The Convergence of Hedge Funds Into Private Equity

Last week Roger Ehrenberg had a great post pertaining to the convergence of hedge funds into private equity. I commented on his blog and liked what I said, so I'll reprint it here.

Control

When they buy the equity of a target company, private equity firms may replace the company’s senior management. However, finding top-notch management is, in many instances, more difficult than finding the right investment. Even if senior management is retained, the private equity fund will control the board of directors. Newly appointed directors are often principals of the private equity firm.

In the case of many hedge fund investments, management may often be left alone while the hedge fund works towards a buy-and-sell trading position in debt or equity. The trading position often is protected through esoteric and complicated hedging strategies.

I'm sure readers remember the Steven Cohen interview with WSJ- I bring it up because he talked about how he's been holding investments longer than he used to, as returns have shrunk due to the sheer size of funds fighting to generate alpha. Similarly- in a “loan to own” investment, the hedge fund may mimic the private equity fund with respect to both management and board involvement [read: Carl Ichan, Daniel Loeb- more HFs are leaning towards some sort of activism- while I don't know the McDonald (MCD) 5%+ shareholder's name he's been on MCD's back to raise dividends/buybacks. More recently Steve Cohen said he will not back Freeport-McMoran's (FCX) bid for Phelps-Dodge (PD)- I'm not sure about you but I've seldom seen SAC act activist; they like to keep things quiet.]

Strategic Direction

The above point brings me to the strategic direction. Private equity funds, having longer hold periods, are very interested in the strategic direction of the companies and industries in which they invest. For that reason, prior to making an investment, private equity firms engage in a significant amount of research regarding both the targeted company and the industry in which it operates.

Hedge funds assess target companies’ strategies with a different focus, one tied to hold periods, returns and company and industry hedging strategies. However, hedge funds are
increasingly seeking board seats and seeking to influence management decisions made by companies in which they have invested.

The average pension fund is looking to make just 8 percent, after deducting fees, on its hedge fund investments, according to a recent study by the Bank of New York and Casey, Quirk & Associates, a consulting firm. That is a far cry from the returns of more than 25 percent generated by celebrated managers like Mr. Soros and Michael Steinhardt at their peaks.

Also hear the 2 minute podcast of Michael Covel on September 5th, 2006, where he talks about Paul Tudor Jones and why PTJ returns have been reduced (due to investors wanting preservation and not as much as risk as before)

Now that the performance bar has been lowered, there is less incentive for managers to make more aggressive bets, consultants said, especially when they can still charge the same steep fees they did in the past.

So when Roger said the trend for compensation is more PE like for HFs, I agreed for the most part. However, investors in hedge funds are resigned to paying dearly for top hedge fund talent thanks to the law of supply and demand. Sure there are lots of HFs underperforming, but then there are stars like Peter Thiel, who over three years has notched a 200% return for original investors, and I'm quite sure investors will pay very handsomely to be in his fund.

Comments

[Amit Chokshi_:]

PE funds get paid a multitude of ways and can easily rival hedge fund managers (and IMO usually exeed) in overall compensation. An LBO fund get paid 1/2% and 20% (after a 6-8% hurdle rate) and what's crazier was that in the beginning of the industry the LBO funds would get paid that on a per deal basis as opposed to the total funds return. In contrast a hedge fund gets 1/2% and 20% on new net profits. Some may say the fund manager gets paid more compared to the LBO firm but consider that in a typical LBO, the buyout firm will charge a % of the total transaction value as the firm's own "M&A fee" to basically compensate the buyout firm's professionals for analyzing and purchasing the company.

So in one of the megabuyout deals, an M&A fee could be $25-$50mm dollars that rivals the sellside ibank fee that goes into the pockets of the buyout firm before any value has been created. Secondly, the privately held funds are then charged a "management fee" to the buyout fund which can range from a few hundred thousand to millions depending on the company size. What makes these even more ridiculous is that in certain instances both the M&A fee and the management fee are 100% pocketed by the GP and the LPs (the insitutional and HNW investors) don't get a penny from that. So again, no value created yet but plenty of cash going into the buyout firm.

On top of that, with the current credit markets, buyout firms can run leveraged recaps to redeem their initial equity investment and still retain control of the firm such that between ultimately deleveraging the holding + dividends will allow the fund to sell the business in 3-5 years at an even lower valuation multiple and still make 20+% IRRs. That's why I'd say LBO firms are not "very interested in the strategic direction of the companies and industries in which they invest." It's a basic financial engineering process that can be applied to steady cash flow businesses. It's the same process for a newspaper company, a donut shop (Dunkin Donuts), a financial software company (SunGard), it's just certain, steady cash flows with limited capex. That's why a mattress maker has had about 6 different PE owners over the past 10 years or so.

If anything, I'd say hedge funds that take a long-term approach to investing (ValueAct, Bill Ackman, Second Curve Capital, Lisa Rapauno, Greenlight Capital) take an intensive approach to their investments since the holdings are marked to market every day and since they don't have control of the managment team/board, they will have to be that much more detailed in their analysis.

Also, hedge funds are not an asset class in the same regard as buyout funds. Buyout funds have some pretty strict rules in place in their fund documentation. It's really just buyouts and the occasional PIPE that are allowed and some other rules regarding public equity positions. Whether it's a $50mm or a $15bn LBO fund, the process is the generally the same, it's just the deal sizes are smaller and you'll use more bank than bond debt. But when people talk about hedge funds, they lump a variety of strategies into one asset class that can have no relevance to one another. A hedge fund that focuses on energy trading or FX may have nothing to do with a vanilla long/short fund or a distressed debt fund or short-only or a value/long-biased fund yet they will all be lumped together in many press articles (institutional investors generally have allocations for strategies, however).

So the belief that some hedge funds use complex trading strategies is just a broad generalization that may only refer to a few strategies and not even the majority of hedge funds. Kynikos and Sea Breeze are not lilkely using complex trading strategies outside of sizing/balancing their shorts and Cerberus, which is widely known for distressed debt, is probably not trading off minute spreads. You have the SACs, Renaissances, and DE Shaws of the world that command a lot of capital and have a lot of trading velocity but that still will not apply to every hedge fund. Also, guys like Cerberus have been buying whole business for a few years at this point, they bought one of Georgia Pacifics business back in 2004, and have teamed up with/bid against PE firms. Same with guys like Five Mile Capital.

2007 Jan 02 11:44 AM