Need Financing?

Call your local hedge fund

Bryan Gordan, chairman and managing director of Madison Capital Management, LLC in New York
Originally published in the September 2006 issue

Asset based lending (ABL)-in its simplest meaning, lending secured by an asset-is an ageless concept, perhaps finding its earliest incarnation in the pawnshops of ancient civilizations. In more recent times, hedge funds have become active providers of ABL, as they seek inefficient markets in which to deploy their abundance of investor capital. For hedge funds, ABL opportunities can provide attractive risk-adjusted returns.

Under the right framework, hedge fund forays into ABL can lead to a symbiotic relationship between lender and borrower. Borrowers generally seek ABL when more traditional sources of funds, such as banks or the capital markets, are not viable. There are many reasons behind this lack of financing options, stemming from both the characteristics of the borrower, as well as the traditional lenders. Hedge funds bridge this gap, acting as a flexible capital “partner” who is willing to work hard and quickly to address a borrower’s needs.

ABL borrowers are not only firms in distress or emerging from bankruptcy; they may also be firms that have attractive business plans but lack the steady cash flow that traditional lenders seek. The saving grace of this borrower is its ownership of a valuable asset-the cornerstone of the ABL transaction. Asset based lenders assess the value of the underlying assets, including atypical assets, and provide financing to borrowers based on the collateral safeguarding their investment. Take Michael Jackson, for example, who borrowed against his share in Sony/ATV Music Publishing, LLC. Although Jackson was rumored to be close to bankruptcy, he was able to restructure his finances by leveraging his share of Sony/ATV, which includes a song catalogue that holds a Beatles collection said to be one of the most valuable recording assets in the world. Borrowers may find traditional banks, private equity companies and hedge funds amongst their financing options, with the last often being its best opportunity for small, less established businesses or businesses in distress. Why?

Although there is much money to be made in ABL, and it is a market where banks have been active participants, supply is not always available to meet demand, particularly when the demand is coming from a smaller borrower. In recent years, banks have begun to view lending as a loss leader for more profitable businesses, whereby the lending relationship brings the bank revenues through other, less capital intensive, products, such as cash management. In this world of relationship banking, the micro-cap borrower often finds itself locked out since it is not likely able to generate sufficient supplemental business. Even if the borrower was sizeable enough, the required complexity of the transaction, and unique features required by the borrower may cause the banks to view the loan as being too costly, time consuming or difficult. Additionally, a bank’s organizational structure may be a limiting factor, where rigid lending policies and regulations may prohibit the bank from pulling the trigger on a deal that makes sense economically and financially. All of these roadblocks are more easily addressed or do not exist for hedge funds, whose entrepreneurial spirit and “down-in-the-trenches” attitude allows them to structure a deal that satisfies all parties.

Private equity companies, more flexible than behemoth financial institutions, might also be able to work with companies to provide financing-but likely at a higher cost because private equity firms take a controlling stake in the company. Although some companies benefit from and seek an active investor, there are many companies who are unwilling to give up management collaboration often required by private equity firms. Hedge funds tend to view their investments solely as means to a return, and consequently are better able to maintain autonomy.

For many borrowers, hedge funds are an ideal source of financing. Not only are they flexible, but they can also be speedy. Hedge funds, being generally less rigid than more traditional financiers, are able to turn things around quickly. These characteristics are not only crucial during the initial structuring of the loan, but also throughout the life of the loan. A borrower, faced with unforeseen circumstances, might risk defaulting under a loan with a more traditional funding source but is more easily able to work out a restructuring with hedge funds, given its flexibility, speed and entrepreneurial attitude. Despite the hedge fund’s litheness, it could be argued that hedge funds will be more inclined than traditional funding sources to foreclose on collateral if its perceives its investment to be at risk.

It is this ability to foreclose on collateral that makes ABL attractive to hedge funds and why the value of the collateral is the keystone behind a profitable transaction. Even if the borrower ultimately fails in its venture, the hedge fund can still turn a profit if strong collateral backs the loan. For example, a winery located in the Napa Valley region of California may approach a lender to finance its daily operations until its wine production is able to sustain its activities. Where a traditional lender may be focused on the winery’s current cash flow and its growth prospects, an asset based lender may be able to obtain a lien on the land, which in Napa Valley is extremely valuable.

In some instances, the value of the collateral may require a significant amount of research prior to an investment decision. Take the case of an Appalachian energy company that acquired a natural gas pipeline that had lain dormant for many years. The company required funds for capital expenditures to restart operations; however since the business was not producing cash flow the company was not able to obtain traditional financing. The solution was to seek a loan, secured by the company’s asset, from a lender who was willing and able to value a unique asset. The pipeline was strategically situated in an area that lacked competing pipelines and would be unable to support construction of new pipelines, giving it a virtual monopoly over local gas transport. Additionally, due diligence indicated a vast supply of trapped gas in the area which could be extracted for sale. By obtaining capital via an above-market-rate loan to refurbish, expand and update the pipeline, the company’s revenues and cash flows would be increased to a level that would enable it to satisfy its debt service. If, however, the borrower was unable to rehabilitate the pipeline, the lender’s research showed that the in-place value of the pipeline was more than sufficient to repay the loan. Although the collateral is the focal point of the transaction, hedge funds may undertake additional strategies to improve its ABL investments. Like traditional lenders, hedge funds may syndicate the loan to other lenders or funds, pocket a nice return via origination fees and any spread that may come from the syndication, and free up capital for other investments. The fund could also partner up with other financing sources such as banks and private equity companies to jointly originate loans. For instance, hedge funds can take on positions in loan syndications arranged by banks, giving the bank the revenues from the fees and reducing the risk of holding the position, while creating a means to deploy more capital with less effort than a loan that they might underwrite themselves.

Hedge funds considering entrance into the ABL space have much to consider before jumping in. Firstly, the same lack of bureaucracy and flat structure behind hedge funds’ litheness may also be a potential weakness. Hedge funds should ensure that they have sufficient infrastructure and resources to properly manage the loan and the collateral, including safeguards to adequately track the collateral value and monitor its lending exposure. Similarly, the fund should establish a seamless asset management process to ensure timely invoicing, payment tracking, maintaining documentation, etc. Secondly, asset based loans are notoriously illiquid. As a result, funds must consider their redemption terms and how these loans will integrate into the funds’ portfolio from a liquidity perspective. Lastly, directly sourcing and holding private loans can pose tax problems for offshore funds. As with all new strategies, doing your homework before embarking on an ABL program is essential.

The same type of flexibility in identifying new spaces to deploy money that brought hedge funds into the ABL space makes them attractive asset based lenders. Hedge funds will likely continue to carve out a niche in this space, however much of the lending to date has been in a benign credit cycle; it will be interesting to examine how they will adjust to the changing environment.