More hedge funds are playing in the second-lien loan market with the hope of owning the loans rather than selling them in the secondary market, said participants at Institutional Investor Events' U.S. Turaround Management & Distressed Investment Forum last week. Jeff Schachter, managing partner of Cedarview Capital Management, said a lot of large hedge funds are forming big direct lending groups with the plan of originating and holding onto second-lien loans.
Gary Katz, director of Delaware Street Capital, said the explosion of the second-lien market has been driven by hedge funds that are seeking equity returns rather than debt returns. The drive to own loans is influenced by the fact that the secondary market for second liens is still very illiquid. "A ton don't invest with a view to trade," said Katz. "If you want liquidity you need to source from the sellside. They are the only ones that will give you a bid," said Schachter.
Owning second-lien loans also brings risks that some hedge funds may not be equipped to handle. David Feldman, partner and co-head of distressed and special situations lending at Kramer Levin Naftalis & Frankel, said many small hedge funds do not have the manpower to manage a loan if it goes bad. He said hedge funds often have small teams that do not have the time to manage a loan through the bankruptcy process.
Many second-lien deals still lack protections such as covenants that are commonly found on secured paper, but hedge fund managers see this changing. Schachter said accounts are becoming savvier and that covenants, such as call protection, are being added to more deals. Feldman also said there will be more convergence of second-lien and mezzanine financing. Eric Green, senior partner at FriedbergMilstein, agreed. "A lot of second liens will be taken out by mezzanine," he said.
Ronald Bringewatt, managing director of research at the Seaport Group, said he is seeing more clients interested in investing in individual assets, buying control of companies and seeking opportunities outside of the U.S. Stephen Freidheim, managing partner and chief investment officer at Cyrus Capital Partners, agreed that the difference in investment strategy of hedge funds and private equity funds is blurring. "I would agree hedge funds are gravitating towards private equity," said Freidheim.
Fierce competition from alternative investors in the distressed debt market is also leading hedge funds to look abroad for opportunities. Geoffery Gold, partner at Strategic Value Partners, said that half of the firm's investments are based outside the U.S., adding that the firm is staking its future on opportunities abroad. The firm has teams based in London, Frankfurt and Tokyo. "The market is more commoditized and competitive in the U.S." said Gold.
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