By MITCH DEACON Staff Reporter

Distress comes with a high price these days.

Although capital remains relatively accessible for quality borrowers, credit options have severely diminished for struggling firms, with large public corporations on the ropes facing particular challenges.

"Banks are still willing to lend to distressed companies, but they have become much more stringent in their credit requirements," said Scott Kolbrenner, a director at investment bank Houlihan Lokey Howard & Zukin in Los Angeles. "The pricing of loans has gotten significantly more expensive."

And the shortage of credit for cash-strapped companies couldn't come at a worse time when more firms are facing liquidity shortfalls. Lenders report rising numbers of troubled companies seeking financing.

"We are definitely seeing an increase in the number of distressed borrowers," said Tim Turner, managing director of Wachovia Capital Finance, an asset-based lender in Pasadena specializing in lines of credit from $10 million to $1 billion. "Before July, even a marginally performing midmarket company could raise capital."

Large corporations with liquidity problems face particularly high obstacles in the credit markets due to the unwillingness of investors to buy packages of debt securities.

With banks tightening their belts, alternative financiers like hedge funds, mezzanine lenders and private equity investors are finding a profitable niche by offering capital at premium prices. That will especially be the case if a bank determines that a distressed company has poor fundamentals, rather than just a rough patch on the road to profitability.

Among the popular forms of credit offered by hedge funds are second lien loans and "stretch" loans, according to George Blanco, a partner in business restructuring services at BDO Consulting in Los Angeles.

Second lien loans are subordinate to initial lien loans and are typically made at 50 cents on the dollar for inventory and 80 cents for receivables. In a stretch loan, the debt capital is collateralized on the remainder of inventory, accounts receivables or other assets such as real estate, equipment or patents.

In some cases, a hedge fund will even allow borrowers to submit pro forma financial statements, which exclude some expenses and generally enhance the appearance of earnings. It's a high-risk game that pays high interest rates, but the funds are often hoping to get more than a premium on their loans.

"Hedge funds are more predatory than commercial lenders," Blanco said. "Banks don't want to want to force liquidation or Chapter 11, but a hedge fund is willing to take the downside risk to end up owning the company."

Hedge funds will often load trip wires into a loan package, so even if a borrower is making timely payments, it might still fall into default by violating a covenant, such as a minimum level of profitability. That can trigger higher interest rates and fees, or even force the conversion of debt into equity, Blanco said.

Getting out from under a hedge fund usually involves partnering with a private equity sponsor in a package for equity and new debt, but the borrower can expect to pay high fees for refinancing and early termination of the loan.

One of Blanco's clients is a local transportation company with about $70 million in senior debt borrowed from a hedge fund, which is now in a position to begin charging higher interest rates and possibly even force an equity conversion if profitability continues to deteriorate.

"If the weakening economy slows the import business, the company may not meet the debt covenant, even though they are not losing money," Blanco said. "You can't blame the hedge fund. They give you high-risk money without a significant equity requirement, so they have triggers built into the loan."

Equity, in addition to costly financing, was crucial in securing capital for Blue Holdings Inc., a struggling L.A.-based designer, manufacturer of premium jeans and denim apparel.

The company, which has seen its share price fall to less than a dollar from a high of $28, raised $2 million this month through a private placement of secured, convertible notes to institutional investment fund Gemini Master Fund Ltd.

Blue Holdings paid 8 percent in annual interest, in addition to offering Gemini warrants to purchase 875,000 shares of common stock.

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