3 Intangible Assets Hedge Funds Like in Private Businesses

As of 2009 there were nearly 10,000 hedge funds worldwide controlling about $2 trillion of assets. Typically one thinks of billionaire managers like George Soros or John Paulson, a speculator and an arbitrageur, respectively, who participate primarily, if not solely, in public markets. Suffice to say neither one of these guys is in the market to make a $2m bridge loan to a land developer waiting on permit approval. But thousands of hedge fund managers are.

Seeking returns uncorrelated to broad equity markets like the S&P 500 and able to stomach more risk and operate with more flexibility than corporate banks, certain hedge funds buy securities – CDO’s, mezzanine debt, equity stakes, or whole assets – from private businesses and entrepreneurs looking to restructure or recapitalize. These funds, generally categorized as “Distressed” or “Special Opportunities,” are especially attractive to investors in times of uncertainty and high volatility in global public markets, and are to an extent insulated from market crashes. During a week when the Dow Jones is down 5%, funds divested of public securities are unaffected.

These funds aim to make investments that are also uncorrelated to each other. The same fund could provide litigation funding to law firms and bridge-financing to farmers, as long as there are demonstrable receivables, assets, or personal guarantees or insurance policies to serve as collateral. It could also take an equity stake in a local produce wholesaler flying under the radar of private equity firms. Private businesses will almost always pay higher rates to hedge funds than banks, but this liquidity can be the difference between bankruptcy and growth, and can be a better alternative than no financing at all. But keep in mind that hedge funds often attempt to include strict covenants, and subsequently failing to meet them can result in penalties ranging from increased interest rates to outright claiming of assets, so beware.

Advisors and business owners often overlook hedge funds as private liquidity providers, but hedge funds will consider almost any proposal in their constant search for yield. When credit is tight and the macroeconomic outlook is hazy, hedge funds will step in where banks can’t. They can be integral players in private markets and ought to be considered accordingly as a lender of last resort.

Here are three assets that will endear you to potential hedge fund investors:

1. An existing, quality investor, preferably with a seat on your board

There is often strength in numbers, in addition to validation and safety, in private market financing. Whether the existing parties are junior or senior investor, their stamp of approval can impart confidence to a hedge fund considering committing capital. However, the first investor must not only be accomplished and respected, but should also be ideally sitting on the board and able to leverage contacts, information, and wisdom to grow the business. As hedge funds are often taking risky short term positions, the presence of another investor gives a considering hedge fund flexibility, optionality, and a cushion to minimize their risks in the event the investment fails.

2. Management and officers with proven track records

As in any prospective investment for any investor, apart from those earth-shattering ideas born in college dorm rooms, experienced leaders are a must. This means that your CFO and COO should have held those positions and been successful at reputable companies in the past for more than just a few years. Management should not include your next-door-neighbor, brother-in-law, or old frat brother, unless they happen to meet the experience credentials of course, and is more important to a hedge fund than to a private equity firm, as the latter thrives on actively aiding or implanting management while the former just doesn’t have the time or people to do so.

3. A trick up your sleeve

Hedge funds have shorter investment horizons than private equity firms, and aren’t in the business of hands-on monitoring and long-term waiting, in part because their lock-up periods rarely exceed two years. Thus hedge funds seek alpha, or abnormal risk-adjusted returns, through isolating what they find to be anomalous opportunities in the form of businesses set to outperform peers for some special reason in the short run. The special reason for outperformance can be a new drug, a new gadget, a new chemical, or something intangible like an optimistically pending lawsuit, a new CEO in the wings, or a beneficial piece of legislation soon coming into effect. Whatever the catalyst is, as long as it is a catalyst, it will intrigue hedge funds and help your chances of receiving their funding.

These three assets are by no means esoteric to measuring your company’s viability as a hedge fund investee. Considered broadly, any business will benefit from incorporating the above characteristics into a strategic plan.