Understanding how hedge funds work is like navigating a complex maze. Even the terms used - alpha, gamma, information ratio, and distressed debt - sound like classes at Harry Potter's Hogwarts. Lawrence Gosling takes you on a journey into an unknown and mysterious world
Once the preserve of the super rich and generally inaccessible to most of us, hedge funds are increasingly appearing on the investment radar. Estimated to be worth £3500bn worldwide and growing at about 20 per cent per year, it is certainly hard to ignore them. So are they something North West companies in Insider's Top 500 should be getting to know better?
If recent news on financing deals is anything to go by, then yes. Small private companies have a hard enough time as it is to find backing for a new product line, equipment or strategic acquisition because they are generally too small to go to investment banks, while commercial banks favour conservative strategies that do not always allow flexibility when it comes to growth plans.
For publicly-listed companies, raising cash from the market can be expensive and unpredictable. Companies looking for alternatives to the banks or the stock market have tended to turn to private equity.
But, increasingly, hedge funds are offering another possibility for companies looking for finance.
In a way, hedge funds act like private equity funds, in that they are willing to finance growing companies. Indeed, more recently they have been accused of encroaching on some of the more traditional areas of private equity firms. While some industry commentators are nervous of this development, others see it as providing a healthy dose of competition in the financial market place as a whole.
David Green, of the corporate finance team at Brewin Dolphin, believes hedge funds are finding their place: "Hedge funds often take a contrarian view to the mainstream investment community, and therefore have an important role to play in providing alternative sources of liquidity when other investors are not interested. Equally, hedge funds are also increasingly acting as a halfway house between the listed market environment and private equity or venture capitalists."
Nigel Birkett, director of the specialist debt advisory team at Deloitte in Manchester, says hedge funds are set to become a major threat to more traditional providers of company finance. "Hedge funds are providing a wide range of services, effectively forming an alternative asset class," he says. "They provide funding to a whole range of businesses, although typically offering mezzanine type investments over £320m. They provide a competitive offering in auctions - on a recent transaction, where we were looking for £3120m of debt/mezzanine funding, a hedge fund came up with the strongest offer, thereby presenting a real threat to the mainstream banks."
Neither are they afraid of innovation. A hedge fund will be much more willing to explore unconventional financing deals so long as they see a return on the share price. Although more recently hedge funds have begun to flex their financial muscles, particularly in the distressed debt and secondary debt markets. In these situations board directors are not always aware that hedge funds are involved, or the power they can ultimately wield.
Birkett explains: "The distressed debt market typically involves a business that has borrowed from a bank and breached one of its covenants. Rather than the bank exercising its rights following a covenant breach, it sells the debt onto another party, often a hedge fund, at or below par. The hedge fund can then use its rights to restructure the company.
"Hedge funds are also becoming big players in the secondary debt market. They are acquiring underperforming debt from mainstream banks and using their position to renegotiate the funding package offered to the banks. This rise in secondary trading means that directors of businesses often do not know who owns the debt in their business until it starts to underperform," he says. "As such, it is important that business managers are aware of the rights attached to debt providers under the facility agreements and that independent advice is taken when the loans are taken out."
Recent examples of hedge fund involvement in company financing include the takeover of Manchester United by Malcolm Glazer. The deal was part funded by hedge funds as Glazer sold £3275m of preferred securities, PIKs (payments in kind) to three New York hedge funds to help finance the deal. As well as annual payments on the securities, the preferred securities give the hedge funds - Citadel Horizon, Perry Capital and Ochs-Ziff - the right to 30 per cent of United's equity in 2010 with proportionate representation on the board.
A number of hedge funds have also invested over the last five years in the bonds issued by a range of European football clubs, which are backed by revenues secured on future season ticket sales.
It was recently revealed that one of the UK's biggest hedge fund groups, RAB Capital, has taken a majority stake in A1 Grand Prix, the world cup of motor racing, started by a member of Dubai's ruling family, the Maktoums.
But hedge funds have also diversified into complex structures to fund films, as a recent announcement by 20th Century Fox of a hedge fund-backed film financing deal worth more than £3300m following the success of films such as Borat and The Devil Wears Prada. The agreement will see Dune Capital Management investing in at least 15 new films.
Do not, however, be fooled by thinking hedge funds simply offer an alternative to private equity when it comes to financing growth. Unlike private equity funds, hedge funds have another function as alternative investment vehicles. Basically, they offer a more flexible alternative to unit trusts, one of the key differences being that they are allowed to effectively bet on the movement of company shares and other financial instruments.
The original idea behind the first hedge funds launched in the 1930s was to allow an investor to hedge their risk. But they have now developed to offer a number of alternative investment strategies, which allows investors to participate in the value of investments going down as well as up.
This works in exactly the same way as a bookmaker who will lay off some of this potential risk of say, Manchester United winning the Premiership. If he has taken a lot of bets on the Reds, he might himself place a bet with another bookmaker on United. This would mean that if United did win the Premiership, then although he would have to pay out to his punters, some or all of his losses would be covered.
Called long/short, this is still the most common strategy for a hedge fund. This involves a hedge fund buying shares in the expectation the price will rise over time, but in the short term, if they believe the share price will fall, they can also make money by going short on the stock, which involves selling the shares in the anticipation of buying them back at a lower price in the future. They can also buy an option on the share price falling, which does a similar job but means they do not have to physically sell the shares.
The most famous bet by a hedge fund happened when George Soros backed the price of sterling falling after its exit from the European Monetary Union. He did this by selling £315bn of sterling and then buying it back at £314bn, basically making the hedge fund a £31bn profit. While this is one of the most famous hedge fund bets taken, there are plenty more going on all the time.
Clever stuff, but surely not applicable to a company listed on the stock market? Think again says Andy Brough, who runs a hedge fund for quoted asset management group Schroders alongside pension funds and unit trusts for investors.
Brough runs a hedge fund that invests in smaller to medium-sized companies - anything ranging from a market capitalisation of £3100m up to nearly £31bn. He says many hedge funds will use CFDs (contracts for difference) as a way of investing in quoted companies because they are more tax efficient and they retain anonymity, which means they can hold big stakes in businesses without having to reveal themselves as corporate investors.
Although this means they have no voting rights, they can get the necessary control if they need it because they can simply convert the CFDs to direct shares.
Just as businesses may not know who owns their debt with it being resold in the secondary market, so they may also not know who owns their equity.
But Brough has a simple message for all businesses: "If you're running your business well, then hedge funds can be your friend. If you're not, be afraid."
Lawrence Gosling is a freelance business journalist and former editor-in-chief of Hedge Funds Review magazine
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