How is a hedge fund like oxygen? You get too much, it makes you high: not enough, and well, you know... A key theme of the institutionally oriented panel in Atlanta on March 31, 2005 was living with hedge funds as credit partners. According to our distinguished panel, hedge funds can be your new best friend when you are trying to exit a credit, or raise capital for exit financings or rescue funding. Since most hedge fund investments are second or even third lien structures, they can present unique challenges in a workout or bankruptcy.

These are just a few of today’s liquidity dynamics discussed by Matthew Berk from Wachovia Securities, Special Situations Group, Tom Elkins of Bank of America Strategic Solutions, Inc., Pat Flynn of GE Commercial Finance, and Rich Pulido of Prudential Mortgage Capital Company, at the recent AIRA educational program in Atlanta. Jim Decker of Houlihan Lokey Howard & Zukin (www.hlhz.com) moderated the panel. Over 50 AIRA members and guests attended the function, hosted by Alston & Bird, LLP (www.alston.com) and Houlihan Lokey Howard & Zukin at Alston & Bird’s beautiful new offices.

The panel generally characterized a “hedge fund” as any private pool of capital not subject to governmental regulation, such as banks and insurance companies. This definition was further defined as funds that tend to provide the longer-term, more junior components of the capital structure, as opposed to those who primarily trade their positions with great frequency. Many funds today originate their own investments in lieu of purchasing positions in the secondary markets. For these funds, some may really view their investment as a prelude to ownership in the event that the issuer is unable to meet its obligations.

As a market force, hedge funds have created an expanded liquidity outlet for par lenders with distressed debt. In the past, lenders with troubled credits had few alternatives to engaging in the expensive and time-consuming task of the workout process. Thanks largely to this new class of investors, more exit strategies to liquidate troubled debt now exist.

As the secondary market matures, the hedge funds have improved upon their deal structures, giving themselves stronger “negotiating value.” Examples include participating in the same credit facility, second-lien positions, and mezzanine debt.

Having hedge funds as co-creditors—rather than more traditional banking/institutional partners—may negatively impact a workout scenario, however, for, among others, the following reasons: First, the hedge fund investor is looking at the upside between its basis and face value, whereas the par lender is attempting to be made whole. Second, the consensus amongst the panel members was that, generally, hedge funds don’t always have an appreciation for the practical realities of running a business, especially one in which they don’t have current industry experience. The panelists noted that historically their greatest losses were incurred after becoming owners; a view perhaps not displayed by the hedge funds due to their newness in dealing with financially distressed businesses. Third, the panelists noted that sometimes hedge funds do not adhere to strict confidentiality about the debtor in furtherance of their effort to trade out of their debt position. Finally, the panelists noted that most regulated lenders are constrained by the need to moderate their behavior based on lender liability concerns. Since hedge funds lack regulation, there may be a greater tendency on their part to insert themselves in the company’s decision-making process. Where a hedge fund is a participant in a syndicate of creditors including regulated lenders, conflicts of approach and motivation may be difficult to reconcile.

The consensus view among the panelists was that the emergence of hedge funds as market participants has been a positive influence on the capital markets. However, the real test of their impact awaits the next downturn when many of their investments may be undergoing the workout process. Stay tuned!

Grant Stein, the MC and AIRA host for the evening, narrated a brief overview of the Senate version of the proposed new bankruptcy law following the panel discussion. While specific issues are beyond the scope of this text, some of the changes are substantial and all practitioners are encouraged to read the text. His crystal ball indicated that the House of Representatives would pass this bill, probably in its current form.

By:
Wes Pennington, CIRA
Hays Financial Consulting LLC
Atlanta, GA