Veni, vidi, vici - How hedge funds have stormed the capital markets
- United States
- 06/19/2007
“Neither a borrower nor a lender be; for loan oft loses both itself and friend, and borrowing dulls the edge of husbandry.” Had Shakespeare written Hamlet after spending a few afternoons in Connecticut or reading a few issues of The Wall Street Journal, he might have included “(except for hedge funds, which make fast friends of borrowers and lenders and sharpen the heck out of the capital markets).” Hedge funds, which are often defined as lightly regulated investment vehicles or entities, manage more than $1 trillion of assets, and a Bank of New York study indicates that investments in funds by institutional investors should triple by 2010. With large checkbooks and hungry investors, funds have moved beyond their traditional investments in stocks, currencies and interest rate derivatives based on expected price fluctuations. Funds, like private equity firms, now acquire controlling interests in companies. They join with investment banks to deliver complex derivatives. They partner with and compete against commercial banks to make loans. Funds borrow more frequently than ever to finance their operations and investment activities. Because of their growth, flexibility and appetite for risk, hedge funds are transforming the American economy. This article focuses on hedge funds as lenders and borrowers, and their growing influence on the capital markets.
A hedge fund is generally comprised of a manager and a series of investment entities. The manager acts as the fund’s brain, making its investment decisions, and the entities act as the fund’s body, giving life to those decisions. Another way to look at this is that an investment entity is like a car, and the manager is like the car’s driver. Because funds are often described as being “lightly regulated,” and because fund entities are often limited purpose organizations, many incorrectly assume that funds are free from restrictions placed upon commercial banks, finance companies, and others in the capital markets. In fact, light regulation ties primarily to disclosure.
A typical hedge fund is not a publicly traded company, but instead a privately held limited liability company or limited partnership with an average investor that is an institutional investor or an individual with an annual income of at least $200,000 or a net worth of at least $1,000,000 (and, as of the date this article was written, the Securities and Exchange Commission [SEC] was trying to add to these investor requirements). A customary fund transaction involves a private securities issuance or a complex contractual arrangement with a highly sophisticated counterparty. As a result, unlike publicly traded companies required to make regular filings with the SEC regarding their financial condition and their material transactions, funds generally do not provide public notice about their activities. Funds, their investors and their transactions rely upon laws and regulations such as Section 4(2) and Rule 144A under the Securities Act of 1933 and Section 3©7 of the Investment Company Act of 1940 to eliminate most public disclosure duties.
Historically, few worried about limited fund disclosure because funds were profitable, limited to the sophisticated and wealthy, and engaged in distinct types of transactions. However, as laws such as the Pension Protection Act of 2006 remove restrictions on investments in hedge funds by large institutional investors such as pension funds (which indirectly results in small investors being exposed to hedge funds), and with funds like Amaranth Advisors losing billions in bad trades, members of Congress and governmental agencies seek greater fund regulation.
The SEC attempted to impose manager registration requirements and disclosure duties upon funds, but the U.S. Court of Appeals for the District of Columbia invalidated those efforts in Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006), calling the efforts “arbitrary.” Given that the SEC’s chairman and many congressmen continue to lobby for more disclosure, it seems the D.C. Circuit’s decision will not be the final word on fund regulation.
Participants in the capital markets have independently enacted limited regulations. For example, many syndicated financing documents now include material nonpublic information, or MNPI, provisions requiring lenders to establish lending teams separate from other parts of their institutions, and prohibiting lending teams from sharing confidential nonpublic information with their affiliates, including those trading equities. MNPI provisions came about as the SEC investigated certain funds that may have engaged in short sales of borrowers’ stocks based on confidential information purportedly received in the funds’ capacities as lenders.
Because light regulation generally relates to disclosure, those representing funds as lenders should continue to ask the same questions they ask when representing traditional lenders: Is there a usury risk? Is the fund operating in a state that requires lending licenses? Do consumer protection or predatory lending laws apply? A fund is not free from lending laws simply because it is owned by the wealthy, and generally should be viewed as subject to restrictions governing traditional nonbank finance companies.
One regulation more specific to funds is Rule 206(3) of the Investment Advisers Act of 1940, which generally requires that an investment adviser, such as a fund manager, obtain a consent from its client, such as a fund vehicle, in a transaction where the adviser acts for its own account vis-^-vis its client. Think of this as a fiduciary, conflict of interest or fair dealing requirement. Because many fund entities are organized abroad to limit U.S. tax liability, consider whether an entity’s activities such as multiple extensions of credit or deliveries of amendments will result in the entity being engaged in a U.S. trade or business, ultimately resulting in U.S. taxation.
Funds initially planted their flag in the capital markets by investing in large syndicated term loans that were subordinate to other types of debt. Over time, these term financings evolved to include “second-lien” financings, where first- and second-lien lenders hold equal payment rights, but second-lien lenders hold junior collateral rights. Even while evolving, these transactions usually represented one-time financings with a fund extending a single loan and then passively collecting interest and fees or trading such loan in the secondary market. Funds have moved beyond their “one-and-done” roots and now offer revolving and asset-based loans and other financings requiring ongoing customer relationships. They frequently operate on the capital markets’ frontier by offering facilities secured by illiquid or esoteric assets, such as song catalogs and pharmacological products. Their investors accept greater risks for greater returns and often avoid the safety and soundness guidelines and credit committees facing banks. Also, with large commercial banks engaging in fewer transactions with small and mid-size companies, funds have filled the resulting gap.
Hedge funds typically finance their lending activities through equity and debt issuances and investment earnings, and these sources of funds are important because certain financings and sources must be linked. A fund cannot offer a revolving facility unless it can regularly extend credit on short notice, so funds solely relying on equity contributions are disadvantaged because these contributions are usually received only after lengthy notice periods expire. Funds offering letters of credit or multiple currencies must have the wherewithal to obtain such products, and if funds rely on their own revolving credit facilities for liquidity or financial products, then they must be able to obtain these products before they are to be delivered to their customers.
Fund entities often have limited lives, so their loans cannot run beyond their expiration dates. Lesser-known funds may be required to fully fund their commitments into cash collateral accounts in multiyear, multidraw financings. As funds lead and administer more transactions, fund managers must ensure that they have the resources to analyze collateral appraisals and borrowing base reports, maintain tangible collateral, and complete other similar tasks. Rating agencies such as Moody’s even rate funds on these abilities using “operational risk” matrices.
Traditional lenders often extend credit in conjunction with broader business strategies that seek long-term relationships and opportunities to sell a variety of products like cash management, foreign exchange and custodial services. They may accept lesser fees today hoping to obtain more business and other fees tomorrow. Funds, which typically do not offer customers extensive services, base their profits almost exclusively on interest rates and closing and facility fees. One notable exception is that funds often receive warrants, or rights to acquire a borrower’s equities, in connection with a financing, and usually include those warrants in their compensation calculations.
Funds not only lend money to healthy companies, but also actively acquire distressed debt because of potentially significant fee opportunities. Unlike many banks that engage in lengthy work-outs because of long-standing relationships with distressed borrowers, funds often push for quick restructurings, liquidations or sales resulting in sizeable fees or the funds’ ownership of the borrowers. Funds actively seek seats on creditors’ committees to further these objectives. Many funds even hold indebtedness in anticipation of a default. Funds have held debt owing by companies such as UnitedHealth Group, Navistar and Mercury Interactive because of expected covenant defaults resulting from delayed SEC filings. In several instances, borrowers paid millions in fees to obtain waivers for these defaults. As a result, borrowers may request restrictions upon funds holding and taking assignments of their debt. However, given the number of borrowers that need the liquidity provided by funds, these requests are usually rejected.
Many sizeable financings are only completed with fund-provided subordinated debt. Senior and junior lenders customarily enter into intercreditor agreements governing payment and lien priority, collateral rights, and bankruptcy rights such as waivers of adequate protection and relief from the automatic stay, use of cash collateral, and debtor-in-possession financings. After a default or bankruptcy, intercreditors typically grant senior lenders ultimate decision-making authority. Funds have changed this dynamic, often demanding near equal footing with respect to payment and lien priority, and often refusing to limit their ability to contest senior lenders’ offers of debtor-in-possession financing or use of cash collateral in restructurings. Funds also seek to eliminate caps on debt benefiting from intercreditor arrangements. The foregoing might lead one to think that Shakespeare was right in saying “. . . [a] loan oft loses both itself and friend . . .” but, as the next section demonstrates, fences are quickly mended.
As the saying goes, “You need money to make money.” Hedge funds raise money for their investments from raising capital and from borrowing money from other institutions. Funds will not typically borrow from other funds due to the proprietary nature of each fund’s operations. Structures for financings range from a typical unsecured loan; a secured borrowing base loan; or a “warehousing facility,” which is a secured loan; to the use of securitization entities for the issuance of collateralized loan obligations.
The purpose of borrowing funds may be to front capital calls, provide general funds for equity and debt investments, or provide funds through a subsidiary “feeder fund” structure, which will then use such monies for equity or debt investments at a subsidiary level. Depending on the history and financial strength of the fund, the lender may be willing to provide loans on an unsecured basis, but more typically such loans are secured by the capital call or underlying collateral. Additionally, the principals of a hedge fund may obtain financing secured by their interests in the underlying hedge fund.
When a loan is being made based upon or secured by unfunded capital commitments, the lender may impose a borrowing base composed of unfunded capital commitments from eligible investors or a cap on borrowing at some percentage of the unfunded capital commitment. A lender should carefully review the fund documentation to understand the nature of a capital commitment and will want to impose restrictions in the loan documents that prohibit the amendment of the fund documentation in a manner that could reduce any investor’s obligation to fund capital calls. Additionally, if the loan is to be secured by the right of the fund to make a capital call, then the lender will want to take all steps to ensure that it will ultimately be able to enforce such right to make a capital call.
A lender should seek to have documentation executed directly by the fund (borrower) and its investor in favor of the lender to provide that (a) such investor consents to the security interest in favor of the lender and the enforcement thereof, (b) such investor agrees to fund such capital call to a bank account that is subject to a control agreement in favor of the lender or as otherwise directed by the lender, and© such investor agrees to comply with any request to fund a capital call made by the lender (or its successors and assigns) that otherwise complies with the fund documentation. It should be noted that obtaining the foregoing documentation from investors is not always possible. Sometimes funds do not have the ability in their fund documentation to require their investors to execute such documentation, and their investors may not want to consent to such documentation.
Obtaining and perfecting a lien on the deposit and securities accounts of the hedge fund is a key component for securing the lender’s position in the investments owned by the hedge fund. The lender should follow the standard steps for such matters set forth in Articles 8 and 9, respectively, of the UCC. In addition, a security agreement will be needed with respect to any equity issued by the hedge fund that is to be pledged and any of the equity investments and debt investments of the hedge fund that are to be pledged.
If equities are to be pledged, it is important first to determine whether they are securities or general intangibles, and then to determine whether restrictions on their assignment exist both in the underlying equity documentation and under Article 8 of the UCC (if securities) or Article 9 of the UCC (if general intangibles). Pursuant to Section 8103© of the UCC, an interest in a partnership or limited liability company is not a security unless (a) it is dealt in or traded on securities exchanges or in securities markets, (b) its terms expressly provide that it is a security governed by Article 8 of the UCC, or© it is an equity interest issued by an entity that is a registered investment company, a registered unit investment trust, or a face-amount certificate company that is not registered. Additionally, if the equities to be pledged are issued by a general partnership, careful consideration should be given as to whether the lender wants a pledge given for the assumption of liabilities of a partnership by a general partner.
The organizational documents of pledged entities should be carefully reviewed to identify restrictions on transferability and pledges of the equity issued thereby. Sections 9406(d) and 9408 of the UCC make certain provisions in general intangibles and promissory notes ineffective to the extent they prohibit or require the consent of the person obligated thereon to creation, attachment or perfection of a security interest therein or provide that assignment, transfer or creation or perfection of a security interest may give rise to a default thereunder. It should be noted that Section 9408 does not invalidate restrictions upon enforcement of a security interest. Moreover, there may be constitutional or statutory provisions with respect to limited partnerships or limited liability companies that conflict with such Section 9408; for example, Delaware has rejected such provisions as they apply to limited liability companies and limited partnerships. As such, reliance on Section 9408 is not recommended; rather, it is recommended that a consent to the pledge and any ultimate assignment in connection with the exercise of remedies with respect thereto be obtained from the relevant parties to the partnership agreement or operating agreement, as applicable.
A financing statement filed with the secretary of state of the state in which the hedge fund is organized (assuming it is a registered organization) will be sufficient to perfect a security interest in, among other things, general intangibles, investment property, instruments and accounts. Possession of instruments or certificated securities also will be sufficient to perfect a security interest in such property; and as between a person having possession of such property and a person with a financing statement with respect thereto, the person having possession will have priority. Typically, a lender will want possession of the certificates evidencing the investment property or instruments or a control agreement with the intermediary holding such property. A common structure used in these situations is for the fund to enter into a custodial relationship with a third party that holds all certificates and instruments on its behalf. The financier then enters into a control agreement with such custodian governing perfection matters as well as arrangements with respect to adding and removing collateral.
Finally, in connection with making a loan to a hedge fund, unless the collateral is sufficiently creditworthy, a lender will want to ensure that the manager of the hedge fund cannot be replaced without such lender’s consent. Careful diligence will be required to review the fund documentation and identify on what terms a manager may be removed or replaced. If the investors have a right of replacement, attempts should be made to modify the fund documentation to restrict replacement for so long as the loan is outstanding.
Hedge funds have become a considerable force in the lending market, both as lenders and as borrowers. While they have become a major competitor to other financing providers, they are also responsible for bringing funds to the capital markets and for being a significant user of capital in the markets for their own leverage. Although hedge funds are currently relatively lightly regulated, they also don’t fall under the purview of many regulatory exemptions that banks and other financial institutions can use in providing financing. At the same time, hedge funds face the same issues as any lender that makes loans and any borrower that borrows money. Counsel to funds should work with their clients to ensure that they are observing the appropriate regulatory and legal regimes governing the debt investments they make. Additionally, counsel to financiers of hedge funds should work with their clients to address the special issues around the collateral typically provided by hedge funds to secure any loans obtained by them. In light of the growing scrutiny of the activities of hedge funds, funds should be mindful of the saying “Better late than never” and ensure that they are following the rules governing their lending and borrowing activities.
Source: Business Law Today, Volume 16, Number 5 May/June 2007
