Falcone Hedge-Fund Losses Spur Shell Company's Search for Lasting Capital

Philip Falcone, the hedge-fund manager under fire from clients for tying up their cash in a wireless network and other hard-to-sell assets, plans to help finance such bets in the future by selling stock and bonds through a publicly traded shell company.

Harbinger Group Inc., a onetime oil driller that Falcone’s hedge funds took over last year, raised $350 million this week by selling five-year debt at a yield to maturity of 11 percent. Falcone plans to use the company’s cash and ability to issue stock to buy controlling stakes in industries from agriculture to telecommunications, according to a filing this month.

Ranked among the top hedge-fund managers in early 2008, Falcone made concentrated bets in iron-mining companies and power producers that tumbled during the financial crisis. He put 15 private-equity holdings in a segregated account to avoid selling at distressed prices. After losing about two-thirds of assets under management, in part through client defections, Falcone is looking for alternative ways to finance controlling investments.

“It sounds like a backward way to get permanent capital,” said Daniel Celeghin, a partner at Casey, Quirk & Associates LLC, a Darien, Connecticut, management consultant to investment advisory firms. “Here is a pool of money you can manage indefinitely and you don’t have to worry about redemptions.”

11% Yield

Harbinger Group’s bonds, due in November 2015, have a 10.625% coupon and were sold at 98.587 cents on the dollar to yield 11 percent, according to data compiled by Bloomberg. The average high-yield, high-risk bond has a yield to maturity of 7.82 percent, Bank of America Merrill Lynch index data show. The riskiest debt, rated CCC and lower, yields 11.48 percent.

The shell company’s shares have declined 38 percent this year, and have lost a quarter of their value since the end of August. Shareholders include Legg Mason Inc.’s Royce & Associates LLC and River Road Asset Management, a Louisville, Kentucky-based asset manager acquired this year by U.K. insurer Aviva Plc.

Traditionally, hedge funds have raised money by selling limited partner units to investors and entering into margin loans or repurchase agreements secured by their investments. Both forms of financing are more temporary in nature: investors can sell limited partner interests back to a fund on a quarterly or annual basis, and lenders can demand repayment or sell the funds’ collateral should its market value decline.

Wireless Bet

Making investments through a publicly traded company allows Falcone to raise more permanent capital through bond and stock sales, supplementing funds from institutional investors that can be redeemed. It may also make it easier to meet redemption requests by using the shell company’s shares to pay investors, rather than having to divest the underlying, illiquid assets, said David Guin, head of the U.S. securities practice at law firm Withers Bergman LLP in New York.

“Harbinger Group Inc. was not acquired to be a mechanism to deal with Harbinger Capital fund redemptions,” said Jeffrey Zelkowitz, a spokesman for Harbinger. “Rather, HGI is a permanent capital vehicle to house longer-term controlling equity stakes in companies that operate across a diversified set of industries.”

Falcone, 48, has angered some clients by tying up about 90 percent of his flagship Harbinger Capital Partners Fund and more than half of the Special Situations Fund in wireless- telecommunications investments, as of September. The hedge-fund manager is trying to build a multibillion-dollar private wireless network that would wholesale high-speed Internet connections to companies that want to provide their customers with services tied to the Web.

Goldman Pulls

Advantage Advisers Management LLC said in a June 8 regulatory filing that it was redeeming a stake in the flagship Harbinger Capital Partners Fund because of a “mismatch” between the liquidity offered investors and the liquidity of the Harbinger Capital Partners’ underlying investments.

Goldman Sachs Group Inc. plans to pull its entire $120 million investment from Harbinger Capital Partners following a 15 percent decline through mid-October and the disclosure that Falcone borrowed money from a fund to pay his personal taxes, according to people briefed on the plans.

Harbinger Capital Partners began to embark on a different financing strategy in July last year, when three of its hedge funds paid $74 million to acquire a 51.6 percent stake in Zapata Corp. from the family of financier Malcolm Glazer. Falcone reincorporated Zapata as Harbinger Group in December and later moved its headquarters to Manhattan from Rochester, New York.

‘Long-Term Holdings’

The company, co-founded in the 1950s by former U.S. President George H.W. Bush as an oil drilling contractor, no longer has any operating businesses. As of Sept. 30, its assets included seven employees, about $139.9 million in cash and Treasuries, and a listing on the New York Stock Exchange.

Under a formal investment management agreement in March, Harbinger Capital will use the shell to obtain “controlling equity stakes” in companies that operate in six industries, including consumer products, insurance and financial products, telecom, agriculture, power generation and water and natural resources, according to a Nov. 1 filing with the U.S. Securities and Exchange Commission.

“Our corporate structure provides significant advantages compared to the traditional hedge-fund structure for long-term holdings,” Harbinger Group said in the Nov. 1 SEC filing. The company’s corporate structure also provides additional options for funding acquisitions, the filing said, “including the ability to use our common stock as a form of consideration.”

Spectrum Brands

Falcone doesn’t plan to use Harbinger Group to finance LightSquared Inc., the company building the wireless phone network, Zelkowitz said.

The Harbinger hedge funds plan to swap most of their majority stake in publicly traded Spectrum Brands Holdings Inc. for an additional 119.9 million Harbinger Group shares, a move that will leave them holding 93 percent of its common stock. After the share swap, Harbinger Group would hold Spectrum Brands shares with a market value of about $767 million along with the company’s cash.

Harbinger Group needed to start making acquisitions because the NYSE notified management in August that the shares could be delisted unless it has an operating business by May 2011, according to the quarterly report filed with the SEC on Nov. 9.

According to an Oct. 8 SEC filing, Harbinger Capital’s flagship fund offered to assign the shell company its right to buy the U.S. life insurance unit of Old Mutual Plc, a $350 million deal that was announced in August. Harbinger Group considered financing the acquisition through bank borrowings or the sale of high-yield bonds or convertible preferred stock.

Citadel, KKR

On Oct. 22, Harbinger Group reported that the company and the hedge fund had jointly decided not to transfer the rights to the buyout.

There have been few other moves by hedge funds to lock in long-term financing, in part because redemptions were rarely a problem before the credit crisis, according to Celeghin.

Ken Griffin’s Citadel Investment Group LLC sold $500 million of five-year notes to investors in 2006, in the first- ever sale of bonds by a hedge fund. The sale may have helped the Chicago firm reduce dependence on financing from Wall Street investment banks.

Private-equity firms, which invest in hard-to-sell assets, have in the past sold shares in funds that are then listed on an exchange, requiring investors who want to cash out to sell their stock on the open market rather than selling it back to the fund at net asset value.

Redemptions

Kohlberg Kravis Roberts & Co., now KKR & Co. LP, raised $5 billion in 2006 by selling stock in a private-equity fund that traded on the Euronext Amsterdam exchange until last year. For KKR, the fund was the first step in becoming a public company. The firm last year merged with the public fund and this year moved its listing to the New York Stock Exchange.

“It wasn’t until 2007 when everything became illiquid and everybody wanted out that hedge funds had a problem,” Celeghin said.

Investors sought to pull almost $300 billion out of hedge funds between Oct. 1, 2008 and June 30, 2009, according to Chicago-based Hedge Fund Research Inc., forcing managers to sell illiquid assets at depressed prices or block redemptions.

Harbinger was hit particularly hard. During the third quarter of 2008, when the benchmark Standard & Poor’s 500 Index dropped 8.9 percent, Falcone sold $4.1 billion of stock in his hedge funds by reducing or eliminating stakes in 15 companies.

LightSquared

That November, Falcone considered having his flagship fund purchase almost 20 million Calpine Corp. shares from the Special Situations Fund. Harbinger ranked as the power producer’s largest stockholder at that time, with a 25 percent stake.

Falcone is liquidating about 80 percent of the $2 billion Special Situations Fund, which holds a chunk of the LightSquared investment, at the request of clients, investors say. Falcone has been trying since June to raise $1 billion to $1.5 billion for LightSquared from investors who would be willing to commit capital for several years, according to potential investors who have seen the marketing documents.

The New York-based firm’s overall assets have declined to about $9 billion, as of September, from $26 billion in mid 2008.

To contact the reporter on this story: Miles Weiss in Washington at mweiss@bloomberg.net

To contact the editor responsible for this story Christian Baumgaertel at cbaumgaertel@bloomberg.net.

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