For years E*Trade Financial Corp. invested a good chunk of its capital in collateralized debt obligations. It seemed like a great way for the online brokerage firm to generate balance-sheet gains: Interest rates were falling and real estate prices were rising, driving up CDO values. But when the real estate market began to tank last summer, so did the value of E*Trade’s CDOs, and by November 2007 mortgage-related losses had slammed the company. Its stock price fell 58.7 percent virtually overnight — or, to be precise, over a weekend — from $8.59 per share on Friday, November 9, when the company announced after the market closed that it would have to take “significant write-downs” in its CDO portfolio, to $3.55 on Monday, November 12.
Although E*Trade didn’t publicly quantify the losses, they were clearly staggering, and the firm was in desperate need of outside help. Its savior? Citadel Investment Group, the $22 billion Chicago-based hedge fund firm.
Citadel and its partner in the deal, New York–based money manager BlackRock, stepped up with a comprehensive capital-infusion package: $1.6 billion in cash in exchange for a 20 percent equity stake in E*Trade and senior unsecured notes that yield 12.5 percent. Citadel ponied up an additional $800 million for E*Trade’s asset-backed-securities portfolio, which carried a paper value of $3 billion. E*Trade also agreed to hand over much of its equity-trading business and all of its options trading to Citadel. The deal, completed on November 29, instantly turned the hedge fund firm into a player in the retail trading market. In a single stroke Citadel had executed the kind of feat usually associated with big banks like JPMorgan Chase & Co. and Goldman, Sachs & Co.
The Citadel-E*Trade pact — extraordinary as it was — exemplifies the increasingly blurry line separating commercial and investment banks from hedge funds. The change is occurring as traditional capital markets have rapidly dried up and as hedge funds have begun to market themselves as financiers, promoting their services (and their bankrolls) on their Web sites and through intermediaries. Nowadays, says Lawrence Goldfarb, chief executive officer of hedge fund firm LRG Capital Group in Larkspur, California, “it’s hard to tell a hedge fund from a merchant bank.”
What many hedge funds have going for them is what borrowers want and something that most banks have run low on these days: liquidity. Bear Stearns Cos. is out of the market. Citigroup has been raising capital, reorganizing business units and selling off pieces of its loan portfolio. UBS has restructured by writing off $37 billion in bad debt since the credit crisis started last year, selling a $15 billion mortgage portfolio to BlackRock and cutting back on staff.
Once considered the last resort for troubled companies whose prospects are too dicey for traditional investors, hedge funds have become crucial financiers even for large and stable companies simply because commercial and investment banks aren’t lending like they did in the early part of the decade. This trend has developed in part because banks are facing regulatory pressure to shrink their balance sheets, so even companies with good credit are having trouble borrowing money.
“That leaves the banks ill-equipped to provide the financing that companies will need in coming years,” says Richard Ronzetti, global head of investment management at Marathon Asset Management, an $11.7 billion hedge fund firm in New York. “We’re entering into a credit crunch that is really historic in its proportions.”
And that creates opportunities for hedge funds like Marathon, which provides a variety of registered and unregistered corporate financing, including structured-debt products. Marathon has a staff of 20 loan originators and 100 researchers, much of whose time and energy in recent months has been spent acquiring mortgage-backed securities, though the team is also adept at figuring out how to structure a loan fast — in just a few days, in some cases. “We pride ourselves on being able to provide a SWAT team with all available resources,” Ronzetti says.
In addition to their willingness to provide financing more quickly than banks do, hedge funds are often more flexible. Daniel Farkas, a hedge fund analyst with Chicago-based investment research giant Morningstar, says many funds attach fewer strings to loans than do traditional lenders.
But there are downsides as well for borrowers and lenders alike. Hedge funds may take a very hands-on approach that can affect a company’s management (since Citadel’s investment, E*Trade has changed its CEO, CFO and general counsel). The sheer speed of a deal can obscure risks. And because hedge funds often lend to companies in speculative sectors like mining and biotechnology, risks are inherent. But part of the appeal from a hedge fund manager’s perspective is that lending can create alpha.
Marketing issues still have to be overcome. Ensconced in the collective corporate memory are dot-com deals from almost a decade ago, in which hedge funds lent money to struggling tech-sector companies under terms that ultimately hurt borrowers. But it’s clear that the notion of borrowing from a hedge fund has gained momentum and perhaps even become mainstream.
Casino operator Tropicana Entertainment, which filed for bankruptcy protection on May 5, recently borrowed $67 million from Greenwich, Connecticut–based Silver Point Capital, choosing the $9.3 billion hedge fund firm over competing lenders. Liverpool FC, the English Premier League soccer team, and its American owners, Thomas Hicks and George Gillett Jr., are seeking hedge fund financing for a $700 million stadium it broke ground on this summer and for Hicks’s proposed buyout of Gillett’s stake. Dendreon Corp., a small publicly traded Seattle-based biotechnology firm that develops cancer treatments, has an equity line of credit with Acqua Capital Management, a Toronto-based hedge fund.
Some hedge fund firms build their core strategies around lending. LRG Capital’s two main funds, BayStar I and BayStar II, “have collectively invested over $1.5 billion in more than 250 companies,” according to an LRG note to investors. CEO Goldfarb is seeking to raise $500 million for a new fund, BayStar III, to make structured-debt investments in small- to mid-capitalization public and late-stage private companies, mostly in technology and life sciences; $50 million in capital had been committed by early May. Though the BayStar vehicles are hedge funds by definition, Goldfarb says the term doesn’t mean much anymore and that he prefers to think of LRG simply as a money manager looking to generate returns by providing financing.
Firms like Yorkville Advisors, a $1 billion manager based in Jersey City, New Jersey, that specializes in making loans to publicly traded companies, hedge their investments by requiring borrowers to meet substantial conditions. Yorkville looks for sufficient collateral to cover its loans — though that’s not always possible — and prefers to receive options and warrants (in addition to debt payments), which make a profit for the fund if the stock price goes up without diluting the borrower’s equity position at the time the deal is negotiated. Yorkville senior managing director Troy Rillo argues that the combination of debt and equity, through a warrant or conversion privilege, serves both the investor and the borrower. “We prevent companies from doing things that are injurious to themselves,” says Rillo, co-chairman of his firm’s investment committee.
Admiralty Resources, an Australian mining company, has raised capital three times through lines of credit with Yorkville, according to Phillip Thomas, Admiralty’s chief financial officer. The first line of credit, for $2 million, was approved in 2006; the second, in 2007, was for $6 million; early this year, the company added a $20 million line. During that period, Admiralty took an iron ore mine in Chile from exploration to production, and Thomas notes that Yorkville’s support was crucial.
“Investment banks don’t want to get involved until the assets are proven,” he says. “We talked to all the major suspects,” he adds, but banks would not step up while the company was still in the exploratory phase. Rather than doing extensive geological due diligence, Yorkville concentrated on the company’s cash flow and its ability to meet payments; the collateral value of the mines was secondary.
EMED Mining, a mining-development company based in Cyprus with only £5 million ($10 million) in assets, signed a line of credit with Yorkville last fall. The agreement lets EMED raise funds as needed without taxing its balance sheet or diluting its future earnings per share by increasing the share count at a faster rate than net income.
The whole notion of hedge fund lending has what Harry Anagnostaras-Adams, EMED’s founder and managing director, says is an undeserved bad reputation because so many strings have traditionally been attached to it and the results have sometimes been disastrous for borrowers. Most hedge fund lending has come through lines of credit or private investments in public equity, commonly known as PIPEs. (Goldfarb’s BayStar funds flourished through the use of PIPEs.) Such arrangements can cause considerable dilution if the principal on the debt can be converted into equity should the underlying stock price fall — potentially bringing down a company rather than helping it grow.
At the end of the dot-com bubble, for instance, many companies were so desperate for financing that they arranged lines of credit to be repaid in convertible shares. In June 2000 online retailer eToys sold $100 million in convertible preferred securities to funds managed by Citadel and Promethean Asset Management, a New York–based hedge fund that was an active tech-boom lender. By the end of 2000, most of the shares had been converted at bargain prices, giving the funds almost 20 percent of the company and diluting the value held by other shareholders. This drove the stock price down further, hastening the company’s demise. Deals like these earned the nickname “toxic converts,” and most loans today are structured to prevent them.
Gregory Schiffman, chief financial officer for biotech company Dendreon, says its credit line with Acqua Capital Management is “a very flexible means of financing for a company our size.” Schiffman likes that he can pull down financing in $8 million to $10 million tranches as needed for a low per-transaction cost of capital and controlled dilution. He also likes that Dendreon has no obligation to tap the line of credit. Rather than giving Acqua the power to convert Dendreon’s debt into equity at any price, stock issued under the line comes out at a range of prices. Dendreon’s key project is Provenge, a therapeutic vaccine for prostate cancer that has completed Phase 3 clinical trials but is still undergoing review by the Food and Drug Administration.
Isser Elishis, chief investment officer of Acqua, says interest in hedge fund lending isn’t limited by the size of a borrower. “We’re seeing larger companies interested in these transactions,” he notes, adding that Acqua requires borrowers to have a market capitalization of at least $150 million. He says most borrowers are simply businesses that need cash to grow rather than financing to stave off bankruptcy or hostile buyers.
“There are so many companies struggling to get funding right now,” notes Seth Yakatan, co-founder of Katan Associates, an Hermosa Beach, California–based consulting firm. Last fall Katan helped XL TechGroup, a Melbourne, Florida–based company that helps commercialize medical technologies for larger corporations, raise a $25 million line of credit with Laurus Capital Management, a New York hedge fund firm that has about $1.8 billion in assets under management.
Matthew Hoffman, chief investment officer for Westport, Connecticut–based Weston Capital Asset Management, which runs a $130 million fund of funds that invests in hedge fund lenders, says some insist on charging higher rates and fees than do traditional lenders: “Usually the borrower will agree to pricing because the hedge funds will do the loan more quickly, even under stressed environments.”
On the other hand, Noel Ryan, a managing director and a senior member of the private finance group of Los Angeles investment bank Houlihan Lokey, advises clients in the market for a loan to consider borrowing from a hedge fund because the rates are sometimes better than what banks offer. “They are a very strong option for companies,” Ryan says. But his endorsement is tempered. He warns that hedge funds are frequently more interested in returns than in long-term client relationships; they will often sell a loan in the secondary market; and they are prone to moving on to other types of investments, rather than serving as a reliable ongoing source of capital. “I think it’s going to go away,” he says of hedge fund corporate lending, noting that companies have begun to look beyond investment banks — and hedge funds — to other funding sources, including private equity, sovereign wealth funds and holding companies.
Of course, hedge funds that decide to become lenders face risks specific to lending. When Axium International, a privately held Los Angeles–based payroll services company whose clients included independent filmmakers as well as big studios like Warner Brothers, filed for Chapter 7 bankruptcy in January, its biggest creditor was GoldenTree Asset Management, a New York–based hedge fund with $13.8 billion in assets under management that specializes in alternative financing arrangements for small companies. GoldenTree lost $87.5 million on its Axium venture and now finds itself competing with other claimants for whatever may be left of the company’s assets.
For a traditional bank, such problems can simply become opportunities to sell another set of services. A hedge fund, by contrast, can be left holding the bag, especially if its loan was intended to bridge a private company’s finances until its initial public offering. “In a late-stage venture deal, the exit could take longer or not develop,” says Rillo, the Yorkville executive. And unregistered securities like the ones hedge funds frequently underwrite are often illiquid, making them almost impossible to sell.
But for Hoffman, the Weston CIO, the profit potential is irresistible for one hard-to-argue-with reason: “We’re generating double-digit returns.”
