Private Equity Convergence

The ever-narrowing gap between hedge funds and private equity

Jean Turrettini, Analyst and Portfolio Manager, EIM

There is a trend toward a certain similarity in strategies. The fact remains that certain powerful hedge funds have a short-term, predatory outlook. There are an increasing number of similarities between the strategies used by managers of alternative investments and those employed by private equity managers. Alternative investment assets under management are estimated at 1 trillion dollars and spread over 8,000 funds, while the private equity industry manages only 150 billion dollars, distributed among 3,000 participants. There is still a lot of land to be opened up, therefore, which could explain the growing interest in hedge funds.

A phenomenon that is not devoid of risks

Many factors suggest that, in future, we will see more large groups such as Blackstone, which, among other things, has put together a hedge fund and a private equity fund. Likewise, large financial groups and diversified groups will launch their own alternative funds, as illustrated by Carlyle's announced intentions. On a less official level, a growing number of hedge funds are now engaging in transactions that traditionally were considered the domain of the private equity sector, similar to "buyout" deals, both in the United States and in Europe. We believe that such a convergence could entail risks, particularly for the targeted companies and some of their shareholders. On another level, one may also question the quality of the expertise and skills of some of the hedge funds that initiate such strategies.

Need for power against investment

The traditional distinction between the two is still obvious: managers of alternative investments derive their profits by trading traditional types of assets, using leverage and derivative products, while private equity managers provide their own or borrowed capital to companies that are at various stages of development, and for various purposes. Such financing often involves taking over the company. If the alternative managers have long used evaluation methods suitable for private equity, indicating more of an ownership perspective than that of a financial investment, there was little question of seeing strategies that indicated a desire to control the company. Now, "activist" strategies are often used by hedge funds.

De jure or de facto, such strategies reflect a desire to manage the company being financed either by having a representative on its executive board or through an accumulation of voting rights (by an alternative manager alone or by aconsortium set up for this purpose). This approach is now a part of the arsenal of alternative strategies and, moreover, has generated significant returns this year.

The financial strength of certain hedge funds

Two reasons can be put forward: on the one hand, the huge amounts held by the hedge funds now confer on some of them enough financial power to play the role of private equity manager, as "financier". A recent example shows that 70% of the outstanding shares of the Blockbuster Company were bought by a consortium of four hedge funds. The leader of this consortium not only has a seat on the company's board, but has also managed to install two of his allies there. On the other hand, profits from certain traditional alternative strategies have eroded, forcing their managers to look for new opportunities in less traditional areas. Financing a company, making it profitable and/or increasing standards of corporate governance are the very strategies that will make it possible to substantially increase share value, and, consequently, profits in the event ofdisposal.

The notion of corporate governance is crucial

The notion of corporate governance often is crucial to an investor, because this, as much as the quality of the balance sheet, will be evaluated in determining whether to make potential investments. Indeed, shareholdings that are too diluted or have too little involvement in the company will not be able to correct a situation in which a company has squandered much of its value due to poor corporate governance, but an "activist" strategy might well be able to.

However, this drift toward private equity by alternative managers could be dangerous for a company and its shareholders. To illustrate one potential pitfall, one can point to the battle currently being waged by a powerful hedge fund to "persuade" a large American media group to buy back 20 billion dollars of its shares and to dispose of its cable division.

Regardless of what the hedge fund's intentions may be in terms of taking over the group, the fact remains that, once its "decisions" have been applied, the share price should be 70% higher than today. Once this price has been reached, will the hedge fund sell its shares for "quick" profit-taking or will it do its best to consolidate the group's longer-term profitability, an approach that is more traditionally associated with private equity?

Question: Does a more speculative approach risk causing damage?

Therefore, it is necessary to examine the damages or other consequences a more speculative hedge fund approach may entail for a company and, on a larger scale, the markets. For example, hedge funds have been accused of ousting the CEO of the Frankfurt Stock Exchange from his job on account of his attempts to acquire the London Stock Exchange (LSE).

On another level, private equity strategies use a longer investment horizon (3 to 5 years). To avoid cheating the investor, it is absolutely essential that the fund analyst check whether the liquidity of certain hedge funds correctly reflects these transactions, which require an extended horizon and involve very illiquid assets. Therefore, one could hardly blame a fund involved in transactions of this kind for imposing a three-year "lock-up".

On the other hand, a hedge fund that has monthly liquidity and which buys up large blocks of "distressed" securities or goes into "PIPES" (private investment in a public entity) transactions should raise some legitimate questions…

Ultimately, evaluating assets, taking over and managing a company in order to turn it around, all require very different skills than those associated with the management of financial assets. Do all the hedge fund managers who are tempted by these new opportunities have the background and the skills necessary for venturing into activities of this kind?

A new form of predator?

Thus, the convergence observed between certain hedge fund strategies and private equity strategies raises questions that are critical on several levels. The fact that powerful hedge funds are investing in this new playing field may signal the arrival of a new form of predator with a more short-term outlook, which has the potential of being detrimental both to the targeted companies and for investors.

It is up to the analysts to discern the intentions of these funds and to subject them to rigorous analysis.