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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.
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.
Conventional lending to small firms has also suffered.
According to a quarterly U.S. Federal Reserve survey of senior bank loan officers in April, 52 percent of respondents tightened lending standards for companies with annual sales of less than $50 million, up from 30 percent in January.
Also, 65 percent of banks said they made the loans more expensive, up from around 40 percent in January.
The U.S. Small Business Administration recorded a decline of 8 percent in its most popular loans for the year to August 1 versus 2007.
The lack of credit has pushed more small companies toward hedge funds like Madison Realty Capital, which specializes in one-year bridge loans for commercial real estate deals of up to $50 million.
"We have seen more firms come to us for funding, and the quality of those firms has increased," said Josh Zegan, Madison managing partner. "A year ago they would have had far more funding options, but the market is less competitive now."
Earlier this year, Jim Gee, owner of Trinity Communications, a cable television operator company in South Pittsburg, Tennessee, wanted a bank loan to increase his business by laying more fiber optic cable, but was repeatedly turned down.
"Basically I was told the only money the banks are lending right now is to folks who don't need it," Gee said.
Gee's attorney put him in touch with Sands Brothers, which lent him $700,000 four months ago and $800,000 more a few weeks ago -- both at a rate of approximately 14 percent. Citing the first loan, he expects 2008 revenue to rise to $2.5 million from $1 million in 2007.
"The rate wasn't that bad and considering they were taking a risk by lending to me, I found it very fair," Gee said. "I had to use my fiber optic network as collateral, but a bank would have demand exactly the same thing."
Sunder Ramani, a member of the board of the National Federation of Independent Business, said the funds' interest rates may seem high, but small firms have little choice.
"The hedge funds know when small companies need money they need it fast. They can't wait for the next economic cycle," Ramani said. "They also know where to look for returns."
Ramani added that the interest rates may seem high, but small businesses lack the leverage of large corporations and tend to pay higher rates.
With the U.S. sector continuing to slide and the financial sector in turmoil, the funds managers expect the boom to continue.
"I would be surprised if anyone was naive enough to believe that the largest dislocation of asset values in American history is going to right itself in six months time," said Sands Brothers' Steven Sands. "We are counting on this cycle lasting a couple of years."