Hedge Funds Employing Loan-to-Own Strategies Face (and Resolve) Ownership Dilemmas
Hedge Fund Law Report
Loan-to-own strategies are becoming increasingly popular among hedge funds, especially those with a credit orientation. Generally in such strategies, a hedge fund purchases debt of a company with the goal of converting that debt into a control equity position though a triggering event, such as a bankruptcy, other restructuring or recapitalization. In many such circumstances, the pre-event equity is wiped out. Not surprisingly, the popularity and prevalence of such strategies increases as economic conditions worsen – and thus as the distressed opportunity set widens. Moreover, as a route to equity ownership, a loan-to-own strategy offers a certain degree of safety relative to an outright acquisition of the equity or assets of a company: even if the loan-to-own strategy is aborted in media res, the hedge fund investor still may sell the acquired debt at a profit. But for credit-focused hedge funds, a loan-to-own strategy that actually ripens into ownership raises a ticklish question: what to do once you own? That is, credit hedge funds generally are in the business of purchasing passive stakes in the debt of companies, then selling those stakes, ideally at a price above the price at which they were purchased. But majority equity ownership is a very different ballgame from passive debt investment: majority equity ownership requires different managerial competencies, personnel, fund structures and time horizons. It also exposes a fund and its manager to different categories of liability. So how can traditional credit hedge funds see a loan-to-own strategy through to its conclusion? That is, how can they own? Or what can they do in anticipation of ownership to mitigate the legal and practical difficulties of owning equity in a fund organized to invest in debt? We address these questions, and in the course of our analysis discuss distressed debt funds, dedicated loan-to-own funds, cross trading concerns and lender liability issues.