the market. Most are US firms and their European offshoots, such as Amaranth, Black Ant, Cerberus, Citadel, Fore Research, Highbridge, Och-Ziff, Paloma, Satellite and Silverpoint . However, there are about 20 home-grown European funds, including Blue Bay, Brevan Howard, Cognis Capital, GLG, RAB Capital and Vega .

Although hedge funds have previously been unable to hold paper for long and many are still structured this way, some are developing a longer-term strategy that allows them to hold leveraged loans for several years if necessary. In addition to their distressed loan book, many have set up a second European bucket for this purpose.

Their buying capacity is impressive, as illustrated with Rexel’s primary LBO loan in February. Citadel took a hefty €150m ticket, while fellow hedge fund Fore signed up for €75m.

Hedge funds are making even greater headway in the par and sub-par secondary loan market, bidding aggressively and helping drive pricing ever higher; Grohe’s high 102+ print last October was attributed in part to their influence.

A favourite hedge fund strategy is buying heavily into deals that have traded sub-par for technical reasons, then waiting for them to reach par before selling again a few months later. “Hedge funds have been snapping up paper that has traded down temporarily for technical reasons. This short-term, relative value strategy has seen them make healthy profits,” says Dominic Crawley, head of European product and commercial management at Standard & Poor’s.

This strategy was seen in July with Debenhams. When the loan freed to trade, primary lender overhangs meant sellers outnumbered buyers. Pricing plunged in the days after break, with lenders selling the B/C tranches at 97.25 and the pro rata bid as low as 95. The credit is essentially sound, it has since risen to a 98+ context and is predicted to rise further, making a nice profit for those who bought on the break.

Yet hedge funds are by no means restricting their buying activities to primary and secondary senior debt. They were one of the main reasons for the high-yield market’s explosive growth last year and have also been major buyers of mezzanine; cropping up in Coral, Brenntag, Gala and Weetabix. Mezzanine’s higher pricing is nearer hedge funds’ traditional return requirements, so in some ways the paper is more attractive. Similarly, second lien, PIK loans and notes, which started to appear in Europe over the last year, have been strongly bought by hedge funds.

Although some hedge funds lost money as a result of the high-yield correction earlier this year and exited the market as a result, others, such as, rumours suggest, Bluebay, Citadel and GLG, merely sold some exposure but remain firmly in the market.

Indeed, one of the major misconceptions about hedge funds is that they act like a homogenous group. The term hedge fund encompasses an extremely diverse group of open-ended credit funds with very varied strategies. Hedge funds may have branched out into leverage finance for broadly the same reasons; to invest some of their portfolio in an asset class that, with its still ultra-low default rate and stability, still delivers relatively high yields. However, their strategies are extremely diverse.

Some funds are diving in and out of the market opportunistically, while others have a medium to long-term strategy. Some funds are only buying larger leveraged loans and cable, which also have high-yield bonds, in order to do relative-value, arbitrage trades. Arbitrage opportunities abound on deals such as CableCom, Grohe, Invensys, NTL and United Biscuits and on dual-continent syndications with dollar and euro tranches, such as KDG and NTL.

It all depends on the mandate of the fund and its agreement with its investors – some have to turn the portfolio over five times a year, others can hold paper for over three years. “We often see value in senior debt opportunities because of the lower volatility and better risk reward profile than a comparable high-yield opportunity. When you invest in these opportunities, your strategy must consider holding the paper because liquidity in the market does not support an active trading strategy,” says John Young, hedge fund at Fore Research London Office.

Surprisingly, it is not just the major LBOs that are attracting hedge funds. Some are also playing in the mid-market and below. “It’s a fallacy to think that hedge funds are just interested in big deals with high-yield bonds. We’ve seen them in small and mid-market leveraged loans,” says Jon Moulton, managing partner, Alchemy Partners.

Benefits to offer

European senior debt has traditionally been a relationship-driven, bank-dominated market. Although institutional investors have become a significant part of the market in the past five years, most of these institutions are CDOs populated by former leveraged bankers familiar to the private equity community.

Yet hedge funds are managing to crack into some primary deals. This is because, although sponsors prefer relationship-driven syndicates, some, especially the bigger US houses, cannot resist the benefits hedge funds can offer.

Firstly, hedge funds can significantly lower the cost of capital. Not only are they willing to waive upfront fees, but they also accept lower spreads, contributing strongly to the unprecedented fall in spreads this year. For example, insatiable hedge fund demand for paper is believed to be one of the reasons why Coral’s mezzanine financing in January priced at just 8%. Sponsors are using hedge funds to secure more favourable financing terms and flex down pricing post-syndication.

Also, as lower financing costs mean companies can take on more debt, hedge funds have helped drive leveraged levels up; although, as banks and CDOs are also extremely liquid, hedge funds are not mainly responsible for today’s ultra-aggressive structures.

Another significant benefit for sponsors is that hedge funds have added even more liquidity to the market and have enabled more difficult syndications to close successfully. Rexel is a case in point – after many traditional investors declined it, substantial hedge fund tickets were indispensable in propping up the deal.

Sponsor suspicions

Yet although some private equity firms are happy to let hedge funds buy their debt, many are far from enamoured with the new investor pool. In fact, many sponsors are extremely wary of hedge funds. It is hedge funds’ reputation as short-term investors and their likely behaviour during the crucial time before a company gets into serious trouble, when financial covenants need to be loosened and flexibility is required, that is causing concern.

Also, although sponsors that have let their investee companies default are used to hedge funds buying their distressed debt, it is not necessarily these same institutions that are now buying in the par market. Sponsors like familiar, predictable lenders they can control and see hedge funds as a potentially destabilising force. “If a company gets into trouble, hedge funds are far less likely than banks to work with the company and far more likely to sell out at the first sign of trouble. Sponsors like to deal with familiar faces they know they can rely on if there is a problem,” says Alchemy’s Moulton.

The fear is that, having bought at or near par, hedge funds will dump paper at the first sign of serious trouble, precipitating the paper’s fall and exacerbating the company’s woes. “Hedge funds have to mark to market and although they clearly would prefer not to sell at 98 if they bought at par, they will if they think the paper is going to trade below that for some time,” says S&P’s Crawley.

Some sponsors, including Alchemy and, rumours suggest, CVC, have prohibited arrangers from syndicating their debt to hedge funds altogether. “Hedge funds are cheaper than traditional investors, but we don’t want them buying our LBO debt because they can be a nightmare in a recap or default situation. We’d rather pay more and have no hedge funds. It’s a price issue. If you want loyalty you need to pay for it these days,” says Alchemy’s Moulton.

As hedge funds are so new to the asset class, there are few precedents to prove how they will behave down the line, so many sponsors are relying on their instincts. Hedge funds have to mark to market and, although some have a longer-term strategy and are interested in forging relationships, most are still perceived as short-term, yield-driven investors focused only on risk-return profiles, with no interest in relationships. “Although some can now hold paper, most hedge funds are not coming in to hold leveraged debt till maturity. If they buy, it is with a short timeline,” says Crawley.

Default rates remain low, but they are set to rise, as many LBO companies have been levered to the hilt in the past year. Some sectors, such as retail, are already struggling, while more and more companies are now requiring covenant waivers. Elis and Grohe completed waiver financings in June, while Global Garden Products, Kappa Packaging, Ontex, Maplin Electronics and TMD Friction are just a few credits that have needed waivers or whose performance has been worse than expected. In today’s uncertain economic outlook, it is easy to see why sponsors are so worried.

Yet it is not just potential waiver situations that are concerning sponsors. Taking a dividend out with a leveraged recapitalisation often requires consent from 100% of the syndicate. If the company is performing, banks and CDOs are usually happy to give it, in return for a nominal fee and future business from the sponsor. Yet on several occasions this year, hedge funds are reported to have demanded huge fees from sponsors for approving a recap.

As recaps are one of the ways in which sponsors have been able to return such huge sums to their limited partners over the past two years, this is of great concern. “Sponsors are concerned that they will not be able to play the relationship card and influence lenders to comply with their demands. Sponsors don’t want to be held to ransom by hedge funds, which are less relationship-driven,” says Robert Lepone, head of European loan trading at Morgan Stanley.

Investor reactions

Hedge funds are provoking similar two-sided opinions among other leveraged debt investors. Many arrangers are extremely keen to sell to them in primary, as not only can they shoulder hefty tickets, but they are cheaper and often reply much faster than the average CLO. Hedge funds have also proven to be a viable solution to syndication headaches for arrangers selling more challenging deals.

On the other hand, arrangers are directed by their sponsor clients and, where sponsors have blocked selling to hedge funds, arrangers have to be seen to comply.

Secondary traders, however, have a simple mandate to make money and expand their investor base and are unanimously encouraging hedge funds into the market, irrespective of what the sponsor is telling their primary desks. This is creating conflicts between primary and secondary desks in some banks.

Further down the food chain, most retail debt investors are unhappy about the entry of hedge funds into their market. Hedge funds are taking business away; most traditional investors report the size of their allocation has fallen significantly in the past year. This is especially the case in mezzanine, where traditional investors are unable to compete on price due to their internal return requirements. “Hedge funds are competing with traditional investors, leading to lower allocations and tighter spreads,” says Morgan Stanley’s Lepone.

Unavoidable advances

Despite the various objections of investors and private equity firms, hedge funds are nevertheless making significant inroads into the market. Sponsors may be able to block them from primary, but it is far harder to prevent them from buying in secondary.

Although some sponsors insist on transfer limitations in the loan documentation to prevent banks from trading to hedge funds, arrangers are very resistant to restrictions on their ability to reduce their exposure.

Also, banks can sell to hedge funds without sponsors’ knowledge. The first way to do this is through fronting, where banks discreetly sell to hedge funds through sub-participations. “Selling loan exposure to hedge funds through participations is one way for banks to mitigate risk and for hedge funds to gain access to the asset class without the sponsors consent,” says Morgan Stanley’s Lepone.

Another way for hedge funds to get exposure is through the credit default swap (CDS) market. The last 12 to 18 months has seen the dawn of a CDS market for leveraged loans in Europe. Although this fledgling market has been quite illiquid, with dealers all using different documentation, it has taken a leap forward in the last few months. Not only is there now a market for individual names, but Morgan Stanley has created a standard document, which is currently being introduced to other dealers.

“We have created a standardised document for trading leveraged loan CDS and have been quoting prices on up to 30 single names. Other dealers are likely to start using our document to trade as more hedge funds and banks sign into our document and the market expands,” says Morgan Stanley’s Lepone.

CDS allow investors to offload risk to hedge funds without having to notify the sponsor, but also to speculate, hedge risk and take short or long positions. The market will continue to expand as Basel II approaches, since regulatory capital requirements for leveraged debt are expected to rise. “The whole game has changed now. Secondary trading has exploded and CDS for leveraged loans has started to appear in the past year, providing another way for hedge funds to gain exposure to the asset class. Sponsors cannot dictate who buys their debt any more,” says S&P’s Crawley.

Yet hedge funds are not the only investors that sponsors should worry about having a short-term investment approach. A number of traditional lenders have ceased to behave like relationship lenders and are instead adopting a far more risk-return driven, trading-orientated approach.

Some banks and CDOs are now selling down aggressively in the secondary market. Others are declining primary invitations and keeping their powder dry for secondary if they think pricing will fall and are generally being more hard-nosed about lending. Others, mindful of the predicted rise in defaults, are boosting their CDS teams instead of their work-out teams, as their risk departments are enforcing a more proactive investment strategy.

The implication is that, although many traditional lenders will still stay with a company if it gets into trouble, others are starting to behave more like hedge funds themselves. Long-term commitment is becoming a relic of the past for many lenders. “Now that liquidity in the market has improved, some banks are taking advantage of it and they are often selling paper as well as hedge funds. Traditional banks’ long-term relationship with the borrower is becoming less important as the loan market develops,” says Fore’s Young.