For companies shunned by commercial bankers, this is welcome news. Indeed, among the most prominent borrowers have been Krispy Kreme, Calpine, and Goodyear. But borrowers have reason to be wary, too. Unlike banks, which presumably have a vested interest in their clients’ financial health, hedge funds may have other motives, such as profiting from a forced restructuring if the borrower falls behind on its loan. In recent months, several funds have been accused of conflicts of interest because they were privy to confidential information about their borrowers yet continued to trade their securities.
Such trading may be benign — hedging a loan with credit default swaps, for example. But other times, the trading may be more worrisome to a CFO, as in cases in which the hedge fund is shorting its borrower’s stock or engaging in convertible-bond arbitrage, a strategy that can push stock prices lower. “I never see a hedge fund simply go into a deal as lender without something else going on behind the scenes,” says Steven Adelkoff, a complex finance partner in the New York and Pittsburgh offices of Kirkpatrick & Lockhart Nicholson Graham LLP, which represents hedge funds and other investment managers. The reason, he says, is that the margins from lending are too slim for hedge funds; thus the funds have great incentives to seek better returns by trading in the company’s debt or equity.
In November, the Securities and Exchange Commission said it was investigating possible insider trading by hedge funds in instances in which representatives had secured seats on creditors’ committees during bankruptcies. In 2004, the SEC accused Blue River Capital LLC of using confidential information to trade in shares of WorldCom, Adelphia, and Globalstar. The SEC said the hedge fund obtained the information while sitting on the bankrupt companies’ creditors’ committees. Regulators fined Blue River $150,000 and barred it from trading for six months. The hedge fund, which had been operating out of a basement in Manhattan, is now defunct.
Hedge funds’ dual role as lender and trader is also becoming a point of contention among lenders. Last year, Silver Point was accused — and later cleared — of trading on confidential information it had obtained as a member of the creditors’ committee of FiberMark, a specialty-materials manufacturer in Brattleboro, Vermont, which had filed for Chapter 11. According to a court-appointed examiner, two other creditors, AIG Global Investment and Post Advisory Group, had made the accusation to gain the upper hand in a scuffle over who would control FiberMark after bankruptcy.
There is another risk for companies: that a hedge fund could use a loan as a back door to an eventual takeover, a tactic known as “loan-to-own.” During a bankruptcy, a creditor holding a lien can typically negotiate to swap debt for a stake in the company. If the company retires its existing equity — typically worthless by the time of bankruptcy — the creditors become the new owners. “They can basically kick out the shareholders and take over the company,” says Bill Lenhart, national director of financial recovery services for BDO Seidman LLP, an accounting and consulting firm based in Chicago.