As hedge funds give banks a run for their money as lenders, private equity sponsors are proceeding to enlist the HFs for their lending syndicates, but with caution. According to Financial News, HFs have become so prominent in these syndicates that in a recent leveraged buyout consisting of 175 lenders, 75% were either hedge funds or specialist funds.” The allure of private equity’s cousins is their flexibility and their affinity to risk. “Hedge funds are much more willing to accept a higher risk/reward profile than traditional lenders and will accept a higher level of structural risk for great recovery potential,” one London-based law firm partner told FN. “As such, they’re more likely to invest in tranches B or C, rather than tranche A or a revolver.” In addition, says another analyst, hedge funds “can play in all parts of the capital structure, can move quickly, and commit substantial tickets. They can also have a more flexible approach to return, which can help in certain situations.”
So, where’s the problem? “Traditionally,” one HF analyst said in an FN interview, “borrowers have looked for stable lenders. Now they are faced with hedge funds...they are concerned about their volatile nature.” Just last month, a Dresdner Kleinwort report stated that if hedge funds and others take on more risk as they look for higher returns, the European leveraged loan market could suffer “a bloodbath,” depending on how serious a downturn there is. According to the Dresdner Kleinwort report, “All this liquidity is arguably increasing financial risk within the leveraged market,” and after three years of rising liquidity, “investors and sponsors may fit it takes less time to evaporate.”