Hedge funds have pried into nearly every nook of the investing world as they hunt for good returns. Recently, they have increased their focus on a sometimes tricky game: lending money to ailing, cash-strapped companies.

Such lending is one of many nontraditional strategies U.S. hedge funds -- lightly regulated investment pools -- are employing as they seek to find superior returns in a moribund market environment. But the arrival of hedge funds has shaken up the business of giving loans to struggling companies, with many traditional lenders, such as banks and Wall Street firms, decrying the rough tactics they say hedge funds sometimes employ.

These lenders say hedge funds often resist amending loan agreements, thereby making it more likely that borrowers will file for bankruptcy protection. Hedge funds defend their methods, saying their stern stance instills financial discipline and doesn't reward unnecessary profligacy.

A cash-hungry company can't always be choosy about where it gets money. Hedge funds have horned in on the lending business by offering more flexible terms than traditional lenders. In some cases, the hedge funds step in and make loans when others won't. At the same time, these funds sometimes "hedge" their loans by shorting the stock or bonds of the distressed company. An investor goes short by borrowing a bond or stock and selling it with the intention of repurchasing the security later at a lower price. But such strategies mean hedge-fund lenders don't always have a vested interest in the borrower's survival.

"Many hedge funds play in a gray world," says Henry Miller, head of restructuring boutique Miller Buckfire & Co.. "They sometimes do things to make their positions worth more, which can cause difficulty for others."

At the moment, with lending rates favorable and the economy growing, most U.S. companies have little trouble raising money. Distressed companies are the exception. When the credit cycle turns tougher, troubled companies find themselves caught in an increasingly complex tug of war among creditors.

Hedge funds acting in this market "are dramatically changing the landscape" of bankruptcy filings, says Michael Kramer, a restructuring adviser who recently left Greenhill & Co. "This is the first (lending) cycle where loans from hedge funds have been a factor. It will make workouts far more complicated when hedge funds have a louder voice at the table." Workouts are the process of helping troubled firms operating under bankruptcy protection recover.

Hedge funds have gained ground in lending to troubled companies because they now dominate the so-called second-lien loan market. These are loans that give lenders certain rights over some of the borrowing company's assets. But second-lien loans are risky because other creditors often have superior claims on the borrower's assets in a bankruptcy reorganization.

The second-lien market is a place "where companies that can't get funds from their traditional lenders can get cash, even though it is more expensive," says Jeff Stegenga, a senior managing director with FTI Consulting Inc.'s Dallas office. "Borrowers know they are making a pact with someone who may lack a long-term investment horizon."

Tower Automotive Inc. offers a view of this evolving landscape. In February, the company, with debts of $1.3 billion, filed for Chapter 11 bankruptcy protection. Alongside creditor banks were hedge funds, including Silver Point Capital Fund LP, a Connecticut-based hedge fund.

Tower, a Novi, Michigan, supplier of truck frames was being squeezed by rising costs for metals and other supplies. But it was unable to pass on those price increases to the big car makers, according to various Tower statements.

In May 2004, it turned to credit markets. Among its new financing deals was a so-called first-lien loan, valued at $425 million, which gives lenders a priority claim on a borrower's assets in the case of default, and a $155 million second-lien loan. Silver Point took some of the second-lien loan. Both loans, arranged by J.P. Morgan and Morgan Stanley, were governed by the same credit agreement.

But business conditions continued to worsen. By November, Tower needed more money. It stopped paying dividends on some securities and sought a lender that would give it advances on the money the car companies owed it.

However, any new arrangement required existing lenders to forgo certain collateral and make concessions on interest payments. Most banks, led by J.P. Morgan Chase & Co., were initially willing to do that. But in the weeks that followed, opposition grew as hedge funds and even some bank lenders felt they were being asked to give away security that backed their loans with no compensation for doing so, a spokesman for Silver Point says.

When Morgan Stanley stepped down as the agent for the credit facility in December, lenders elected Silver Point as the successor agent. Silver Point, which at one point had a short position in the debt, closed out that position before it became the agent.

"Silver Point has a policy of not using a bank-loan position to cause a company to file for bankruptcy to benefit a short position," a spokesman for the fund says.

Tower filed for Chapter 11 protection two months later. Some bankers believe hedge funds triggered the filing to make their short positions worth more. But hedge funds like Silver Point claim companies delay filing and fritter away valuable cash.

"Hedge funds do what others are not willing to do," says James Sprayregen, a bankruptcy lawyer with Kirkland & Ellis LLP in Chicago and the legal adviser to Tower. "They are willing to take more risk for more return. And they are agnostic about outcomes as long as they are protected."

Tower is expected to emerge from bankruptcy protection next year.