Hedge funds expand role as small business lender

By Nick Carey

CHICAGO (Reuters) - Hedge funds are known for playing many roles on Wall Street, but last-resort lender to small businesses that are turned down by banks is hardly one of them.

Yet with the credit crunch pushing many major U.S. banks to set tougher lending standards for small and medium-sized businesses, hedge funds have stepped in.

The money isn't cheap, with interest rates of 14 percent or more. But small businesses have few places to turn.

"A major void has been created in the marketplace by banks tightening their credit standards and trying to stabilize their balance sheets," said David Grin, co-founder of Laurus-Valens, a hedge fund with around $1.7 billion (870 million pounds) under management. "From the investment point of view, this is as good as it gets."

Laurus-Valens provides loans to public and private companies with average revenues of $30 to $50 million. The fund charges interest rates of about 10 percent to 11 percent, and takes equity stakes in the companies.

Grin estimates that Laurus-Valens' lending to small companies is up 50 percent from a year ago.

Small businesses are considered a linchpin of the U.S. economy, forming the backbone of the country's jobs market and playing a crucial role in creating jobs. According to U.S. Census Bureau data, the United States had 112 million paid employees in 2002. About 56.4 million, or about 50 percent, worked at companies with fewer than 500 employees.

ATTRACTIVE TO BIG INVESTORS

Hedge funds have been lending to small companies for decades. But as they exploded in recent years to become a $2 trillion industry, small business lending has also taken off -- especially since credit markets turmoil began a year ago and the funds sought other investment after conventional markets turned sour.

"This kind of product will be attractive to big institutional investors, a lot of whom have done poorly in the fixed income market," said Ferenc Sanderson, senior hedge fund analyst for Lipper Inc, a unit of Thomson Reuters Corp. "As long as the major banks' balance sheets have not been completely sanitized, there is a pretty good window of opportunity for hedge funds."

Sanderson estimated the market for "asset based lending" -- the industry term for loans to businesses -- has grown to anywhere between $5 to $10 billion currently from around $700 million (350 million pounds) two years ago.

Hedge fund managers say demand is robust so they are seeking fresh cash from investors.

"We've lent more money in the past six months than in the past 25 years," said Steven Sands, portfolio manager at Sands Brothers Asset Management, which manages assets of around $140 million and issues loans averaging $1 million and more to small businesses. "We are raising fresh funds for this product."

Hedge funds have not had a great year. The HRFI Fund Weighted Composite Index, which measures returns, was down 1.17 percent in the year to June 30, after rising 9.96 percent in 2007 and 12.89 percent in 2006, according to data compiled by Hedge Fund Research.

SMALL BUSINESS SUFFERS  Continued...