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Walkers sees rise in hedge fund financing for distressed funds

Law firm Walkers says the trend of hedge funds investing in distressed funds that are in liquidation has grown significantly over the past two years.

The trend is due in large part to the simultaneous increase in the capital managed by hedge funds and the number of distressed opportunities. Sandie Corbett, a litigation partner at Walkers in the insolvency and restructuring group, said: "We've witnessed a sizeable upswing in this trend over the past two years. With so much money and fewer traditional investment opportunities, hedge funds readily accept these types of unconventional high-risk, high-payoff ventures."

Prior to this investment boom, there were few options for distressed funds. Traditional banks are loath to lend money to fund liquidations. Banks generally only lend when there is an assurance that the borrower can repay the loan. Hedge funds, however, are willing to finance such liquidations because of the potential for high returns.

Typically, a hedge fund will buy out as much of the original investment in a distressed fund as it can, with the intention of becoming the sole, or at least the largest, investor. With this controlling influence they are then prepared to assist by way of priority liquidation funding for litigation against wrongdoers or to recover other assets. Whatever funds are recovered in the process are then distributed to all the investors, including the investing hedge fund, which also receives back its loan in priority to all other claims. If the strategy works it can be a very lucrative one.

This trend has seen high interest coming from funds based in the New York and London markets. Companies that have benefited from hedge fund intervention include Foamex International, Inc.; Krispy Kreme; and even Enron Corporation whose international assets are due to be purchased by a group of private equity and hedge fund managers. According to Standard & Poor, hedge funds accounted for 12 percent of all loans allocated to institutional investors in 2005, as compared to less than one percent in 2001.

"Financing liquidations were formerly the domain of private equity funds," Kevin O'Connor, a partner in the investment funds group at Walkers, said. "As private equity funds and hedge funds continue to converge, we see an increase in hedge fund involvement in distressed funds liquidation. In order to accommodate this trend, Walkers is expanding its expertise in this niche."

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