It's no secret that big banks have been beating a steady retreat from corporate lending, which had long been used as a loss-leader to gain lucrative investment banking or bond underwriting business from clients. That has left all but the best corporate borrowers, especially companies with lots of debt or shaky financials, scrambling for a steady source to provide
working capital, expansion funding, or cash for acquisitions. Enter hedge funds, awash in cash and more than happy to serve a host of less-than-A-list borrowers like U-Haul International or Krispy Kreme Doughnut () Corp. Indeed, their share of the $506 billion leveraged loan market is now almost 50%, from less than 20% only five years ago.
There certainly are positives to having hedge funds and other private capital pools pick up the slack for such lending. For instance, these new nonbank lenders have brought more capital, faster decisions, and better loan terms to the less-than-investment-grade borrower market. And spreading investment risk to these new players (besides originating loans, many hedge funds also trade leveraged loans in the secondary market) reduces the likelihood of a banking system meltdown if this class of borrowers suddenly tanks.
But there are dangers aplenty, as well. First, hedge funds and their secretive brethren are so lightly regulated that neither governments nor markets have a complete sense of the lending exposure (or imprudent risks) taken by any market player. Next, heightened demand in the secondary market for the derivatives of these loans may encourage lax credit standards. And Britain's Financial Services Authority -- the equivalent of the U.S. Securities & Exchange Commission -- is examining whether some hedge funds are obtaining private information when making or buying loans in a company, then illegally using that insider intelligence to trade the company's public securities.
It's too soon to say if this explosion of hedge fund lending is a blessing or a curse. But the growing financial reach of these players certainly convinces us that more government oversight is needed right now -- before some hot money partnership inadvertently roils world markets.