Bank Said No? Hedge Funds Fill a Void in Lending

Date: Thursday, June 9, 2011
Author: Azam Ahmed, DealBook

Hedge fund managers have been called plenty of names.

Now, they can add another: local banker.

When Rentech, a clean energy business in Los Angeles, was rejected by its long-time banker last year, it asked a hedge fund for money instead. “You have to take what’s available at the time,” said D. Hunt Ramsbottom, chief executive of Rentech, which has since borrowed $100 million in this unconventional way.

With traditional lenders still avoiding risky borrowers in the wake of the financial crisis, hedge funds and other opportunistic investors are stepping into the void. They are going after midsize businesses that cannot easily raise money in the bond markets like their bigger brethren.

The support is critical in a recovery characterized by high unemployment and anemic growth. These middle-market companies, which generate $6 trillion in revenue a year and employ 32 million people in the United States, are borrowing billions of dollars from the hedge funds for product development, strategic acquisitions and even day-to-day operations like payroll and utilities.

But the lending force also poses a significant risk to the companies and the broader economy, given the unregulated nature of this shadow banking system.

These lenders of last resort typically charge interest rates that are several percentage points higher than banks. Loaded up with high-cost loans, borrowers could find themselves falling deeper into debt or worse, into bankruptcy. Over the last year, Rentech has borrowed from a group of funds, led by Highbridge Capital Management and Goldman Sachs, at an interest rate of 12.5 percent.

“On the one hand, the cost of money is more expensive than what some businesses might be used to,” Mr. Ramsbottom said. “On the other, if the money is not available, the cost is infinite.”

The lending activity is also stoking fears that speculative activities — like those that contributed to the crisis — are shifting from banks to loosely regulated firms that play by their own rules. While policy makers are moving to increase capital and other standards for banks to prevent another disaster, hedge funds and the like are not subject to the same oversight.

If firms load up on debt and the market goes into a tailspin again, the shadow banking system could implode and threaten the entire economy.

“These institutions are essentially servicing a part of the market where banks are not lending,” said Debarshi Nandy, a professor at York University’s business school in Toronto. “The million-dollar question is, Are we benefiting?”

Hedge funds offered a crucial lifeline for Rentech. The company is hoping to build a facility about 60 miles east of Los Angeles to transform yard clippings into fuel, enough for 75,000 cars. If it works, the project would represent Rentech’s first commercial success in its nearly 30-year history.

Unprofitable for decades, Rentech is a risky proposition for a traditional lender. While large corporations with healthy balance sheets can easily tap into the bond markets or borrow from banks, their smaller counterparts with shakier credit have fewer options.

Middle-market companies, with revenue of $25 million to $1 billion, do not typically sell bonds. And their main financing sources, specialty lenders like CIT Group and regional banks, have not fully recovered. Last year, debt securities focused on this segment stood at $12 billion, down from $35 billion in 2005, according Standard & Poor’s Leveraged Commentary and Data.

Hedge funds and other investors are flush with capital. Last year, Highbridge, which is owned by JPMorgan Chase, started a $1.6 billion fund that lends money to midsize companies. The private equity firm Blackstone Group started a $3 billion fund. Even FrontPoint, the firm hobbled by an insider trading investigation, has raised $1 billion for a lending fund and plans to double the size, according to a person with knowledge of the matter.

The concern is that hedge funds are looking for quick payoffs rather than long-term opportunities — and will bolt if there is trouble. A previous wave of money managers that jumped into lending after the collapse of Lehman Brothers in 2008 saw their loans sour. The firms, mainly smaller, fringe players, have since disappeared.

“The new funds rushing into direct lending now will learn the hard way that it is easy to make what appear to be sound loans as the economy is improving, but it becomes brutal to either collect the loans or foreclose when the downturn comes,” said Max Holmes, the founder of Plainfield Asset Management, whose lending-focused fund, once as large as $5 billion, is winding down.

Unlike their predecessors, players today say they are operating like community bankers, focusing on multiyear deals backed by significant collateral and capital. They are also locking up investors’ money for years rather than quarters. This can alleviate some short-term pressures.

“The people who last are those with a relationship-oriented business, not those who view it as a trade,” said Rob Ladd of D. E. Shaw, which manages $1.7 billion in lending strategies.

Stephen J. Czech of FrontPoint spent weeks researching Emerald Performance Materials. He scoured the chemical manufacturer’s financials, visited several facilities, and met with executives — all of which gave him the confidence to lend the company money.

Emerald used the loan to buy a European rival. “All types of financing were considered,” said Candace Wagner, Emerald’s president, but the company preferred the “flexibility and certainty” of FrontPoint.

Some who borrowed from hedge funds have not been so satisfied. Hedge funds have been lumped with payday lenders that charge usury rates. Plainfield has been accused of predatory lending in civil suits, and local and federal authorities have looked into the firm’s practices. Plainfield said it won or settled all of the suits and investigators closed their inquiries without taking action.

The creditors of Radnor Holdings, a disposable-cup company that defaulted on a roughly $100 million loan, claimed Tennenbaum Capital Partners charged excessively high rates as a takeover tactic, a strategy referred to as “loan to own.” After a protracted legal battle, the fund took control of Radnor in 2006, renaming it WinCup.

Tennenbaum did not return calls for comment.

Another worry is that funds will trade on nonpublic information they receive as lenders. A March study in The Journal of Financial Economics found a spike in investors betting against the shares of companies that took hedge fund loans. Businesses that borrow from banks did not experience the same activity, according to the authors, including Professor Nandy.

For Mr. Ramsbottom of Rentech, the benefits outweighed the risks. While the company could end up losing the profitable fertilizer plant it put up as collateral on the loan, Rentech can continue to pursue the clean energy venture.

“An entrepreneur will pay whatever,” he said, “to keep his business alive.”