Hedge Funds Find Returns in Making Small Loans

New York Times

February 21, 2006

Market Place
By JENNY ANDERSON and JULIE CRESWELL

On a summer day in 2003, Anthony DiMartino was helping pour concrete on a construction job in Manhattan when he tripped on a cable sticking out of the ground and fell, injuring himself. While the operations on Mr. DiMartino's back and knee were mostly covered by insurance, other bills piled up as a lawsuit against Consolidated Edison, which he says did not properly bury the cable, made its way through the courts.

So Mr. DiMartino recently visited a small finance company in Brooklyn; a few days later, the company, LawCash, advanced him $6,000. What Mr. DiMartino did not know was that he had another benefactor: SageCrest, a $1 billion hedge fund in Connecticut, which has provided financing to LawCash.

On the surface, LawCash looks like a risky venture for SageCrest. If Mr. DiMartino receives a settlement, LawCash will get its money back, plus 30 percent interest. But if there is no settlement, Mr. DiMartino will not pay back a dime. (Con Ed declined to comment on the litigation.)

Indeed, no collateral backs any of the advances LawCash makes. Lawsuits and claims can easily drag on for years, which means there can be a huge time lag before payment is received. And if there is no settlement, there is no repayment of the original advance or interest.

Yet SageCrest is not the only hedge fund in this business. So why are hedge funds — supposedly the sophisticated money, making bold, broad bets — rushing into lending?

Part of the answer is that while interest rates are low, hedge funds are able to lend money at sky-high rates. SageCrest, for example, charges LawCash 16 percent annually for what it borrows. But the trend also reflects the fact that as some 8,000 hedge funds look for ways to put their billions of dollars to work, they are pushing further into uncharted territories in search of high returns.

"Hedge funds seem to be sticking their nose into just about everything these days," said Charles M. Roame, managing principal of Tiburon Strategic Advisors, a San Francisco management consultant to financial services companies. "They're in every crazy asset class you can think of" including bottles of wine, paintings and coin collections, he said. "The esoteric-ness of the alternative investments just keeps getting more and more esoteric."

Lending, an old and seemingly ho-hum business, is now one of the hottest new investments for hedge funds. The funds are making investments in consumer credit card debt and specialty finance companies, and are going head-to-head with banks to provide loans to small companies and even individuals.

"We have seen phenomenal growth in the last couple of years in hedge funds expanding their horizons to the credit space," said Chad Leat, head of global credit markets at Citigroup. "It wasn't that long ago that they were thought to be long-short equity investors."

Besides hoping for a big payoff in these types of loans, hedge funds are also seeking returns that are not related to movements in the stock or even bond markets.

"In the past several years, the hedge fund industry has undergone dynamic changes where managers are seeking to utilize strategies which do not correlate to traditional market gyrations," said Ron Geffner, a lawyer at the New York law firm of Sadis & Goldberg.

Besides trading weather derivatives and complex life insurance products, some of Mr. Geffner's clients are preparing to start hedge funds that will invest in class-action lawsuits and precious coins.

The greatest activity by hedge funds has been in the credit business. Last spring, Citadel Investment Group, a $12 billion Chicago-based hedge fund, was part of a group that made a £275 million loan (about $475 million) to Malcolm Glazer to finance his takeover of the Manchester United soccer club. And in October, Och-Ziff Capital Management and Farallon Capital Management, two hedge funds known for unusual investing, lent $64 million to Pay By Touch, a San Francisco-based company that sells devices to make payments using a fingerprint.

"Pay By Touch has found that hedge funds are a better fit with our capital needs, providing us with both flexibility and lower dilution for our existing investors," said Gus Spanos, the company's chief financial officer, in an e-mail message.

Market participants say the entry of hedge funds has increased the availability of money in the market. As a result, small and midsize companies may have greater access to loans at a time when most big banks have abandoned that market.

It is unclear how long this will last. While some hedge funds have long-time horizons for their investments, the majority are known for moving rapidly in and out of sectors as they seek the next great investment idea. And hedge fund investors have the ability to redeem their investments, which could force a hedge fund to exit a business sooner than it would necessarily like to raise money.

The more important issue for hedge funds as they venture further out on the risk scale is what types of loans and investments are appropriate. In one case, Citadel and Wells Fargo Foothill got into a legal tangle after making a $60 million loan in 2000 to Jack Abramoff, the lobbyist who has since been indicted, to help him buy SunCruz, a company that operated floating casinos in Florida. When SunCruz went bankrupt and the loan went unpaid, Citadel sued Wells Fargo Foothill, Mr. Abramoff and other parties, claiming it had been defrauded out of its investment. Eventually, the case was settled out of court for an undisclosed amount.

Still, the promise of tantalizing returns continues to attract hedge fund money to some of the far-out sectors of lending, like LawCash.

LawCash, started in the late 1990's with $3 million in equity, is risky and — like the industry over all — unprofitable so far, the company's chief executive, said Dennis Shields, and the co-founder, Harvey R. Hirschfeld. From a small, windowless office, where seascape prints hang on the walls and stacks of cans of Dr. Brown's soda line the small kitchen, they said the company advances money only to claimants who have filed personal-injury suits and who have lawyers.

LawCash's borrowers need no collateral. More than 70 percent of the time, clients need cash to prevent foreclosure on their homes or apartments. If the case is settled, LawCash receives a share of the claim proceeds to cover its principal and its fees. If the individual drops the case, LawCash loses its investment.

"It's a great product for hedge funds," said Mr. Shields. "They can get the yield they need and people benefit from it."

While consumers pay high rates for the money — usually about 24 to 45 percent a year — Mr. Shields said the company was borrowing money itself at a rate of about 18.5 percent. Hoping to reduce that rate, it struck a deal with SageCrest for a line of credit at 16 percent. SageCrest did not return a call seeking comment.

It was not LawCash's first dealings with a hedge fund. In 2003 and 2004, LawCash sold a portfolio of $4 million in advances it had already made to clients to Fortress Investment Group, a $5.5 billion hedge fund. Fortress made a 31 percent return on the investment, Mr. Shields claimed. "We didn't make money," he said. "Fortress made money."

Fortress declined to comment.

Mr. Hirschfeld said another hedge fund manager laughed when he heard the size of the loans, suggesting that LawCash call again when it needed $50 million, not $5 million. "They would give us a loan if we wanted to buy Peru," Mr. Hirschfeld said. "But not $5 million."


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