Emerging Managers 2005: Wolf Rock Capital

Benefiting from the fertile crossover area between private equity and hedge funds

Simon Kerr
Originally published in the September 2005 issue

At one time it seemed that the only common ground between hedge fund strategies and Private Equity (P.E.) investing was that they were both under the label of "Alternative Investments" in the asset categorisations of endowments and large public pension plans. That is no longer true.

The very largest hedge fund groups have been extending their reach into leveraged financings, such as Tudor's financing of US Airways, and looking to assert more control in corporate restructurings. The latter may be carried out/prompted by distressed credit investment groups (Cerberus), activist investors (Dan Loeb of Third Point and Highfields Capital Management) or the restucturings may be following the landmark deals in this area done by Eddie Lampert (takeovers of K Mart and Sears). These are hedge fund groups implementing strategies that are familiar to P.E. groups.

For the most part the activity the other way has not been the adoption of hedge fund methods by P.E. groups in their core competency but has been the setting up of discrete hedge fund businesses. The Blackstone Group and Bain Capital are among the large P.E. groups that have built hedge fund businesses. The Carlyle Group has tried a couple of times to build a hedge fund business, and Whitney has built single manager hedge fund businesses.

The overlap of hedge funds and Private Equity in the U.S.also has been about competition between them. There has been competition for allocations of capital from investors, and more publicly the battle for control of whole or parts of companies. For example last year a group of hedge funds tried to usurp four P.E. firms in the takeover of electricity generator Texas Genco Holdings.

To date there have been few hedge funds that expressly benefit from the flows, pipeline and lifecycle of Private Equity investments as the new larger private equity funds increasingly interact with public companies. Wolf Rock Capital LLP was set up by Edwin Datson and David Holme to exploit the consequences of the growth of Private Equity pools in Europe.

The Fertile Hinterland Around Private Equity Pools

It is clear from Graphic 1 that capital commitments to the European Venture Capital and Private Equity businesses rose consistently in the latter half of the 1990s to a level of around the mid 20's (€bns) each year since. Only last year was the level of investment above the previous Venture Capital (V.C.) focussed peak of €35bn in 2000. So the European V.C and P.E. businesses have been operating at a high level of investment through the 2000's, and bear in mind that these investment pools are pipeline businesses. The V.C. and P.E. investors/owners of operating businesses do not intend to own these businesses permanently. They are bought out, loaded with debt and largely run for cash to pay down the debt over subsequent years. Then the intention of the owners is to sell the companies on by IPO or private sale. The pipeline length varies, but 18-months to two years would be a short period of ownership and five years would be a more typical holding period. All the foregoing suggests that the level of investments should carry on rising as it has for the last three years in Europe, and so it is expected that P.E. investments will increasingly impact European public markets in the medium term. Wolf Rock also benefits to a lesser extent from the deal-flow at the end of the pipeline, when companies owned by PE owners bring those companies to market and influence the peer group of quoted stocks.

Inevitably, the size of deals being done will get bigger, both in public companies bought out and in the companies being sold on by V.C. and P.E. owners. However, it is not just the size of deal that is changing. The maturity of the industry as it is now will also allow a broader spread of companies to be the subjects of leveraged buy-outs. The nascent industry focussed on very steady earning/cashflow type of sectors preferably with asset backing Now the industry has moved on to be able to handle different sorts of businesses from consumer sector firms to communications outfits to distributors and service sector companies. A business such SAGA, the over-55s specialist, could be financed even though it lacked strong tangible assets. The evolution of financing markets to be able to assess cashflow predictability rather than historic book value related metrics has also facilitated the deals for the Autombile Association (AA) and the ISS cleaning business. This increasing breadth in Private Equity deals is a key development for Wolf Rock Capital as it gives them potential to run a portfolio with a far wider range of industries and countries than would have been possible in the past with obvious diversification benefits.

"For what we are trying to achieve we need a team that combines an understanding of both PE and HF methodologies," says Datson. Ed Datson's own background includes both (see Biography Box), as does the background of senior colleague David Holme. In fact Holme and Datson have much in common in their backgrounds – Oxford M.A.s, business school education (Harvard Business School for Datson and INSEAD for Holme), time spent in consulting (Monitor Company and Bain respectively) and then both worked for Morgan Stanley and for the same hedge fund management company (Cycladic Capital Management). The pair form a strong axis around which the team can expand.

A deep understanding of Private Equity is what Audrey Mela also brings to the mix. She has joined Datson and Holme after 6 years with J.P. Morgan Partners in P.E, giving an indication of the appeal of this crossover strategy and the calibre of staff Datson is after..As assets grow from the current $65-75, further employees will be added with significant banking, or consulting experience as well as P.E.

Three Process Elements from Private Equity

Amongst the elements of their process that Wolf Rock Capital utilises from the Private Equity side are some of the analysis tools, the due diligence process and networking. Starting with the tools: it is a central tenet of Wolf Rock that the valuation methodologies of private equity and leveraged loan firms will increasingly influence public market valuations. This is a long term phenomenon which goes back to the previous boom of PE investment that reached its zenith with the "Barabarians at the Gate" takeover of RJR Nabisco in 1988. Since that time the metrics of Private Equity have taken an increasingly prominent role in traded financial market valuation, though they tend to have been adopted by the various sector analysts as those sectors came into play for takeover activity. By now so many sectors have had significant corporate activity that widely available screening/valuation tools used in investment management like HOLT include buy-out measures of valuation as standard. The focus is very much on free cashflow generation, and this in several versions including EBITDA-Capital Expenditure (where the CapEx can be normalised for cyclical considerations). The FCF is analysed for historical trends and projected out over as far as 10 years.

Another consideration that has migrated over to traded market valuations is the concept of enterprise value, that is, taking account of equity and debt in one measure. The enterprise value is used to assess both trading multiples (against revenues, EBITDA and EBIT) and acquisition multiples for companies. It is now a common part of company analysis conducted for broker research and serious buy-side stock analysis, demonstrating the increasing influence of PE metrics.

Due Diligence

A second element of the Wolf Rock process that comes from P.E. is their due diligence process. "The devil is in the detail in this business," states Datson, "so we have to do a lot of work to get to the level of information where we are comfortable. We are applying a model to our understanding of the company and so we need to get to grips with a lot of financial detail that would not be used by a typical equity investor," he adds." Datson and his team will talk to the customers and suppliers to a business they are assessing, and also seek opinions from Private Equity funds and debt providers that have looked at the company or sector. A rounded understanding of the current financial condition and the potential state of the company is considered essential in the process. The firm attempts to identify the critical drivers of cashflow and, where appropriate, hedge out unwanted risks. "We typically like to hedge out a macro factor or commodity exposure in a share by shorting a commodity or macro factor exposed equity," he explains. "But we are also prepared to hedge out with futures the commodity exposure where we don't want to have to take a view. So for example in the cable industry 50% of the cost is copper, and we may want to hedge out that exposure with copper futures. At other times we might use the shares of a supplier to hedge the input price effect on a company's shares."

The due diligence is a major commitment of resource for firms like Wolf Rock. It takes time to understand the dynamics of a company and its sector, and conduct a thorough analysis. So they, in common with Private Equity investors, prefer to see that resource thoroughly exploited. The models built in some detail for one company will be amended and applied to others in the same sector. The spotlight of the PE industry ultimately moves around, but remains on several sectors at any one time whilst those sectors are in play.

This industry focus presents opportunity in equity markets both long and short. When Pirelli sold off some of its cable assets itbrought about an auction amongst P.E. companies for those assets. The cable industry was not well covered by street research. There were significant differences in valuation for companies in the sector across Europe. This enabled Datson to go short of the over-valued companies as well as to go long the under-valued cable manufacturers. This example is a good template: the short positions were put on to generate profits, not only to hedge the long positions, and an in-depth understanding of the sector could be applied in several positions in the portfolio.

Finding Opportunities

Similar patterns of activity were seen in the European satellite industry, as an initial single deal put the whole sector in the spotlight. Then various ownership interests were bought and sold, and in the process the the disparity between old public valuations and the leverage that was possible as an LBO was considerably reduced. Before the satellite industry, the yellow pages directory businesses of Europe were reorganised in a similar way. Whilst there may seem to be an element of happenstance about on which industry the Private Equity and Leveraged Buy Out (L.B.O.) spotlight falls, there are common circumstances and sometimes gross under-valuations that lend themselves to corporate activity. This allows Wolf Rock Capital to screen for ideas, via proprietary cash flow selection criteria. Such screening is a help in finding potential investments, and so too is networking.

Networking is the third element of the Wolf Rock process that has a strong Private Equity flavour. It is clear that having been in P.E. for some time is big plus. Datson, Holme and Mela have a formal and informal network of relationships with private equity principals, leveraged loan providers and consulting firms. This helps give feedback on structures, taxation and models. Of course Datson and his colleagues track Initiative Europe and the Private Equity auctions of businesses, that is the publicly available information. But they do more. By assiduously staying in the loop, the scuttlebutt of the industry is open to interpretation by these experienced professionals.

The Wolf Rock Capital process for identifying opportunities also uses its own database of Private Equity activity. The database is updated for new deals: it helps show which are the active areas and teams. For example, it can help identify active sectors and the potential for expertise and structures to migrate across regions: "We've noticed that ideas for sectors transfer from the US to Europe," discloses Datson. "So we like to track debt activity, and syndicate pricing here and in the US, to give us a lead about what could be about to happen locally."

Portfolio Construction and Risk Control

Private Equity investing is long only, and as oftentimes the exit route is public markets via an IPO, PE investing is often perceived to have cyclical returns. The approach taken by Wolf Rock Capital generates long and short positions, so that portfolio construction methods are more similar to equity hedge fund strategies than P.E. The expectation therefore is that Wolf Rock's returns goal of 10-15% (and 10% volatility) should not be dependent on strong equity market appreciation.

Indeed, it is very much part of the design of risk management at Wolf Rock Capital to control and monitor risk in a way that would be recognisable to hedge fund investors. The portfolio construction framework includes constraints on industry longs and shorts, and country long and short exposures. Typically the gross will be of the order of 150% and the net exposure, say, 20% on a beta-adjusted basis. The 25-30 securities either side of the balance sheet will populate 15 ideas long and 15 ideas short

The sizing of individual positions is driven by scenario analysis. This attempts to identify and quantify specific risks to each thesis (the core long or short idea and its offsetting hedges). On occasion, tools such as Morgan Stanley's BasketLink maybe used to assist this analysis. For example, when assessing a telecom position, it may be helpful to simulated the thesis through the varied market conditions experienced between 1998 and 2002, so encompassing emerging market/liquidity and event risk as well as the pumping up and bursting of the TMT bubble.

The risk score of a potential position is combined with a scenario-based valuation analysis to provide a live "opportunity management" tool, as it is described in the firm. The risk and return characteristics of both potential longs and potential shorts are analysed, taking account of liquidity constraints. Conceptually this enables the team to focus on concentrating their resources on the highest potential ideas.

In looking at portfolio risk management, the Tradar system is used for portfolio management/fund accounting at Wolf Rock as it is at many hedge funds. The tools MS Risk Analytics and BasketLink from prime broker Morgan Stanley are used for risk control information in a way that would categorise Wolf Rock as a sophisticated user of these capabilities.

Experience in Building Businesses

Unlike many starting out in the hedge fund business Datson and his team have had experience with the operation of businesses through several board participations. "We know what it takes to establish, build and manage a business, and how to handle growth," he says. "That broader business background should be a help."

Datson clearly sees what he is doing as different from most hedge funds in Europe: "We see ourselves as the antithesis of the market-smart hedge fund manager," he expounds. "To do what we do requires data, lots of it, and we must have a template for that particular business to analyse it fully," says Datson. "We have set up the investment process correctly from day one, with solid resources and experience. Our approach to building this business is different too. We have built a platform that can run half a billion dollars, but we are not driven by adding lots of capital early." Rather, he sees that their rather long-term approach to investing for positive returns ultimately may make Wolf Rock International Fund a suitable investment vehicle for endowments and sophisticated family offices. Such investors often require a minimum of a two-year track record, so patience will be required for that target investor base.

Crossover Appeal

The influence of Private Equity on public markets for equity has been increasing for nearly two decades, and managers bearing the hedge fund and P.E. labels will increasingly compete for capital and investment opportunities. The European end of the Private Equity business looks set for increased activity in coming years, and Wolf Rock Capital is very unusual in being able to exploit the consequences of that expansion in the hedge fund format. Often the corollary of immaturity in a market is that the opportunities for profitable exploitation are large in the early stages. There has been much talk recently along the lines that "hedge funds have been selling themselves as providers of alpha, but have been providing packaged beta." If European equity markets have become more efficient, and equity hedge funds ever more reliant on markets advancing to make returns then maybe a new approach to public markets, as offered by Wolf Rock Capital, has some crossover appeal.

Summary Financial Terms

  • 1.5% Management Fee
  • 20% Performance Fee, subject to high water mark
  • Quarterly redemption with 60 days notice.
  • Initial one year lock with 3% early break fee