RSM Resources

Some hedge funds are flush with cash but finding fewer high-yield investments. So the fund managers are seeking opportunities to finance,or invest in, midsized companies that are seeking to find new capital in tight debt markets.

This emerging trend should cause business owners and finance chiefs to consider the potential shortcomings hedge-fund loans could present.

"In many ways, this represents a marriage of convenience, because the hedge funds are looking for higher returns, and some midsized companies don’t have the risk credentials mainstream lenders require to provide funding," says Kislay (Sal) Shah, a managing director with RSM McGladrey. "If yours is a midsized company with well-established financials, I would be skeptical about partnering with a hedge-fund investor."

Many companies are taking the plunge. According to Loan Pricing Corp., a division of Reuters,hedge-fund and private-equity financing for midsized firms increased 73 percent from 2003 to 2005. Meanwhile, Standard & Poor’s reported that hedge funds supplied 12 percent of all institutional loans in 2005— up from just 1 percent four years earlier.

Hedge funds and private equity: not the same
Typically,hedge funds and private-equity groups are limited partnerships that invest in a variety of securities. But that’s where the similarities end.

Private-equity groups (PEGs) often seek well-managed companies with strong financials that may be too small to float an initial public offering or attract a larger buyer. Most often,private-equity deals channel through 10-year funds that the PEG administers as general partner. Investors join as passive limited partners. While PEGs will partner with existing company management on some deals, they also can assume control of a target company if the general partner believes the move is required to meet growth objectives.

Hedge funds gained prominence in the 1990s for their ability to identify marketplace inefficiencies and apply arbitrage techniques to balance pricing risks. For example, a common merger-and-acquisition hedge-fund strategy is to buy stock in a company targeted for acquisition while shorting the stock of the acquiring company. Assuming the share value of the target company rises while shares in the would-be suitor hold steady or dip, the hedge fund seeks to make a profit by maximizing the difference.

In today’s market, many hedge funds are seeking small to midsized firms that are cash-strapped, offer an unproven product or service, or otherwise are not a good fit for conventional lenders. Under these circumstances, the hedge fund often provides "sub-prime" or second-tier financing that a company’s cash flow — not equity — secures. These loans are often for shorter time periods and attached to higher-than-market interest rates compared with conventional financing. In exchange, a business gets relatively fast access to cash with minimal red tape or regulatory approvals.

Still, critics say the hedge-fund industry is ill-suited to such investments, since fund managers frequently take multiple positions on a company’s debt or stock to heighten overall profit potential. For example, a New York hedge-fund manager recently was ordered to pay $16 million to settle allegations that his firm engaged in abusive "short-selling" of several small-cap pharmaceutical company stocks while also handling private placements for those companies. To address concerns that the industry does not have enough oversight, the Securities and Exchange Commission (SEC) now requires managers of hedge funds with more than $30 million in assets and 15 or more investors to register as investment advisors. Previously, the SEC regarded hedge-fund managers as private advisors and exempted them from registration.

Is your business considering a relationship with a hedge fund? If so, Shah and other professionals suggest the following tips:

Screen the fund’s objectives and history. Take a close look at a hedge fund’s investment profile, with an eye toward deals it has made with businesses of size, market or industry similar to yours. If you don’t see alignment between the hedge fund’s objectives and your business, the prospective relationship may not be a good one.

Look for a focus on business lending. In contrast to many hedge funds that still focus on leverage and pricing techniques to turn a profit, a growing number of funds now are solely engaged in business lending. Shah says this approach usually takes two forms: direct lending to companies whose risk profile does not meet the needs of mainstream banks, or business loans secured by assets such as credit card receivables, mortgages or real estate. In some cases, borrowers have put up works of art and life insurance policies as collateral for hedge-fund loans.

Consider the risk vs. reward tradeoffs. Clearly, hedge-fund loans are not for every business. The low level of regulation and easy access to credit through hedge funds may only prop up businesses with an underlying problem. However, proponents contend that hedge-fund loans can help borrowers weather short-term financial turbulence. Perhaps it should reassure skeptics that investors in hedgefunds have a lot at stake themselves.

"If the loan is not successful, the risk to the fund is that a lot of high-profile investors, could lose a lot of money. That is an outcome they seek to avoid," Shah says.