Hedge funds have been steadily increasing their participation in the syndicated bank loan market. As they have in other markets, hedge funds have used leverage to maximize their internal rates of return. Hedge funds seeking to acquire a leveraged position in a bank loan have used: (i) total return swaps with a dealer or side entity that holds the loan portfolio and (ii) ownership of special purpose vehicles (“SPVs”) which borrow money from the dealer to purchase a portfolio of loans and pass the economic return of such portfolio, including coupon payments, through to the fund. Repurchase agreements and collateralized loans are not generally used in this market.
Hedge funds may use either structure to actively manage a loan portfolio. Similar to CLOs, concentration limits are typically imposed on the loan portfolio in order to ensure that a minimum level of diversification is maintained. Also, as is the case in other financing structures offered to hedge funds, margin is collected by the dealer on an ongoing basis if the value of the loan portfolio decreases or if the portfolio concentration limits are breached.
Why Not Use a Typical Repurchase Agreement or Revolving Loan Facility?
While a standard repurchase agreement or a revolving loan facility secured by a pledge of the relevant loan portfolio could also be used by hedge funds, each of these structures fails to provide the applicable dealer with certain key protections such as the right to terminate the agreement in the event of the hedge fund’s insolvency and the right to set-off the collateral against amounts owed to the dealer under the agreement in the event of an automatic stay under the Bankruptcy Code. Although the Bankruptcy Code does provide certain safe harbors for the above referenced protections with respect to repurchase agreements which reference securities or certain mortgage interests1, bank loans do not qualify as securities or mortgage interests. Without the protection of the Bankruptcy Code’s safe harbor provisions, a non-debtor party is subject to the stay and may not unilaterally terminate the related agreement, liquidate the related collateral, or otherwise take any action to collect from the debtor as special court approval is required to do so.
Financing Structure Analysis – Total Return Swap
Total return swaps may be attractive structures for hedge funds to use to achieve leverage because they don’t require a transfer of the underlying loan. Furthermore, the total return swap financing structure provides more favorable regulation capital treatment for certain banks, which may translate into larger financing facilities for hedge funds.
However, there may be certain drawbacks to the use of a total return swap. One drawback of a total return swap is the exposure hedge funds face via the portfolio’s market and credit risk and the counterparty dealer’s credit risk. Another potential disadvantage may be the absence of voting rights with respect to the loan portfolio. 2 The exercise of voting rights is an important issue, particularly in the context of distressed debt, due to the potential for such rights to be exercised to the benefit of certain creditors to the detriment of others. In the event that a dealer elects not to physically hedge its position under a swap agreement with respect to a particular loan, no voting rights would be exercisable by either the dealer or the hedge fund with respect to the relevant loan. Moreover, even in cases where the dealer does physically hedge, the dealer would remain the lender of record and may refuse to vote in accordance with the instructions of the hedge fund for a variety of reasons, including, preserving the character of the transaction as a swap, internal policy considerations or a conflict of interest (which may arise if the dealer owns a competing debt interest in the relevant issuer’s capital structure).
Financing Structure Analysis – Special Purpose Vehicle
Hedge funds and dealers may also use an SPV to permit the hedge fund to leverage its investment in a loan portfolio. Under an SPV structure, the dealer lends money to the SPV, which in turn purchases a portfolio of loans selected by the hedge fund. The hedge fund is typically granted an economic interest in the loan portfolio through an equity interest in or a note of the SPV or through a derivative transaction between the fund and either the dealer or the SPV. Careful consideration should be given to the particular needs and characteristics of the hedge fund when choosing the method to provide economic exposure to the loan portfolio held by the SPV. This financing structure generally grants hedge funds equal freedom to a leveraged financing and more freedom than a total return swap in the exercise of voting rights with respect to the loan portfolio.
In general, under both structures (assuming that the dealer physically hedges in the total return swap structure), the hedge fund is likely to be treated for U.S. federal income tax purposes as directly owning the loans in the underlying portfolio. Therefore, the hedge fund should conduct the same tax diligence and analysis that it applies when it acquires loans directly.
While a variety of financing structures are available to hedge funds seeking to finance syndicated bank loans, the structures described in this memorandum are particularly well-suited for the task. In determining which method to use, due consideration should be given to the particular needs and characteristics of the hedge fund, the desirable level of control over the exercise of voting rights and the creditworthiness of the dealer.