D.E. Shaw, Convergence and the Future of Institutional Asset Management

Ah, convergence. An oft-repeated yet seldom understood word, at least as it relates to hedge funds and private equity firms.

Sure, a hedge fund with a loose document can do lots of illiquid investments, either in the main fund or in side pockets, but this raises a whole host of issues concerning valuation, fee calculation, lock-up periods and culture that I've written about in the past. And now I read in the Financial Times that DE Shaw is contemplating the creation of a discrete private equity fund, into which it would sell certain of its private equity-like assets held within its main hedge fund.

The article, written by James Mackintosh, hits on several of the key issues I've raised concerning the booking of illiquid assets within a hedge fund structure:

According to people who have discussed the fund with DE Shaw, in which Lehman Brothers bought a 20 per cent stake last month, a separate fund would be structured with fixed life and buy-out-style fees, rather than hedge fund charges.

The move would further demonstrate the speed with which the private equity and hedge fund industries are converging.

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Hedge funds have been increasing their involvement in buy-outs, putting an increasing amount of money into illiquid investments they could not sell quickly.

But this creates a mismatch between the liquidity of their investments and their investors, who can typically withdraw money quarterly. Private equity structures avoid this problem by locking in investors up for 10 years, while some hedge funds get around it by setting up “side pockets”, specialist separate vehicles for private equity investments with strict limits on withdrawals. Hedge funds have also been changing their terms, imposing lock-ups and requiring longer notice periods for withdrawals.

Let me present some discussion from previous posts that gets right to the heart of DE Shaw's decision-making: why the company split off its illiquid, private equity investing activities into a separate and distinct private equity entity. My conclusion is that DE Shaw's move addresses most of the complexities and conflicts associated with running private equity investments within the context of a hedge fund structure and culture:

07/21/2006: Broadening the Multi-Strategy Mandate - Where do Hedge Funds end and Private Equity Funds begin?

...I think what is more interesting is to look at the structural differences between hedge fund firms and private equity firms and how this might impact performance-based compensation, disclosure and regulation. Private equity firms generally collect commitments for investment, draw on those commitments, make investments, and get paid performance fees as those investments become liquid over time, e.g., perform. Seems to make sense - match the payment for success with the successes themselves. Hedge funds, interestingly enough, grew up differently, as the concept of a "hedge fund" generally meant buying good stuff (long) and selling bad stuff (short) in an effort to minimize the impact of the broad market on performance (beta) and isolating the manager's skill (alpha). Since this buying and selling, by necessity, took place in the public markets, there were readily ascertainable values for the hedge fund's positions at each reporting period. It was these values that were used to compute the payment of performance fees (the net asset value or NAV). As long as the portfolio is liquid, fair values are readily observable and, in theory, the entire book could be liquidated at the NAV (absent bid-offer spread). But as I mentioned above the world has changed - a lot. Hedge funds now have portfolios that are a mish-mash of liquid assets, somewhat liquid assets (where one could go and get bids from 5 dealers and obtain a fair value) and totally illiquid assets (where the value is highly subjective a dealer would not be willing to provide a 2-way quote). So how have hedge fund compensation customs changed to reflect these altered portfolio characteristics? Not much.

Now, I am firmly convinced that this trend - hedge funds and private equity firms looking more and more alike - will not stop, and I am also a strong believer in market-based regulation (as opposed to ill-conceived legislation developed by bureaucrats who don't understand the investment business). But this issue - getting paid on NAV when NAV itself is highly questionable - is a real problem. It looks bad. Real bad. The implications extend beyond compensation. For instance, if you can't arrive at a fair value for an asset, a "thumb in the air" method is used like book value minus an illiquidity haircut. This approach dear friends, is not very scientific and is extremely prone to error. Beyond error, once an approach is used for a particular asset that approach tends to be used again and again and again. This has two potentially adverse effects upon disclosure and compensation: (1) compensation may be overstated because NAV might be much lower that the level reflected in the NAV calculation; and (2) volatility of returns will be understated since this asset, whose value invariably is moving up and down but whose value is difficult to measure, is being valued in the same way quarter after quarter after quarter. This is called autocorrelation. This skews the analysis of fund returns and makes a fair comparison across different firms and different strategies nearly impossible. Does any of this sound good?

Well, my prognostication certainly came to pass as more and more hedge funds are investing in illiquid, private equity-like assets. As noted in the FT article, Fortress, Cerberus, Blackstone and TPG already run discrete hedge funds and private equity funds, and DE Shaw is poised to soon join their ranks. A far less stressful and conflicted ranks, to be sure.

08/01/2006: Convergence Redux

I think this issue of Hedge Fund/Private Equity convergence comes down to two fundamental issues - culture and compensation. Sure, there are "glamour" issues such as the potential conflicts of interest between those trading in the public markets (the hedge fund guys) and those with access to non-public information (the private equity guys), but these risks can be managed through a strong control environment. No, the much more interesting questions to address are: (1) will these efforts work; and (2) why are these efforts happening in the first place?

Will these efforts work? Good question, hard to answer. The first issue comes down to a melding of cultures which are very, very different. Private equity guys are deal guys. They tend to be pretty good communicators. The have a modicum of patience. They understand the concept of delayed gratification, i.e., waiting for the big payout when the investment is liquidiated or a large dividend is scooped out of the portfolio company. Hedge fund managers, conversely, are often lousy communicators, highly impatient, and want to be paid yesterday. OK, so maybe the private equity guys and hedge fund guys won't go bowling together on Wednesday nights. But what about setting them up in separate, walled-off units with an eye towards addressing both the conflicts issues and the culture issues? OK, I'll buy that. But there is this one lingering issue gnawing at me - compensation.

This is where culture and cash really get into it. You have a bunch of senior people with huge egos with the same company name on the business card. They each have giant bank accounts and the trappings of financial success. But one set of guys gets a few million bucks a year and then a big wad of cash 5-7 years later, while the other set of guys get $25 million a year, every year, right now. How do you reconcile this fundamental structural difference between private equity and hedge funds? Insanely hard if not impossible.

Hedge fund guys are from Mars, private equity guys are from Venus. When you try and get them to play nicely together in the context of the same fund, better watch out. Far better to let them have their own distinct areas within which to operate that have their own culture, approach and compensation structure. Otherwise you are just asking for discord and conflict.

08/04/2006: Side Pockets - Use or Abuse?

Today's WSJ article highlighted the flip-side of how hedge fund should be using side pockets and segregation of illiquid and hard-to-value assets - namely, cherry picking - which will only serve to bring greater scrutiny to the industry:

An accurate value for these investments sometimes can be derived only when they are disposed of, so hedge funds often are slower to put up-to-date valuations on the accounts. Regulators say side pockets are appropriate for investments that are difficult to value or are illiquid, that is, hard to trade, noting that if a fund was forced to place an inappropriate value on these investments, it could penalize a fund's investors.

But side-pocket accounts often have more onerous terms for investors, such as limits on their ability to withdraw their money, terms that are put in place so a fund can avoid being forced to sell investments at a sizable loss if a number of investors suddenly want their money back.

Now, regulators are expressing some concern that hedge funds might be tempted to store investments with less rosy prospects in these accounts, enabling firms to make their returns look better.

The real issue here shouldn't be viewed as the delayed withdrawal issue, as long as the hedge funds are following the illiquid asset percentage outlined in their offering document (which they generally all do). The bigger issue on this score is that these assets should attract delayed compensation as well. The asymmetry between delayed withdrawal and current compensation just doesn't make sense, and in my view is not sustainable and will be modified - either voluntarily or by regulation - over time. This is a structural problem that requires changing conventional mores and practices.

The truly insidious issue here is that of cherry picking, where a hedge fund manager, regardless of the liquidity characteristics of the assets, will shift between the main fund and its side pockets in order to hype fund performance (and associated compensation). This is accomplished by either shunting off less successful liquid investments into the side pockets or including hard-to-value but seemingly successful illiquid investments into the main fund. This is just wrong yet is sometime that is done.

Just as with the rules governing the valuation of employee stock options, this is an area where there is simply too much latitude that will (and has) inevitably give(en) rise to abuse. Rules or practices will evolve to address this issue, with a clear and consistently applied framework for determining the following:

What is a liquid asset (and should be in the fund)? What is an illiquid asset (and should be in a side pocket)?

How should risks be quantified?

How should the valuations be performed?

How should performance be measured and communicated?

How should compensation be paid?

How should redemptions be handled?

Suffice it to say, operating private equity-like investments in the context of hedge fund side pockets raises lots of important questions that simply go away when these investments are booked in a separate private equity vehicle. Much clearer. Much cleaner. Fewer potential conflicts. Better GP/LP alignment of interests. Quite simply: why not do it this way?

As convergence continues apace, we will continue to see more moves like these. DE Shaw isn't a hedge fund. It's an institutional asset manager. Hedge fund, long-only, and private equity all under one roof. We are seeing the future here.