More hedge funds are looking to capitalize on the economics of buying unfunded revolvers trading at a discount, and some market players are raising concerns over the increasing counterparty risk involved with assigning unfunded loans to these unregulated entities. Banks are among those concerned as they question whether or not these funds will have the appropriate capital to back up a potential drawdown. "Because they are not regulated no one is really sure about how creditworthy these hedge funds are," noted one dealer.
A more liquid bank loan market combined with the tough credit environment has attracted a number of players who are seeking the security of senior loans. The one problem for investors, however, is the small return associated with investing in corporate loans. "People are moving up the capital structure," commented Marc Lasry, managing partner of Avenue Capital Group. He explained the reason that more hedge funds are buying into unfunded revolvers rather than funded term loans is to increase their returns. If the hedge fund does not have to put up any capital to fund the loan, it simply buys the paper and the return on capital is infinite, noted one trader.
Traders explained that a hedge fund could buy a $5 million piece of an unfunded revolver in the secondary market at 90, without having to commit capital on the amount for the loan. The fund then receives the commitment fees on the unfunded paper. "It gives the hedge fund money to play with," commented one dealer. "You get paid your fees on the full amount of the commitment, but seldom is the cash out of hand on the full amount of the commitment." If the loan is then held to maturity the fund reaps the difference between 90 and par on the $5 million piece, or $500,000. This type of play is called net-back play, noted another dealer.
Concern among lenders seemingly has not yet advanced to the point where banks are refusing to let in some hedge funds. Counterparty standards vary from bank to bank, but to date there have not been any major turndowns, traders said. There are reportedly some companies who are refusing to allow hedge funds to receive assignments in their unfunded revolvers. But names of those borrowers could not be determined.
Most recently, many hedge funds bought into AT&T's $4 billion commercial paper backstop, led by J.P. Morgan, Citibank, Credit Suisse First Boston, andGoldman Sachs. The credit offered an interest rate of LIBOR plus 7/8% and a 12.5 basis point facility fee and received solid investment-grade ratings from both Standard & Poor's and Moody's Investors Service. But market players said the paper traded actively in a grey market between 94-97 and as low as 92 after it broke into the secondary market as investors who had been badly burned by other telecom names showed interest only at the right price. For hedge fund investors, the paper offered a prime opportunity. "They could buy the paper in $50-100 million pieces. They thought it was the greatest thing," said one dealer.
There are a number of checks and balances and capital tests to ensure that any potential investor is an eligible assignee and will have an appropriate level of capital to back up a draw down. "There is a capital requirement set by the arranger and the issuer," said Michael Rushmore, ceo of LoanX, adding. "I would be surprised if there was a situation where the arranger and issuer would not provide a comfortable cushion of capital."