The Convergence of Hedge Funds and Private Equity Funds

The convergence of hedge funds and private equity funds

David Billings, Akin Gump Strauss Hauer & Feld

In the course of the last year, hedge funds have become increasingly active participants in company auctions, takeovers and other traditional private equity transactions. Whether this increased activism represents a temporary condition or instead marks a longer term trend with profound implications for the future is a subject of sharp debate and controversy within both the private equity and hedge fund industries.

Historically of course, hedge funds and private equity funds occupied two distinct realms within the larger universe of alternative investments. Hedge funds specialised in shortterm trading strategies while private equity firms made illiquid investments in private companies which they then sought to improve through financial and operational means. With rare exceptions, there was virtually no overlap in the firms operating in these different markets. The investment vehicles they employed also reflected their fundamentally different approaches to investing. Hedge funds have typically been structured as open-ended vehicles which permit both periodic subscriptions and redemptions by investors based on the fund's prevailing net asset value. Private equity funds, in contrast, have been structured as closed ended vehicles in which new subscriptions are permitted only during an initial offering period and investor withdrawals are prohibited until the dissolution and liquidation of the fund.

Particularly in recent months, however, the lines separating these two asset classes have begun to blur. A survey of recent private equity transactions in which hedge funds have played a prominent role highlights this trend. Examples include ESL's involvement with US retailer Kmart and its subsequent $11.5 billion merger with Sears Roebuck; Texas Genco, in which a group of private equity firms led by KKR was challenged by a consortium of hedge funds; and British Energy in which Duquesne and other distressed funds helped engineer the restructuring of the company, converting their debt into equity in the process. In the US last year, hedge funds and their affiliates announced deals for at least 23 companies valued at approximately $30 billion.

Drivers

A number of factors are driving convergence. First and foremost is the growth of the hedge fund industry over the last several years. Based on informal surveys, there are now approximately 9,000 hedge funds with approximately $1 trillion in capital. This compares with 3,000 private equity funds with approximately $150 billion in capital. Regardless of how accurate or precise these estimates are, the disparity in size between the two is clear and significant. In addition to increasing in number and size, hedge funds are also becoming more institutionalised. Many now support large research staffs and possess significant industry expertise which they are able to bring to bear in the private equity arena.

Another important factor driving convergence is hedge funds' continuing search for yield. In the current low return, low volatility market environment, hedge funds are finding it harder to identify and exploit misvaluations and arbitrage opportunities. Due in part to the activities of hedge funds, public markets are more efficienttoday and hedge funds have had to search for yield in less traditional places, including private equity.

Convergence is being facilitated by the increasing use of auctions in takeovers and buyouts.

Private equity firms have historically prided themselves on their proprietary deal flow and their ability to steer clear of auctions. As the private equity market has matured, however, it has become increasingly harder for firms to avoid auctions, which are now a fixture of the private equity market. The transparency afforded by auctions allows new participants, particularly hedge funds, to compete in buyout opportunities to which they would not otherwise have had access.

Competitive Advantages of Hedge Funds

Though they lack experience in the private equity market, hedge funds have some important competitive advantages over private equity firms. Because they are open-ended and evergreen, hedge funds can raise capital at any time. Private equity firms must raise a new fund every few years and typically devote far more time and effort in the marketing of their funds as compared to hedge funds.

Hedge funds also offer more immediate financial rewards than private equity firms due to the different compensation structures of their funds. Hedge fund managers are typically paid a performance fee each year on the fund's gains, both realised and unrealised, on a markto- market basis. There is generally no preferred return to investors and no clawback of the performance fee in the event of subsequent losses. In contrast, private equity managers receive a carried interest only upon the disposal of their investments and in many cases only after all the fund's capital has been returned. Preferred returns and clawbacks are also customary. These financial incentives have allowed hedge fund managers to poach experiencedinvestment professionals from some of the leading private equity houses. The resulting talent war is another factor driving convergence.

Hedge funds also benefit from a more flexible business model compared to private equity firms. Hedge funds can invest opportunistically in different markets and across the entire capital structure of their target companies. Private equity firms on the other hand are generally restricted to equity investments within their designated geographic and/or industry sectors. When they do acquire debt, it is generally on a temporary basis and for the purpose of facilitating a long-term equity investment in the company.

Hedge funds are also free to invest in hostile transactions. Private equity firms, in contrast, are often required by their limited partners to invest only in friendly deals. This is because many government and private pension funds, which are their core investors, do not want to be in the position of funding hostile takeovers that may attract negative publicity. In addition, private equity funds generally insist on having access to the books of a target company before investing, which assumes that management will be friendly or at least not hostile to the approach.

Another important advantage of hedge funds is in the area of financing. Through their prime brokers, hedge funds have access to large credit lines and can finance their investments on attractive terms. Private equity firms generally have to arrange separate financing for each portfolio investment they make.

Given these numerous strengths, it is not surprising that many in the private equity industry are fearful of the competitive threat posed by hedge funds.

Longer Lock-ups

In order to better align the liquidity (redemption) rights offered to investors with the liquidity of their underlying assets, many hedge funds have recently lengthened their lock-ups beyond the traditional period of one year. Some hedge funds now feature lock-ups of three to five years, which begins to resemble the investment period of a traditional private equity fund. This trend was arguably reinforced by the US Securities and Exchange Commission which recently adopted a mandatory registration requirement for hedge fund managers. The requirement does not apply to a manager of a fund in which investors' capital is locked up for more than two years. In order to avoid subjecting themselves to registration and SEC inspection, some hedge funds are seeking to extend their lock-ups beyond two years.

Consolidation

Many of the factors driving convergence are also contributing to growing consolidation within the alternative investment sector. Firms like Bain and Blackstone were among the first private equity firms to expand into hedge funds but they are now being joined by others. Recent examples of this consolidation trend include Texas Pacific Group's alliance with former Goldman Sachs star trader Dinakar Singh and the acquisition of Richcourt, a fund of hedge funds group, by Hamilton Lane, one of the world's largest private equity fund of funds.

Hedge funds and private equity funds share many of the same types of investors and an increasing number of managers see the benefits of being able to offer these investors a full range of alternative investment products, particularly products with complementary investment cycles (hedge funds for short term and private equity for longer term). Private equity firms also want to be able to capitalize on the research information they generate. Such firms typically accumulate enormous amounts of information on an industry before making an investment, much of which can be used to trade in the public markets.

Skeptics

Despite the convergence trend, many remain skeptical about the ability of hedge funds to compete successfully in the private equity marketplace. Dealing with the risks of illiquidity and being large control shareholders require different skills from trading a portfolio of liquid assets. From the portfolio company's perspective, it is reasonable to ask whether hedge funds can add value beyond just capital, which is certainly not in short supply. Hedge funds are famous for their short term culture and orientation and may find it more challenging to build value in companies over the longer term. This concern is perhaps shared by private equity LPs. Because they see little similarity between hedge fund and private equity strategies, many of these investors are wary of the convergence trend. It is noteworthy that their asset allocation models treat the two asset classes as entirely separate.

Whether hedge funds will ultimately prove successful as private equity investors, in the short term they can be expected to play an increasing activist role. Hedge fund capital will continue to dwarf private equity capital and this factor alone means that the current activity is likely to continue. Private equity firms can therefore expect to see increasing competition from hedge funds for future deals as well as upward pressure on the prices they have to pay to secure them.