HONG KONG, Oct 10 - Before the Chinese initial public offering boom began to fizzle late last year, hedge funds jumped to buy stakes in hot companies before they went public, an investment known as pre-IPO financing.
What seemed like a good idea at the time is about to come back and haunt them.
With Asian capital markets all but shut, forcing billions of dollars worth of IPOs to be shelved, many hedge funds are sitting on illiquid and often hard-to-price pre-IPO investments that in some cases could end up worthless.
The problem might not be as severe if markets were still rising or at least steady. But the financial market bloodbath of recent weeks has made a miserable situation dire for many Asia hedge funds, one of the world's worst performers even before the latest surge in volatility.
"You can hold at cost, but when people start demanding their money back, that's when you get into trouble," said a Hong Kong based investment fund manager who did not want to be named.
Huge numbers of clients are said to be pushing to redeem their investments. Sources close to the situation say the hedge funds under the greatest pressure, small players holding a large percentage of illiquid investments like pre-IPO stakes, will be forced to close up shop.
Among the firms that took part in pre-IPO financings of Asian companies were DKR Oasis, as well as U.S. hedge fund giants such as Stark Capital, Och-Ziff Capital Management Group LLC and Citadel Investment Group LLC, according to several investment bankers who did not want to be identified.
The four firms declined to comment.
"We have a few," said Liang Meng, a managing director at U.S. hedge fund D.E. Shaw, when asked at a conference about the financings. "But we're not the guys who in the last two years invested in a lot of pre-IPOs."
Abax Global Capital, a hedge fund partly owned by Morgan Stanley, confirmed it also participated in two deals worth less than 5 percent of assets. The majority of its investments are privately negotiated transactions with public companies.
Unlike most hedge funds, Abax requires investors to lock up their capital for three years, though they can redeem a small portion after a year if they're prepared to pay a penalty. Long lock ups are more common with private equity funds.
"Since we began, our focus has been on privately negotiated investments. We recognised the inherent mismatch between these longer-term investments and standard hedge fund terms," said Benjamin Happ, the firm's head of business development.
NOTHING IN THE KITTY
Pre-IPO financings are privately arranged deals, making it difficult to identify which hedge funds are most exposed, and at what cost.
Property companies, among the darlings of the IPO boom, were especially prone to pre-IPO financings because their businesses were low on capital but high on hopes of cashing in on China's real estate boom.
"You had people crawling all over Asia lending. Their strategy was 'I'm going to IPO this one day," said one Hong Kong-based prime broker who did not want to be identified.
"Now you're looking at a Chinese property company that can't pay. They've got nothing in the kitty any more."
Chinese property developer Evergrande Real Estate Group Ltd is often referred to as the classic example of pre-IPO financing gone wrong. Evergrande, which sources say had several hedge fund investors, scrapped a $2.1 billion Hong Kong IPO in March.
Excluding these property deals, another 13 China and Hong Kong IPOs worth $2.2 billion have been withdrawn or postponed, year to date, according to Thomson Reuters data.
Indeed the list of China IPOs shelved this year is long, and it contains several property firms with pre-IPO investors: Glorious Property, Star River Group and Hengda Real Estate, which hoped to raise more than $4 billion combined.
The combination of Asia's hot IPO market and immature bond market led to the pre-IPO financing boom. Investment banks also invested money in the deals, sources say, hoping to win the IPO mandate when it came time to go public.
Pre-IPO financings were mainly structured as convertible bonds, or loans to the company that would turn from debt to equity once the company went public. If the company didn't go public by a certain date, most arrangements included a bump in interest rates on the loans or the promise to pursue the sale of the company to a buyer willing to pay a premium.
Bankers who arranged the deals say many of the trigger dates are six to 12 months off. And even if the IPO or mergers and acquisitions markets are dormant then, higher interest payments will allow the funds to recoup money.
The worry is that a lot of these pre-IPO companies, especially property firms, are so cash-strapped that they'll never be able to handle a higher interest rate on their loans.
Hedge funds may be able to pursue legal action against the companies should they default on the pre-IPO loans. But some bankers wonder just how much legal sway a New York or London hedge fund will have in a Chinese court, for example, in seeking money from an insolvent company.
Given near-term redemption pressures, hedge funds won't have the luxury to pursue long legal battles. Industry sources said that for some, the only option may be to write off their investment or sell at a loss to a more patient investor.