Lend to Own – Borrower Beware
Neither a borrower nor a lender be;
For loan oft loses both itself and friend,
And borrowing dulls the edge of husbandry.
From Shakespeare’s Hamlet
Bankers have long been taught to know their borrowers. However, with hedge funds becoming increasingly active in providing second lien financing, borrowers would be well advised to know their lenders. This is because some hedge funds’ motive in providing financing is to take control of those companies.
“Lend-to-Own” strategies often start out seemingly innocently enough. For example, borrowers could be required to maintain minimum liquidity levels (in their stock’s trading activity) or share price. Another example could be that hedge funds stipulate that their borrowers must file the reports required by the SEC on a timely basis. Who could find fault with borrowers complying with SEC rules as a condition of receiving financing?
However, let’s say that a borrower had an issue with options backdating which caused a delay in its auditors finishing their review. Since this situation would result in the company not filing its quarterly reports on time, it would constitute default. This non-monetary default could trigger other debt provisions since these loan covenants have cross-default provisions. Sometimes these defaults allow holders of convertible notes to convert their debt positions into stock.
Another method of trying to gain control of a borrower’s company occurs when a second lien holder threatens to throw the company into Chapter 11. The second lien holders use such threats to gain leverage over the first lien holders.
Yet another motive for some hedge funds lending money to companies is to acquire litigation claims. This occurs when the funds use their stakes in distressed companies to sue investment banks or others on the theory that they failed to identify alleged problems.
Just a few related points:
Some Wall Street firms arrange for hedge funds to loan money to finance their deals. This is an alternative to floating bonds and they require little disclosure compared to floating bonds.
Wall Street firms can offer value added services. For instance, in an energy deal, Goldman Sachs arranged derivatives transactions that protected the new owners against the possibility of a plunge in energy prices.
Sometimes, investment banks join hedge funds in lending to do deals. In other instances, they compete with them for deals.
These are some of the issues that will be discussed at IncreMental Advantage’s Private Equity Due Diligence Conference which will take place in New York City on December 7, 2007.