Hunting Hunters

Animal trophies cover the walls of the Dallas headquarters of Highland Capital Management, according to people who have been there. Some, it is said, came from beasts bagged on safari in Africa by Jim Dondero, who founded the firm with Mark Okada in 1993 – while others were shot from Mr Dondero’s back porch in Texas.

The symbolism is fitting. When the global financial turmoil began last year, Highland was one of the more feared big-game hunters in the credit markets. It was a leader of a new breed of alternative hedge funds that invested in high-yield loans to junk-rated corporate borrowers and helped fuel a leveraged buy-out boom in the process.

With the leveraged loans market now in free fall, however, Highland’s large holdings of such debt have transformed it from predator to potential target. Its main funds fell sharply in value during January and, although its results in February are not known, its executives have been forced to take an unusually defensive posture – meeting investors to discourage redemptions, paring back the use of borrowed money to amplify bets and hedging its positions.

The rise of the credit funds had marked a historic shift in finance. Loans were traditionally extended by banks, while hedge funds played in the markets, betting on stocks, bonds or currencies. But banks began selling loans and a derivatives market grew up around the trade, enabling players to buy and sell protection against default.

Hedge funds jumped into this asset class but no firm cast a larger shadow in the loan markets than Highland. At the end of 2007, it sat on a portfolio of $40bn (£20bn, €26bn) – up from $33bn at the end of 2006 – most of it consisting of the debt of companies owned by private equity. Highland also emerged as a leader in the new business of packaging loans into securities – called collateralised debt obligations – that were sold to investors.

Highland was distinguished not only by its size but by the aggressive methods it used on troubled borrowers who violated even minor terms on their loans, demanding huge fees to agree to concessions and threatening some with bankruptcy.

Its officials showed up at creditor meetings and shouted at the founding partners of powerful private equity houses such as Apollo and TPG. It called executives of its borrowers at home at night. Prominent private equity firms tried to prevent Highland from acquiring debt in their portfolio companies. Highland was so demanding it required its analysts to punch a time clock and put in a minimum of 60 hours a week at the office.

“There are three risks we are managing,” says Jack Yang, a New York-based Highland partner. “We are managing the market risk around our portfolio by reducing our leverage. We are actively meeting investors to keep our redemptions low and actively engaged in a dialogue with dealers so there is no financing risk.”

The private equity world is watching to see whether a firm that made its name by being tough on borrowers can keep afloat by winning the sympathy of its investors and lenders. Highland’s reputation goes back to several celebrated clashes. In 2001, for instance, it forced Bridge Information Systems, which was owned by Welsh Carson, into bankruptcy after Bridge violated a covenant on its $800m bank loan. At one point in the dispute, with most creditors supporting Welsh Carson’s restructuring proposal, Patrick Daugherty, head of special situation investments for Highland, called John Clarke, a Welsh Carson partner, to say Highland had a clerk on the courtroom steps in St Louis, where Bridge was based, poised to begin bankruptcy proceedings in 10 minutes unless the private equity firm agreed to a Highland proposal.

“They see no reason to compromise,” says Mitch Harwood, an attorney who has found himself on both sides of the negotiating table with Highland executives. “They ask for what they are entitled to and they hang tough longer.”

Highland did not always win, notably in the December 2004 talks between creditors and Gate Gourmet, a European catering business that TPG bought from Swissair in the course of the airline’s bankruptcy proceedings. Appearing before several dozen creditors in the London offices of Citibank, Richard Shifter, a TPG partner, disclosed that Gate Gourmet would be unable to pay interest on its debt.

Jean Luc Eberlin, Highland’s London-based managing director, then demanded large fees from TPG in exchange for concessions on Gate Gourmet’s debt (see picture left). “Their message was, ‘Pay me off or I will own the company’,” recalls one participant. TPG was being told to “get out of the way”.

TPG officials tried to contact Mr Dondero to work things out but people familiar with the matter say Mr Dondero declined to return calls. One executive at Highland says Mr Dondero did not want to get into a dialogue with the private equity firms.

As it turned out, the majority of the creditors gave TPG the benefit of the doubt and Highland sold its position in the Gate Gourmet debt. TPG was able to save its equity and eventually the remaining creditors got all their money back.

By the height of the buy-out boom, in 2005 to mid-2007, private equity firms were so powerful they could tell their bankers they did not want Highland as an investor in the debt of the companies they owned. Highland subsequently adopted a more conciliatory approach. In November 2006, Mr Yang called Scott Sperling and Anthony DiNovi, co-presidents of Thomas H. Lee Partners in Boston, to repair relations. Mr Yang said he and Mr Okada wanted to have lunch in Boston with the Lee people, according to both sides.

“We should have had a closer dialogue. It was a mistake not to sit down face to face with the sponsors,” says Mr Okada. “We let the intermediaries speak for us. We had people who had no skin in the game point to us as bad guys.”

But by last summer, as conditions in the credit markets deteriorated, the balance of power shifted back toward lenders such as Highland. That leaves it unclear what Highland’s future will be. Its executives argue that it will emerge from the turmoil stronger than ever, as smaller competitors disappear.

Nor has Highland gone soft. Even as the value of its holdings falls, it is tying to raise a $1bn fund to invest in the distressed debt of private equity deals.