No Loan Sharks Here
Hedge funds may be more ruthless taskmasters than banks when borrowers run into financial difficulties. That’s the case with Calpine, one of the nation’s largest power producers, which declared Chapter 11 bankruptcy in late 2005. Earlier that year, Harbert Distressed Investment Master Fund, a New York–based hedge fund, sued Calpine twice for violating its debt covenants.
Some hedge funds are taking steps to reassure potential borrowers that they are not, in fact, loan sharks. Silver Point promises its clients that it does not engage in “loan-to-own” deals, and its policy is not to use loans to benefit a position in a public security. Even so, “you need to have your eyes open” when borrowing from hedge funds, cautions Chuck Bralver, executive director of Mercer Oliver Wyman, a financial consultancy in New York. He suggests CFOs investigate whether a fund has a position in the company’s stock before borrowing. He also advises borrowers to investigate funds’ lending histories and ask for references from other CFOs.
Tough negotiating may help protect a borrower’s interests. Rob Rosenblum, of the Washington, D.C., office of Kirkpatrick & Lockhart Nicholson Graham, says in some cases a borrower can convince a hedge fund not to short its stock during the life of the loan. But many of these borrowers are in no position to be choosy. “Most of the companies turning to hedge funds are starved for cash,” says Lenhart. “The problem is, most borrowers don’t realize that when things go wrong, it’s not going to be like dealing with traditional lenders.”
Still, hedge-fund money may fit neatly into a company’s capital structure at a crucial moment, providing a bridge to the next stage of development. This is how CFO Neely views Trident’s $450 million in second-tier loans from a syndicate of hedge funds and other investment groups. “This allows us to have a floating structure,” he says. “Although there are penalties to pay off the debt early, we can do that as things improve.”
Don Durfee is research editor of CFO.
Reining In Hedge Funds
The SEC imposes new rules on the booming hedge-fund industry.
Ever since hedge funds first appeared in the 1950s, the business has been the untamed frontier of the financial industry. But as with most frontiers, it was only a matter of time before the federal marshals rode in to impose some order.
February 1 marks the official start of the crackdown. That’s when the Securities and Exchange Commission will require hedge funds to register as investment advisers. Under the SEC’s new rules, funds will have to establish policies and procedures, hire chief compliance officers, and open their books for inspection by the agency, if asked.
It’s not hard to understand why regulators want to pry open this secretive business. With an estimated $1 trillion in assets, hedge funds are a powerful, if lightly regulated, force in financial markets. Recently, they’ve been jumping into new lines of business such as commercial loans and credit derivatives. A series of scandals last year seemed to confirm the worry that light oversight breeds mischief. “The SEC was embarrassed by the mutual-fund market timing scandal, and can’t afford a blowup on this side of the industry,” says Michael Caccese, a securities lawyer with Kirkpatrick & Lockhart Nicholson Graham LLP in Boston.
Will regulation have an impact on the freewheeling funds? That’s debatable. The rules leave at least one yawning loophole: any fund with a two-year lockup period can avoid registering. (A lockup bars investors from withdrawing their money from the fund for two years.) Several of the most prominent firms have said they will take advantage of the loophole, among them Cerberus Capital Management in New York, Citadel Investment Group in Chicago, and SAC Capital in Stamford, Connecticut.
Indeed, critics say the main effect of the rules will be to increase costs for the industry. Those costs are likely to fall mainly on new funds that haven’t established a successful track record and thus can’t afford to impose a lockup period on investors.
But Janaya Moscony, president of SEC Compliance Consultants in Philadelphia, argues that the new requirements will force hedge-fund managers to get serious about internal controls. “There are clearly advisers out there who just don’t know the rules,” she says. A former SEC staff accountant, Moscony believes the agency will intensify oversight if it finds that many funds are avoiding registration. — D.D.