Berwin Leighton Paisner's Timothy Spangler and Daljit Singh examine the implications of the entry of hedge funds into the realm of private equity.
Recently, much attention has been given in the financial and industry press to the steady progression of hedge funds into transactions typically reserved to private equity (PE) players.
This has caused a stir in the markets, both from the point of view of private equity players, as well as their financial advisers, who see the increasing prominence of hedge funds as an opportunity for more deals and greater fees. What are the implications arising from such hedge funds activities? How will established PE funds react? What does the future hold for both sets of alpha-driven money managers?
Structures - Similarities or Differences?
A basic understanding of the structure of private equity funds/hedge funds is crucial to understanding their competitive advantages and disadvantages. While hedge funds draw down all investor money on day one, by contrast PE funds have a commitment from the investors to provide monies up to an agreed amount as and when draw down notices are served up to a certain date, upon which the unused commitment falls away. As a result, hedge funds are actively investing/managing the funds from day one whereas the PE funds are seeking out deals in which to invest funds from day one.
The typical annual fee of a hedge fund for managing these funds can vary from 0%-5% (with 2 per cent serving as a market standard) whereas that of a PE fund can typically vary from 1%-4% (the higher end being more venture type funds that pure LBO funds). Hedge funds have traditionally not had a hurdle rate (calculated on an annualised basis) that must be achieved before the manager receives any share of the "carry". On the other hand, PE funds have traditionally had a hurdle rate, often set at 8 per cent per annum before the "carry" kicks in.
The share of the profits distributed to the managers of hedge funds has traditionally been 20 per cent, although upward trends can now be seen as performance fees reach up to 50 per cent, whereas PE funds have traditionally remained at 20 per cent of the gain. The share of the profits has in the context of hedge funds been calculated, earned and received on an annual basis (mark to market on unrealised gains and losses) whereas PE funds have only obtained a share of the carry on realised gains which in normal circumstances would mean that, assuming a typical life cycle of a fund of, say, seven to nine years ignoring extensions they would only be "in the money" in the final two to three years (subject to performance).
Another significant feature in the context of hedge funds is that managers quite often invest within their own fund a significant amount of their own money, as well as that of third party investors (based on a view - which investors appreciate! - that their hedge funds are the best place for their money in the market). Whilst managers of PE funds do traditionally put money to work within the fund (often a requirement of the investors) it is nowhere as significant as that for hedge funds.
A typical investment thesis?
It is hard to generalise about the investment theses of hedge funds, as they invest in all forms of asset classes, geographies and with varying degrees of risk and of control. Typically, the only requirement has been sufficient liquidity in their underlying positions to enable them to trade in and out of them opportunistically, either to generate gains or to fund redemptions from investors. Regardless, hedge funds will individually have their own "sweet spot" rather like the PE funds, whether by sector or geography or financial instrument.
On the other hand, PE funds tend to be fairly "ecumenical" in their approach, while they will profess, in certain cases justifiably, to only look at certain industry/geographic areas for their deal structure. The deal structure for a PE fund typically involves taking a controlling stake at the equity level and controlling further investment, strategy (stated to be working with management) and exit strategy.
PE funds have nearly always only invested at the equity level ranking behind third party debt. By contrast, many hedge funds are willing to invest at all levels of the "capital structure" including secured and unsecured debt as well as derivative instruments. Hedge funds will get involved in deals/situations where PE funds would never dare to tread or very few of them would and only then on the basis that it's their specialist sector.
For instance, very few PE funds would take minority positions in listed vehicles on the basis that they will agitate the change and improve the business as an active investor and thereby make a return. On the other hand, many hedge funds engage in such "activist" strategies. Thus the range of deals and opportunities hedge funds will look at is significantly broader than that of PE funds.
Why the sudden change in the attitudes of hedge funds?
The hedge fund managers would argue that there is, in reality, little change from what they have done in the past - possibly it is just a question of "timing". In the past many have taken positions in deals that have been completed by PE funds, typically at various debt levels, and then pressed home their economic position/advantage. Now some "brave" hedge fund managers are just going further down the capital structure and getting into the deals earlier - namely when they are first done.
Unfortunately, in many sectors there is a scarcity of deals for private equity money to invest in. Vendor multiples have remained high and indeed there is a convergence between PE ratios in the private market versus those of the listed market, as opposed to the traditional discount applied within the private market due to, amongst other things, liquidity. As a result, PE funds generally fear that there will be more competition on deals and pricing will remain high and increase. The arrival of increasing numbers of hedge funds gives them added concern.
Another phenomenon that has attracted hedge funds to Europe is the increasing trend of debt providers to trade their debt or to work with distressed funders (including hedge funds) to rescue problem deals. Hedge funds are no doubt conscious of the multiples of EBITDA/free cash flow being presently offered by debt providers to PE funds. As things tighten up there will be certain failures that will attract the hedge funds to seek an involvement in these deals. This trend has started, but the real "feeding frenzy" could begin within the next two to three years.
How will the private equity funds react?
In a nutshell, there is not much that the PE funds can do. Why? Hedge funds will take on the typical deal structure of a PE fund but also take on others. Hedge funds thrive on innovation and are focussed on discovering and exploiting new investment opportunities. They strive to be nimble and highly effective.
A private equity firm, however, will have raised their closed-end fund on the basis of a more narrow investment thesis set out in the information memorandum and marketed on that basis. Their investors, to no one's surprise, have allocated their funds across a number of investment strategies, geographies and sectors.
For the private equity players to start to compete with the hedge funds in terms of deal structure and ethos would militate against the risk profile that the investors in the private equity funds have accepted.
Moving an asset allocation from private equity funds (8%-13%, for example) is not something that is going to go down well with the investors when they are asked to change the investment profile/allocation. However, various private equity funds are now setting up what they define as "hedge funds" as a further investment class, in an attempt at "fighting back".
As we are all aware, a number of the PE funds have been fund raising over the last couple of years and therefore are locked into their current strategy. Their investors are not going to be interested in being approached with a different thesis now. So there is little room to manoeuvre, save on price, and then only in the type of deals they normally do, in terms of reaction to the threat of the hedge funds. On the other hand, the hedge funds tend to have great flexibility and as stated, get involved not only in deals in competition with private equity players but also ones where the private equity players are not involved at all in any event.
What does the future hold?
In the future, we will continue to observe the convergence of these alpha-based managers and the acquisition of skills sets that one lacks and which the other has.
Further, the phenomenon of investing in various levels of a capital structure will result in a threat to other financial market players (such as the senior/mezzanine providers themselves) who in turn will have to innovate.