Strategy Commentary: Financing

PSolve Alternative Investments provides insights into a less than transparent market

Hedgefund Journal

Financing strategies have been around since the days that banking systems were born. They come in many different forms such as asset backed lending, private investments in public equities (PIPEs, formerly known as Reg-D investing) or structured finance, and can generate return streams that are not only highly stable, but also sustainable and highly attractive. Less informed investors should be wary, as the space has a dark side and one has to be mindful of the risks that may not be apparent when looking into a fund with a highly attractive return profile. The risks tend to be idiosyncratic and usually involve the pricing of privately negotiated securities.

From the diagram above it can be seen that this industry got badly burned as the "tech-bubble" burst. Many firms had been making significant returns and attracting large amounts of capital, but providing finance to companies with little or no utilisable collateral. When these small tech companies began to unwind, the finance providers had little or no recourse on the funds provided, and faced substantial losses with liquidity in the market rapidly vanishing.
 

500Estimated growth of assets/net asset flow regulation D 1996 - Q3 2005

Financing managers generally operate within narrowly defined sub-strategies whether by asset class, geography or by sector. This function was one that was previously provided by regional banks in the US which, in the drive to cut costs and exposures at the end of the tech bubble, fired entire departments. This left many highly experienced individuals on their own with only their expertise and networks. As such, financing managers represent a classic hedge fund opportunity: a manager establishing a business and utilizing a relatively small pool of capital in an area in which he has tremendous expertise.

Managers in the various strategies under the financing heading have produced compelling return profiles with the most cautious in the 6-10% range, and others achieving 15% and higher (these may have some degree of leverage) with very limited downside.

Many investors have been wary of reputational risk given some of the bad press surrounding the strategy in particular. This perception relates primarily to the activities of some years ago where some ruthless managers engaged in so-called death-spiral trades in which they would use re-settable convertible issues whilst aggressively shorting the underlying company's shares, effectively sending the shares from reset level to reset level, diluting other shareholders at each point and often sending stock prices to the "penny-level". Such market abuse must of course remain a concern for potential investors, and is an appropriate area for scrutiny during due diligence, with ongoing regulatory actions such as SEC v – Langley Partners, North Olmsted Partners, LP., Quantico Partners LP., and Jeffrey Thorp 14 March 2006, whereby the manager naked shorted the shares of the company in order to hedge the un-registered stock that they had been issued. The manager would then use the newly registered shares to cover their naked short position effectively exerting downward pressure on the shares. However, the industry has definitely cleaned up its act and there are many managers who act with the utmostprobity and in close concert with the companies they finance.

When analysing financing strategies, the focus should be on how the managers are structuring their deals, the collateral and collateral cover that they are getting as well as the manager's experience at collecting and monetising collateral in times when this is necessary. Further attention should be paid to the legal structure of the agreements and what rights are afforded to each side of the transaction in certain events. Some managers have effectively put "strangle" restrictions on companies, not allowing them to act in their own best interests, which, although it has not been made illegal, is unlikely to be viewed favourably by regulators.

Investors should always remain aware of the risks in the strategy, but should not forget the opportunities, and there are many firms that require capital and cannot approach the conventional lenders, whether for short term real estate projects or for international trade. Lean hedge fund management businesses represent an ideal source of capital because even small deals make economic sense for them.

Issues

IssuesThe skills of a financing manager are very different from those typically required in the hedge fund universe, with the professional careers and educations of the managers likely to be fundamentally different. Deal-sourcing and legal expertise may be more important than a quantitative or trading background; these managers are not seeking alpha through identifying mis-priced securities, but rather seeking compensation for individually negotiated business transactions.

Relationships are central in this strategy. Effective managers are being rewarded and their returns depend upon business transactions. Good financing managers are working in close collaboration with company managements, and frequently a significant number of their deals are repeat deals. As mentioned above there are both old and new managers offering terms that are not like this and not conducive to growth, and these may come under the scrutiny of the SEC in time.

Outlook

As long as there are small to medium sized companies requiring short term financing, and which have limited access to other capital sources, financing managers should continue to see healthy deal flow. As with all other hedge fund strategies, increased capital flows to the strategy may dilute returns, but until then reputable managers with robust infrastructures and a genuine deal-making edge will continue to offer an extremely attractive risk and return profile for hedge fund investors. This is not a strategy for which allocation decisions should be based on quantitative assessments of past performance. However, for investors who have the time, skills, and resources to conduct a thorough qualitative assessment of managers, the financing strategy represents an exciting and profitable investment opportunity.