By Mara Der Hovanesian As commercial banks back away from making corporate loans, a new breed of lender is stepping in: Hedge funds are providing hundreds of millions of dollars to companies whose shaky credit disqualifies them for prime bank loans or whose needs are too puny to attract big commercial bankers.But with the new source of capital come new dangers, including the possibility that hedge funds will make risky loans and exploit information gained as lenders to benefit their trading gambits.
The uncertainties haven't stopped companies from lining up at hedge-fund loan windows. SLS International (SLS), a small Ozark (Mo.) maker of audio speakers for musicians and movie theaters, struck a distribution deal in March with Wal-Mart (WMT). But to take advantage of this opportunity to break into the consumer market, SLS needed cash to build a new factory in the U.S. and pay for supplies and production overseas. Big banks "wouldn't have provided the amount of capital that we needed," says SLS President Steven Lamar. "There's only so much risk they'd take."
QUICKER ON THE DRAW. Enter hedge fund manager Lawrence Goldfarb of BayStar Capital in Larkspur, Calif., which loaned the company $8 million out of $15 million raised from several funds. Hedge funds, which are largely unregulated pools of private capital, "are able to respond quicker to the needs of public companies and with more creative terms," says Goldfarb. "And they have a lot of cash to put to work."
Funds like Goldfarb's are filling a vacuum created by consolidation in the banking business. As commercial and investment banks have combined, the resulting behemoths have favored more lucrative activities, such as advising on mergers and acquisitions, and avoided commercial lending, which sometimes leads to losses.
The banking giants still make loans to their biggest and best customers but increasingly avoid smaller and riskier deals. Bank of America Corp. (BAC) slashed its corporate loan portfolio from $110 billion in 2000 to $34 billion in 2004. For certain borrowers, hedge funds and other investment outfits not normally thought of as lenders are filling the gap. The Carlyle Group, a prominent buyout firm that has previously invested in high-yield corporate debt, announced recently that it would start making loans, too.
EVER-RISKIER TRANSACTIONS. Hedge funds and other institutional investors now provide almost 50% of the $509 billion market for riskier, high-interest rate loans to corporations. That's up from less than 20% in 2000, according to Loan Pricing Corp., a unit of Reuters (RTRSY).
One potential peril is that hedge funds will try to lure borrowers with relatively low rates, easy terms, and lax attention to creditworthiness. With barely any government oversight, fund managers inexperienced in lending may misjudge their borrowers. As a result, hedge fund investors ranging from public pension funds to wealthy individuals could face large losses.
"You cannot have ever-riskier transactions and not ultimately have repercussions," says Neal Schweitzer, senior vice-president of Moody's Investors Service Corporate Finance Group. Overall conditions in the high-yield debt world are already growing more worrisome. In the third quarter, only 41% of the ratings changes Moody's issued for high-yield paper were upgradesdown from 57% in the second quarter. Default rates are ticking up.
TRADING CONFLICTS? Lending may also create conflicts with hedge funds' trading of stocks and bonds. Unlike traditional commercial banks, which promise to protect their clients' interests, hedge funds are notorious for sometimes betting against the very companies whose securities they hold. Funds that buy the bonds of a struggling company -- a bet that the issuer will recover -- commonly hedge by simultaneously shorting the company's stock, an investment that pays off if the share price falls.
In Britain, the Financial Services Authority -- the equivalent of the U.S. Securities & Exchange Commission -- is examining whether hedge funds are illegally using sensitive private information that they gain as lenders when they trade companies' bonds and stocks.
For now, though, corporate borrowers couldn't be happier. They find that hedge funds and similar institutional investment firms are willing to cut deals quickly, without the red tape big banks require to meet regulators' demands.
The difference in interest rates is surprisingly slight. Prime loans from banks generally run 5% to 6%. Hedge funds elbowing into the corporate loan business are offering 6% to 8%, according to people in the industry. The list of companies turning to alternative lenders includes U-Haul International's parent, Amerco, Krispy Kreme (KKD), Aloha Airlines, textile manufacturer Dan River, and Salton, which makes George Foreman grills.
BOOMING MARKET. IGN Entertainment, an Internet publishing company based in Brisbane, Calif., obtained $35.5 million to pay for acquisitions from GoldenTree Asset Management, a New York firm that runs a hedge fund as well as a lending unit. "A large bank is just not going to marshal its resources for a company that needs $30 million," says GoldenTree partner Jonathan Ezrow. The firm got its money back early when News Corp. (NWS) bought IGN for $650 million this month.
Many loans made by new-breed lenders are quickly sold off, and hedge-fund money is fueling more intense trading in this secondary market. Trading of high-yield loans has increased from roughly $112 billion in 2002 to about $163 billion in the last 12 months, according to Loan Pricing. Loan prices have skyrocketed as new money has poured into the market. Nearly 50% of high-yield loans are priced above their face value, up from less than 2% in 2003.
In addition to the fear that hedge funds will be tempted to make reckless loans that could go sour when the economy slows, some observers worry that eventually the funds will simply lose interest in lending and buying loans. "Let's face it: The economy will change someday, and all these hedge funds will decide that there is someplace else they would rather be," says Darvin Pierce, executive director of Van Kampen Senior Loan Group, which manages about $6 billion in prime bank loan funds for individual investors.
DEEP POCKETS. Hedge fund managers counter that they aren't fair-weather lenders. One fund executive, who asked to remain anonymous, said: "We do an enormous amount of analysis very fast and provide these companies with rescue financing that allows them to preserve value in their businesses."
Then there are others who say hedge funds make the economy more resilient. Federal Reserve Chairman Alan Greenspan is a fan of mechanisms like loan trading that spread credit risks rather than leave banks carrying the entire burden. Glenn Yago, director of capital studies at the Milken Institute, a Santa Monica (Calif.) think tank, notes that secondary markets have made credit crunches rare. "We've absorbed a lot of disruptive credit events over the past few years -- the Asian crisis, the Russian default, the Nasdaq crisis, September 11," says Yago.
The secondary markets won't lack for loans anytime soon, as companies hard up for cash continue digging into hedge funds' deep pockets.
Der Hovanesian is BusinessWeek's Finance & Banking editor in New York