Are Hedge Funds at Risk in the Commercial Finance Arena? Caution Is Warranted

By Fox, John | The RMA Journal, July-August 2005 | Go to article overview
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Are Hedge Funds at Risk in the Commercial Finance Arena? Caution Is Warranted


Fox, John, The RMA Journal


This article is not intended as an indictment of hedge funds. It is a criticism of perceived trends. The author believes that if a major high-profile loan goes bad, there will be an exodus of funds from the industry that will be negative for everyone. Better education and cooperation between commercial financial companies and hedge funds can help reduce risks on both sides.

Hedge funds are one of the fastest-growing areas in the financial services arena. Fifteen years ago, hedge funds managed less than $40 billion. Today, the figure is approaching $1 trillion. Unlike the 1970s and 1980s, when hedge fund investors were predominantly wealthy individuals and families, today institutions such as endowments and pension funds are playing an increasingly significant role in that growth.

A recent article in The Economist cautions against investing in hedge funds that are awash in excess cash. t To reach their target yields and attract new money, such funds may be tempted to invest in riskier deals. As a corollary, stumbling borrowers approaching the risk-cycle phase of their investment profile are being shown the door by commercial banks. Such firms will be attracted to take hedge fund money, no matter what the pricing.

What's Really Going On?

On the surface, this relatively new role for hedge funds appears to be a positive trend. Hedge funds make rapid-fire decisions to quickly offer money for any purpose, and they structure their deals to fix the borrower's immediate problem. But what happens in the longer term if, for example, the hedge funds do not take the time to fully analyze the real cash-flow-generating capability of their new borrowers,? Or if they fail to ask for enough managerial information to monitor the operational performance? Or if they rely solely on receivables and inventory collateral without managerial oversight? These what-ifs are ingredients for potential disaster.

According to the New York Times, retail industry companies are selling for prices that were not possible just a few years ago.-' For example, the price for Neiman Marcus, which has only 37 stores, is expected to be about $5 billion, while the price for the 230-plus stores in the Saks department store group is around $3.5 billion. These prices are a result of billions of dollars of private equity and hedge funds looking for transactions at prices that make retail industry investors want to take their money off the table.

Lehman Brothers has agreed to buy 20% of Ospraie Management, a hedge fund that manages about $2 billion. This transaction illustrates that investment banks are seeking access to hedge funds in order to meet demand from both institutional clients and wealthy investors.

While many commercial banks are presumably investigating such investments, only a few have occurred. Last year, JPMorgan Chase bought a majority stake in Highbridge Capital Management.

New Players, Fewer Rules, Faulty Strategy

During the 1970s and 1980s, hedge fund investors were predominantly wealthy individuals and families; today, institutions such as endowments and pension funds are playing an increasingly significant role in hedge fund growth.

Unlike mutual funds, which are highly regulated and restricted in their investment opportunities, hedge funds are lightly regulated. They can take on more risk and seek more opportunities, investing in a variety of different instruments, including receivables, inventory, and a variety of hard assets. This is not likely to last for long. There are several hints over the past few months that regulation is on the way.

Has the diversification strategy of hedge funds moving into commercial finance worked? Not really. Recent returns of many hedge funds have been mixed, and industry experts predict that over time they will inevitably come down. Until that time, however, hedge funds are continually searching for the perceived higher-yield opportunities, and commercial finance appears to be an attractive target.

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