New Role for Hedge Funds: Lending Money

Date: Tuesday, January 6, 2009
Author: Bruce W. Fraser, Marketsmediaonline.com

With banks and other traditional lenders sitting on the sidelines in the credit crunch and refusing to lend, hedge funds, funds-of-funds, and other alternative investors are stepping in to fill the financing void. Today, they are hard-money lenders to scores of businesses in need – de facto lenders of last resort.

The lending is much broader than transactions involving commercial real estate, though these are among the most common. Hedge funds are providing asset-based financing for a variety of transactions, involving both large and small businesses, loans to private equity and other hedge funds, fund formations, venture capital and real estate firms.

Right now the biggest players are hedge funds which view the lending as a way to diversify their portfolios during a time of economic tumult while collecting double-digit returns. Many funds charge interest rates double what a conventional bank would charge. The universe of funds currently involved in lending is relatively small, but it promises to widen in coming months as more banks curtail lending.

“We're lending to extraordinarily good credits right now. The complete shutdown of lending by many money centers, traditional lenders and regional banks has allowed us to lend on very favorable terms (as it has with Warren Buffett). We are getting high coupons, good loan-to-value ratios, and very attractive potential equity upside. Current cash pay coupons are well in excess of 10 percent,” says Lawrence Goldfarb, chief executive officer of San Francisco-based LRG Capital Group, a global investment, banking and advisory boutique, and portfolio manager of its hedge fund subsidiary, LRG Capital Funds. The firm has been lending capital since 1998.

“There's a real situation now in which borrowers of almost any kind are unable to get financing, and these aren't just speculative borrowers. They're solid borrowers who would normally be borrowing from banks, but because of the credit situation are unable to do so,” says Ben Shoval, managing director of Ambit Funding, a Wilkes-Barre, Pa., firm that has dedicated $250 million in two hedge funds toward commercial real estate lending. “We're essentially filling the necessary role in the credit market that nobody else is willing to fill.”

Recently, the firm made an $11 million loan to a large New Mexico developer who had commitments in place from several big box stores, but the bank had pulled out at the last minute. “We were able to step in and provide short-term financing that will allow them to get over the hump until they're able to get a bank loan,” says Shoval.

Terms were highly favorable. “This is a first position mortgage,” says Shoval. “Our collateral is at 38 percent loan-to-value and we have it personally guaranteed by all the principals.”

“We're seeing the acceleration of a trend of evolution in the hedge fund industry,” says Ken Heinz, president of Hedge Fund Research in Chicago. Today, as many as 145 funds specialize in fixed income or asset-based securities, 154 funds concentrate on distressed assets and 58 specialize in alternative yield assets, according to HFR. Of these, approximately 140 hedge funds focus on a combination of distressed asset and fixed income securities lending, and also provide commercial real estate lending.

Often, transactions involve hedge funds not only originating new high quality debt, but funds buying bad debt from banks themselves. Michael Gray, head of the fund formation and investment management practice group at Chicago law firm Neal Gerber & Eisenberg LLP, says: “I've got some clients who are buying debt from banks. Some are doing new money; some are buying the actual paper at a discount. The bank loaned about $25 million, and they're buying (the debt) for $10 million.”

Big Opportunities for Investors in Distressed Assets

Gray points to the recent popularity of distressed securities and increased vulture investor activity as the driving force behind much of this lending. “Most of the situations do have some level of distress,” he says. Collateral can be most anything – accounts receivable, inventory, equipment, real estate, intellectual property. One hedge fund client, Gray says, even made a loan based on the trademark of the retailer, which had significant value.

Liquidity at a Cost

Gray feels hedge funds are providing a legitimate contribution to the business landscape, because they offer financing when no one else will. However, the terms that they negotiate are much more aggressive than with traditional financial institutions. Returns range from 10 percent to 12 percent, or more.

Ambit Funding, for example, typically gets 13 percent, plus two points up front on its loans and two points on exit, according to Shoval.

To be sure, there are risks such as potential defaults. The softening economy remains a serious threat. But the hedge funds say they are protecting themselves by being highly selective. “Only two to three deals get done a month, out of a much larger universe of potential deals,” says Goldfarb.

Gray feels that distressed assets, the basis of much of the lending, are going to be a huge area of activity for hedge funds until traditional sources of funding come back. That could be one to two years or more, he says.

“You're dealing with turnaround situations and distressed situations. There's always more risk than if you have a nice company that has been plugging and chugging along for 20 years with the same revenue and profitability,” says Gray.