Over the last decade hedge funds have emerged in the distressed debt markets and that presence has continued to grow rapidly. The involvement of hedge funds in distressed investing provides a number of benefits to the companies themselves and the market as a whole through:
There is increasing involvement of large hedge funds in more complex transactions, such as the purchase by Citadel in conjunction with JPMorgan Chase ofAmaranth’s assets in 2006 when the $9 billion hedge fund made ill-fated gambles on natural gas. Citadel had the capacity to handle this deal as it was able to dedicate a large team to evaluate the complex assets quickly and manage them following acquisition (it has over 1,000 employees). It also secured long-term financing from a $500m bond issue, resulting in flexibility when prime brokers are more cautious with their lending to hedge funds. More recently it has bought Sowood’s credit portfolio following a crash in value as a result of bad bets.
Larger hedge funds are getting good value because they are well placed to provide the cash and are more willing to take on risk. Further opportunities for these funds will no doubt arise as more funds face difficulties in today’s volatile market, chiefly due to the huge losses in subprime securities.
Large and complex insolvencies used to be coordinated by the traditional clearing banks using the principles of the London approach. These institutions would stand by corporate borrowers through difficult times and allocate large teams to assist them through the recovery or insolvency processes. In recent times, however, traditional bank lenders are increasingly prepared to offload debt to distressed investors at the first sign of trouble. This is largely as a result of the Basel II accords, which oblige banks to retain more capital in reserve against problem loans, and the rise in the debt markets. Large hedge funds now drive many of the bigger restructurings in the market as control passes with the acquisition of the debt.
Over the past few years the opportunities for distressed investors have been slim due to robust profits in the market, leading distressed funds into riskier junk bonds and high-yield loans. The first half of 2007, however, has seen greater prudence on the part of hedge funds in the secondary debt market in the face of increasingly risky investments, such as sub-prime securities (which are suffering a wave of defaults by borrowers) and cov-lite loans.
Cov-lite transactions accounted for more than a third of the market this year in the US, representing a rapidly increasing share of new loan issues. They first appeared in Europe in March of this year (debt offerings for portfolio company VNU World Directories owned by private equity houses Apax Partners and Cinven) and other deals were quick to follow (Trader Media Group, again by Apax, and UK-based asset managers Gartmore Investment Management and Jupiter). These loans are essentially corporate debt granted to the private equity sponsors of buy-out deals on very loose terms – “light on covenants”. Typical covenants that would appear in finance terms are maintenance covenants which describe regular tests that a business has to pass. Failure of the tests allow lenders to declare the loan in default and demand their money back or push for a restructuring. These tests are absent in cov-lite loans, and lenders therefore do not receive any early warning signs that a company may be unable to cover its debt. A default by a borrower will therefore mean that it actually cannot afford to pay any of the loans back and leaves the lender high and dry with few options to protect its position.
The US market has begun to reject cov-lite transactions, however, amidst concerns over subprime lending and a looming credit crunch. Deals with covenant-lite financing have been shunned on the market in the last few months, and banks have been forced to amend the finance terms with the addition of maintenance covenants.
The changing approach and strategy of hedge funds, made possible by their flexibility, is leading to a convergence with private equity. Pressure from institutional investors requiring stronger governanceand better risk management have compelled larger funds to become more transparent in their operations. There has also been a move by hedge funds to longer-term and more illiquid strategies – larger funds are now moving towards one-year-plus lock-ups with triggers allowing early exit.
Modern restructurings are characterised by complex capital structures and multi-layered debt, much of which will have been traded to the secondary debt market. Under current regulations, only lenders that are ‘banks’ as defined in the Income and Corporation Taxes Act 1998 are permitted to ‘go on the record’ – become a named lender of record (common in English law governed syndicated credit facility agreements). Trading, however, is now largely conducted behind the scenes via sub-participations. It is therefore impossible for a debtor to rely on its list of lenders in order to identify who its stakeholders are, as often the lenders on the record have little or no economic interest in the debt. Debt will often have been traded several times in subdivided tranches to secondary investors such as hedge funds.The secondary investors that have the economic interest in the debt naturally demand greater control over the credit. This is often achieved in the form of participation agreements that vest control in the lender of record to act (subject to some limitations) on the instructions of its sub-participant. These agreements can be entirely confidential as they are purely contractual and not even the debtor or other members of the lending syndicate may know of their existence.
In a bid for greater transparency, companies are seeking ways in which to ensure that bank lenders disclose the identity of secondary investors. A facility agreement may require the prior written consent of the borrower in order for the loan to be assigned, and the Court of Appeal has recently held that in order for an assignment of the loan to be valid prior actual or deemed consent must be received (the case of Barbados Trust Company Limited (formerly known as CI Trustees (Asia Pacific) Limited v (1) Bank of Zambia (2) Bank of America N.A.  EWCA Civ 148). Another tactic used is for the company to tell the banks that it wishes to choose who holds the loans on a name-by-name basis. Some even try to exclude specific hedge funds known to be tough negotiators from deals, by producing a blacklist and negotiating trading restrictions in the credit documentation. This makes it more difficult for the credit to be syndicated and may harm banks themselves in the long run as restrictions on selling the debt will leave banks lumbered with those loans if the company runs into difficulties. Side letters to the agreements can also be used to prevent funds acquiring the debt in the secondary market from voting.
Hedge funds used to be regarded as short-term investors, recovering their money from liquid or easily liquidated holdings at short notice. However, the flexible nature of hedge funds, due to the lack of restrictions in their investment guidelines limiting them to one type of investment, has allowed them to adapt to market forces and take longer-term positions in the distressed market with a view to a restructuring. They are also able to offer greater liquidity than traditional lenders on account of their size and ready access to capital.
Loan-to-own strategies are a well-known tactic that allows a company to restructure its balance sheet and extract equity upside value. They are increasingly being adopted by hedge funds, who buy different positions in a company with the specific expectation of default. Investors in the debt recognise the potential value in the operating assets and acquire debt in a move to obtain an equity stake via a debt for equity swap.
The resultant restructuring usually involves a debt for equity swap, refinancing and new money facility. Recent transactions that have involved hedge funds in debt for equity swaps are the Gate Gourmet and Jarvis restructurings.
Pursuing a loan-to-own strategy also means a fund has a greater interest in the restructuring and a commitment to the eventual success of the company as it will have made its investment at price below what it believes the credit will be worth post-restructuring. This is in contrast to the traditional par investor who will be keen to exit the credit as early as possible, and if it does stick around for the restructuring there will usually be some damage to the debt and a resulting loss for that investor.
Litigation provides a valuable tool for hedge funds should their rights become threatened in a restructuring, if insufficient value is being attributed to their debt holdings, or if they are otherwise being treated unfairly. The cases of MyTravel, British Energy, Colt Telecom and TXU are examples where hedge funds litigated to protect their position, or challenged the restructurings.
It is clear from the fallout from the US sub-prime market that certain hedge funds have adopted very risky strategies which have cost them dearly. Some commentators have argued that we have seen the end of the dominance of hedge funds.
However, those hedge funds in the distressed arena are here to stay, as every dark cloud can still have a silver lining!
Unfortunately, the performance figures in Fig.2 on page 49 were incorrectly stated due to an error on our part that took place in the design stage of production. We have reproduced below the correct table and apologise to Mike, Threadneedle and to anyone who may have been misled by this error.
Publisher and Managing Editor
The Hedge Fund Journal