Cornell Capital: an alternative to Pipes | What end investors want | Octagon Asset Management | CFA: filling a real estate gap
EXECUTIVE VICE-PRESIDENT Guy Spanos was considering the prospects for his company, Pay By Touch Solutions. Set up in 2002, its payments technology using finger scans had taken off and was being used in more than 100 stores across the US. Pay By Touch had also made a series of fruitful acquisitions. Now, three years on, Spanos and founder, chairman and CEO John Rogers wanted to refinance their balance sheet and rapidly expand the business at home and abroad.
Spanos was clear about how he wanted to raise capital. Earlier in his career he had worked in the capital markets and knew that this time he wanted financing from hedge funds. Using UBS as a prime broker, Pay By Touch secured $130 million – $75 million of which was raised in senior secured notes from five hedge funds.
An increasing number of companies are taking the same path. As Pay by Touch shows, these are not just ailing cash-strapped companies in need of restructuring, or those that have tried every other option for financing, such as Malcolm Glazer in his bid for UK football team Manchester United. Companies with healthy balance sheets and good growth prospects are discovering that hedge funds can offer an alternative and, perhaps, preferable source of financing, be it through private equity-type arrangements, private placements, leveraged loans, commercial loans or asset-based lending.
It’s a suitable marriage. Some $80 billion is expected to flow into hedge funds this year, and it needs to be put to work. And for companies, growth is back on agenda, with flexible and tailored financing offered by hedge funds providing a solution. That’s the way Spanos saw it. “Not being a long-established company with an established cashflow, we knew that the traditional banks would not provide a loan,” he says. “At the same time, we didn’t want to use private-equity firms as we didn’t want to dilute our share price or give up control in the company. We wanted flexibility to structure the financing predominantly in the form of debt, and we wanted smart capital, so we went to the hedge fund community knowing we’d find a solution.”
Treading on toes
The manoeuvring of hedge funds into the financing space isn’t entirely unexpected. The nature of their business allows for flexibility and evolution in the search for returns. It is now widely accepted that there are too many managers pursuing much the same traditional strategies, with the consequence that returns have been squeezed. The only solution is to search for new areas of inefficiencies.
“Hedge fund managers have traditionally repeated the trades they know, which is fine in a bull market and where there isn’t too much money in the strategy, but those legs of the stool have fallen off,” says Ken Calligar, an ex-convertible arbitrage manager who now advises several hedge funds, including a real estate financing fund. “Hedge funds make money by looking for segments in the capital markets that are largely ignored, and in the financing arena there are many inefficiencies and gaps that can be filled,” adds Mead Welles, who runs asset-based lending hedge fund Octagon.
The needs of end investors are also driving hedge funds towards lending strategies. Institutional investors appreciate the steady coupon-like returns they offer; private investors have become accustomed to double-digit returns and can expect them from those hedge fund managers that take on the riskier types of financing deals. The longer lock-ups required from financing strategies are also being accepted by end investors, who appreciate that they might have to give up some liquidity to meet their return requirements.
The move by hedge funds into corporate financing is largely viewed as beneficial. “Hedge funds need to deploy their capital and a number of the larger well-staffed sophisticated managers bring more structuring capabilities, insight and risk capital, which is positive for capital markets in general,” says Bob Morette, partner at Bain & Company and former chief strategist with Citadel.
This new source of financing, however, is putting pressure on other providers. More than half the private-equity professionals surveyed by ACG/Thomson in June complained about the hedge funds’ involvement in their space. With good cause. Hedge funds were able to offer a more suitable alternative to private equity in the case of Pay By Touch; elsewhere they are acting as pure private-equity houses. In the US in 2004, 23 private-equity deals totalling $30 billion were conducted by hedge funds, and in Europe hedge fund involvement in private equity is growing, with a series of high-profile deals this year.
In the reverse takeover of insurer Britannic Life by Resolution Life, hedge funds were the sole providers of equity. In April, Och-Ziff Capital Management bid in the £1.2 billion ($2.1 billion) auction for Yellow Brick Road, a pan-European directories business; in September, a consortium of six hedge funds, including Och-Ziff, Perry Capital and Citadel, entered talks to take over discount retailer Peacock Group.
Inaki Echave, investment director of private-equity group 3i, points out the difference between the hedge fund markets in the US and Europe. “In the US, hedge funds have taken quite an aggressive approach and are competing head to head with private-equity players,” he says. “That is raising some eyebrows as some people wonder whether hedge funds know how to run a company. Although sceptics could say the same of private-equity houses, there are undeniable differences in track record, investment philosophy and resources where private-equity firms can demonstrate they have created value by actively managing their investments.”
In Europe, however, Echave says hedge funds are taking a more collaborative entry strategy in the private-equity arena. They are aiming to participate in consortia working alongside traditional private-equity players. “They can be very flexible with their mandates and, in large transactions in Europe, hedge funds are currently offering an additional source of capital to complement the debt from the banks and the equity from private-equity houses.”