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Hedge Fund Monthly

Convergence in Action
David Goldstein, White & Case
June 2005
 

This is indeed a very special gathering; there are not many industry venues where both sides of the alternative asset management family are brought together to talk about matters in common. Of course, what we are here to talk about today is how these two disciplines are moving towards each other in many different ways - this is the notion of convergence. While this process is just getting underway in Asia, it is very far advanced in the US and Europe, and perhaps by discussing the trends we've seen you will have some insight into what may happen here.

Is this meeting this industry's version of a summit? Perhaps it's not that serious, but there are some people, especially in the private equity community, who have some pretty strong negative feelings about the direction hedge funds are going in. The disagreements in the private fund community over the roles of hedge fund managers in non-traditional hedge fund investments reveal a range of emotions, from concern by the private equity folks for their futures, to hostility towards the hedge fund managers about their new roles.

Speaking about the bid by Highfields Capital Management to take Circuit City private, one private equity manager said that "those guys have no idea of what they're getting into … Taking a company private is very different from trading stocks". The statement, published in a Thompson Financial article, included very derogatory comments about hedge fund managers, comments that I am uncomfortable repeating out loud. Separately, Henry Kravitz said: "Hedge funds know how to pick stocks and make lots of money, but that is not the same thing as creating value through ownership of an asset over the long term in a hand's-on way. They lack the right skills or experience to make a success of turning around or building private companies."

Hedge fund managers have said less, but have not hesitated to call private equity managers "dinosaurs". David Rubenstein, one of the Carlyle founders, has agreed. In fact, Carlyle is starting a fund of hedge funds and soon after that a long/short hedge fund. Carl Icahn is also launching a hedge fund. In addition, they are competing fiercely for talent. Most hedge funds don't have the kind of deal experience necessary to close complex private equity deals and are paying up to get it. For their part, private equity professionals who are not at the partner level of their firms are easily lured by the chance to share in performance fees that get paid annually, not just when there are realisations.

The effect of this process will be to change how you invest, alter your ability to get the out-sized returns that your reputations depend on and how you sell yourselves to potential investors.

Over the last several years hedge fund managers and private equity managers were distinct categories of alternative asset investors. What they had in common was that they represented private pools of capital. That was about it. Their investment styles had virtually nothing in common: their methods were different, their investor bases were different and their cultures were different.

As we all know, things have been changing on several levels. I am going to run through these changes quickly, because the depth and breadth of the changes are pretty profound, especially when you line them up against each other:

  • Hedge funds have busted into investment sectors where they haven't been before, all throughout the capital structure:


  • o
    Private equity-style investments
    o
    Mezzanine investments
    o
    Bridge loans and other kinds of acquisition finance
    o
    Loans traditionally made by banks
    o
    Leasing
    o
    Real estate transactions

  • Market forces have significantly pinched private equity fund returns, which have stagnated, on average lagging behind broad market indices:

    o According to a recent McKinsey report on the private equity industry, in the late 1990s buyout funds raised as much as US$50 billion to US$60 billion each year, but were deploying capital at the rate of US$30 billion to US$40 billion a year. According to Thompson Financial, about US$90 billion in the US and €50 billion are awaiting investment today.
    o The IPO market has dried up, making exits difficult. In fact, many fund exits now are sales to other private equity shops.
    o The overhang of capital in the market, noted before, is driving prices up. Participation by hedge funds in this space exacerbates this problem. As returns fall, the ability to raise new funds is impaired.

  • Seeking returns, investors have flocked to today's hedge funds. Funds of hedge funds proliferate because investors can't manage their choices. More capital flows in and returns narrow further.

Convergence in its different forms

The Fund

In the past, the term "private fund" addressed legal status, rather than serving as a useful description of what the entity did. Is any particular private fund a "hedge fund", or is it a "private equity fund"?

  • Is liquidity the distinguishing feature of the two categories? If there is no liquidity, generally, you would think the sponsor will not get a performance fee or carried interest until realisation of investments. That is the private equity or committed fund model. In fact, a notable number of private equity funds are being required to return all invested capital before any carried interest is paid. Traditionally, the rationale for the sponsor getting an annual fee in the hedge fund model was that the investor could flee at any time. (The fact that the assets traditionally can be priced with accuracy, unlike in a private equity fund, allows the fee to be paid annually, but that is not why it is paid annually.)
  • Hedge funds often have what are called side pockets, which are illiquid baskets of investments. The sponsor cannot get a performance fee on these investments, and investors cannot redeem any portion of their interests invested in illiquid investments, until the side pocket investment becomes liquid. This is precisely the notion that has been turned on its head in the current market.
  • The implications of paying annual fees on locked-up money invested in illiquid securities are at the heart of the dilemma facing the private equity business. There are hedge funds emerging that have multiple-year lock ups and that pay annual performance fees. This is remarkable. They are paid a performance fee despite the fact that investors can't get their money back and there is no clawback, generally. Private equity sponsors cannot get terms this good. Ever.
  • Is the investment strategy the defining characteristic? Again, not always. There are private equity funds that make strategic public investments. These investments are in liquid securities. However, since the fund is required to trade only in contemplation of furthering the strategy of making investments in companies that they can control or influence, and since there is a five-year lock up, the sponsor gets paid under a traditional carried interest formula.

The Sponsor

In the industry we have seen for years private equity firms who wanted to run hedge fund money. Why? Sometimes they wanted a place to put the carried interest they earned in their private equity funds. These boutique sponsors had so much money that they needed someone they knew and trusted to invest their assets. Investment banks had sales teams and traders in-house, and could increase assets under management. Need we say more.

Now, this is not the kind of convergence that has caused tremors in the private funds industry. This kind of convergence is rather a reflection of the evolution of the alternative asset management business. This is asset gathering and trading on a brand name. Managers create products to meet perceived needs of their investors. It is horizontal integration of related businesses. For hedge fund managers, it is a little different - they are pursuing the holy grail of committed, long-term money. For these managers, the question for the medium term is whether investors will provide hedge fund managers with long-term money if their investment strategy is to make short-term investments. Eventually, investors will not agree to long-term lock-ups in connection with short-term trading strategies.

Let's talk for a while about the main legal and business considerations convergence raises for a fund or a sponsor firm:

Managing Conflicts of Interest/Allocation Decisions

For a manager with multiple funds, there is a very simple question with no easy answers: How do you allocate brain power, investment ideas and investment opportunities between the funds? Sometimes it isn't that hard, such as a mezz fund alongside a private equity fund. But the hedge fund/private equity fund is the most problematic.

Solutions:

o
Clear rules about allocation (or making it clear that there is complete investment discretion).
o
Transparency and disclosure have cleansing, beneficial effects and are very protective for the investment manager.
o
Wall-off or ring-fence the conflicts. Some firms have taken this approach. They treat the businesses as separate, not looking to gain cross-fertilisation of investment ideas as much as seeking to gain efficiencies of scale (that is, using the platform) and trading on the firm's brand name, as discussed before. As an example of this, Blackstone created a fund of hedge funds family, rather than hedge funds, as such, because they didn't want the conflict of interests.

Valuations

The implication of valuation concerns center on the fact that hedge funds receive their performance fees annually. (Separately, I note that we are seeing more funds, especially funds of hedge funds, have semi-annual or quarterly performance allocations or fees. The rationale for this practice is uncertain, or even dubious, in my opinion.)

  • In a hedge fund portfolio, how do you mark-to-market illiquid investments? There are benchmark methodologies, such as the British Venture Capital Association rules, but the goal there is to create a transparent practice that is consistent through an industry; it does not mean that the established values represent market value.
  • Then there is the question of how purchasing and redeeming investors are being treated. The portfolio valuation determines whether long-term investors are getting diluted when new investors come in or new investors are paying too much, setting up a conflict of interest that involves the relative position of the investors.

    Hedge funds taking performance fees or allocations on long-term positions or private equity-style investments with perhaps questionable valuations should be known as the Clinton Doctrine: they do it because they can. Why do they seek and receive unrestricted investment mandates: because they can. When will it end? When they get caught - when one fund blows or busts a big deal, when a fund can't meet redemptions because of illiquid positions, when it becomes clear that not every hedge fund manager should be making private equity-style investments without the right talent, experience or infrastructure.

    One way to deal with these issues is what I call The Blum Approach - one of the first private equity funds with a public investment basket was a firm in San Francisco headed by Richard C. Blum. The approach Blum took is consistent with traditional alternative asset principles: despite the fact that the fund could make investments in traded securities, no performance allocation was made until there was a realisation. These investments were expected to be long-term in nature and involve increasing value through influencing management of the portfolio company. This approach is in stark contrast to current practice in today's hedge fund market.
So, what are private equity funds to do?
  • Improve the quality and depth of due diligence
    This will distinguish you from many of the hedge fund managers in the market. This statement doesn't go to the quality of hedge fund managers or their ability to be thorough; it goes to their experience of private equity professionals and the different things they may look for. This plays to the strength of private equity funds.

  • Keep your fund size down
    In a trend that is in full swing in the US - and some smart people in Hong Kong told me that this is happening here - private equity firms are not swinging for the fences on fund raising. They want a fund size that can be deployed within the commitment period without over-paying for deals, stretching for big deals or over-extending the firm. Smaller deals are relationship based, giving the fund the opportunity for proprietary deals.

  • Be hands-on
    These smaller firms take a hands-on approach to the management of portfolio companies, teaming up with operational professionals, former CEOs, CFOs and other senior executives of Fortune 1000 companies to take on diligence roles or even management or consulting roles with portfolio companies. One of our clients will not do a deal unless one of the "operating partners" takes a leading role in the target.

  • Raise targeted funds
    Stay within your bailiwick and emphasise specialty. With specialisation, it is easier to argue that you have more proprietary deals and a deeper network to feed deal-flow and ideas.

One of the key linking features of the items I just mentioned: Network, network, network.

So, what are hedge funds to do?

  • In part, keep doing what you are doing.

  • Think long term about what you want to be to your investors. Listen to them and their concerns, and understand your limits.

  • Bring in the private equity professionals needed to make you a leader in those deals, rather than someone that can be criticised, rightly or wrongly, as someone playing beyond their depth.
 
If you have any comments about or contributions to make to this newsletter, please email advisor@eurekahedge.com

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