In the post above, we discussed how hedge funds’ desire to play financial games like bankruptcy contests by their own rules is backfiring. Not only are they failing to get their way, but their efforts to win special treatment are confirming an increasingly dim view the public has of them.
In Friday’s Financial Times, Gillian Tett’s article, “Private equity groups go into battle with lawyers by their side,” highlights a different problem: that hedge funds’ aggressive tactics are leading powerful financial players to craft strategies to keep them out of their deals. In some cases, specific firms are excluded, in others, the prohibition is more general.
Her story (excerpted below) discusses how private equity firms, which generate a considerable portion of the new debt syndications, are adding contractual terms to their loan agreements that preclude their sale to hedge funds. The logic is that, should a deal founder, hedge funds are particularly mean and greedy. Banks or other traditional lenders, like insurance companies, will often (at least in the early stages of trouble), renegotiate terms and sometimes will even put in new funds in return for improved covenants or better collateral. Hedge funds will have none of that. They are out to maximize their own take (which is understandable up to a point) and often seem constitutionally unable to conceive of, let alone craft, win/win agreements.
For the private equity funds, the decision to exclude hedge funds (if they can make the legalese stick, which as Tett points out, may not always be achievable) is good business sense. They will almost assuredly pay more to raise money if they exclude an important source of funding, but they are trading it off for more favorable treatment in the case of distress. And aside from improving their own and their investors’ financial position, it’s also likely a plus from a reputation standpoint as well. Bad deals are bad for one’s image regardless, but a bad and legally disputed deal due to hedge fund aggressiveness would keep the deal in the public’s eye.
Tett comments that the investment bankers are resisting these changes, but I see this all as negotiation. All the problems she cites are solved by offering investors a higher interest rate. In these times of abundant liquidity, the incremental yield required won’t be very significant, but in an adverse market for credit, the costs will become higher, and may become more controversial with private equity investors.
But the very fact that hedge funds are seen as such bad guys that people who want money won’t take it from them says their fixation on current return may be costing them in the long run. But hedge funds aren’t known for long term strategic insight.
From the FT:
In recent weeks, a number of private equity groups – or “sponsors” as they tend to be known in the debt markets – have asked their banks to raise finance for leveraged buy-outs (LBOs) using instruments, such as loans, which carry legal clauses that essentially prevent creditors from selling debt to hedge funds.
Some funds have even apparently produced a blacklist of hedge fund names they do not like, and attempted to create legal clauses that shut these undesirables out. It is the financial equivalent of being blackballed.
“You get sponsors who say they don’t want such-and-such a fund getting this debt – and demand ways to keep them out,” the head of debt syndication at one bulge-bracket bank in London told me.
He said he had recently seen a sharp increase in such requests, some of which had been fulfilled.
It is not difficult to understand why sponsors would act like this. The last time the private equity world was hit by a downturn in the credit cycle, many of the loans that underpinned these deals were in the hands of banks, particularly in Europe.
But this decade a revolution has occurred in Europe. According to Standard & Poor’s, non-banks, such as hedge funds, now account for about half of the primary leveraged loan market, and the figure can be nearer 80 per cent in some deals.
Meanwhile, in the subsequent secondary-market trading of this debt, funds are even more dominant, since the first thing any bank does when a loan becomes troubled is sell it to a fund.
As a result, in the next credit crunch it will not be the gentlemanly bankers who are holding the LBO loans. Instead, the new creditors are participants who are ruthlessly focused on profits and aggressive about grabbing them however they can. They look rather similar to many of the sponsors themselves. No wonder the private equity world is nervous; piranhas are usually good at smelling each other.
Whether sponsors will succeed in shutting hedge funds out of LBO debt is another matter. Most investment bankers are reluctant to let sponsors insert legal language into debt deals that restricts the subsequent sale of loans. That is partly because such clauses make it harder to syndicate these deals, but also because these controls could potentially hurt banks themselves. If it becomes harder for a bank to sell loans to a fund if trouble hits, banks could be left with toxic problems on their own book.
Even if a sponsor does bully a bank into inserting sales controls, it is unclear how much force these clauses would carry if a downturn hit. Most lawyers claim that any restrictions on the sale of debt become void if a company defaults….
The trend raises two points.
First, it indicates, once again, the extraordinary degree of power that the private equity world has recently been able to exercise in the debt markets….
Second, if – or when – the credit cycle does turn in the leveraged finance world,it will pit private equity funds against hedge funds to a degree rarely seen before. That would make compelling viewing, since it could be a nasty battle.