Alan McNee considers the potential convergence of hedge funds with private equity as they attempt to maintain their high returns.
The distinction between hedge funds and private equity firms gets less clear-cut as the months go by. As they participate in more and more leveraged finance deals, traditionally the preserve of the financial sponsor community, some argue that there is little to tell between them.
So are hedge funds morphing into private equity firms? Or is there, as other bankers argue, more talk about it than hard evidence?
There is no doubt that hedge funds have diversified from their traditional focus on bringing leverage to bear on liquid, tradeable financial instruments.
Steve Conway, co-head of European financial sponsor coverage at UBS, says that while the ability of hedge funds to raise capital seems almost limitless, it is increasingly difficult for them to deploy that capital in their traditional strategies while achieving strong returns.
“As a result, over the past 18 months to two years, hedge funds have been moving into less liquid asset classes, such as high yield bonds, mezzanine debt and leveraged loans,” he notes. “Now we have reached the point where hedge funds are asking to see deals that we’re syndicating, and increasingly they look at the common equity part of deals as well.”
Certain increase
Few, if any, true private equity deals (in the sense of investing in the common equity as well as the debt tranches of leveraged buyouts) have been done by hedge funds in Europe yet, but Mr Conway says they will definitely happen as long as hedge funds continue to have extra capital and not enough ways of making returns on it.
“It will require them to tie money up for longer than they have traditionally been comfortable with, but I don’t believe sacrificing liquidity will be a significant barrier,” he says. “If you’re a fund sitting on $15bn, you’ll do what it takes to put that money to work.”
The US is more advanced than Europe. Hedge funds including Cerberus Capital Management, Citadel and Fortress Investment Group have been involved in private equity deals in the US. Perhaps the most high-profile example was the purchase of bankrupt retailer K-Mart by hedge fund ESL Investments in 2003, and its subsequent merger with rival Sears. ESL, owned by billionaire financier Edward Lampert, surprised the market by turning K-Mart around through cost-cutting, restructuring and selling of poorly performing real estate assets – in other words, by doing all the things that a private equity buyer would traditionally have done.
More recently, Cerberus bought the papers business and various associated assets of packaging firm MeadWestvaco for $2.3bn in January this year. It also attempted to buy retailer Toys R Us, but lost out earlier this year to private equity rivals KKR and Bain Capital.
Sustaining returns
Jonathan Tyce runs Trident Financials, a hedge fund set up by Hambro Capital Management in London to invest specifically in financial-related stocks. He agrees that the rate at which the larger hedge funds have grown in recent years makes it considerably more difficult for them to sustain the sort of high returns they have earned historically – and that the imperative to keep making strong returns means they will overcome their reluctance to move into illiquid areas.
“As you grow, you have more to invest and require more ideas to keep returns high without over-exposure to concentration risk,” he points out. “So if a large hedge fund is presented with the option to achieve 100% to 150% returns over three years by participating in a private equity-type deal, but with the disadvantage that there is a lack of liquidity and its money is tied up, this may well seem attractive.”
Mr Tyce says hedge funds as investors could tend to be more ‘hands-off’ than private equity companies but more demanding when it comes to returns, perhaps eschewing a seat on the board of directors but setting tough targets for management.
He cites the example of the Manchester United Football Club takeover by Malcolm Glazer, where US hedge funds Och-Ziff Capital Management, Perry Capital and Citadel are charging levels of interest (estimated by some observers to be in excess of 10% a year) that some consider potentially crippling for the club if things turn sour. A private equity firm, in contrast, may generally want a seat on the board of directors, but might be less demanding about rates and timing of return.
Skills set
The hedge funds’ involvement in the Manchester United deal is arguably more of a subordinated debt play than the kind of common equity deal that financial sponsors would generally be involved in, but it does require a similar set of skills to the acquisition of common equity. If hedge funds are to give their private equity rivals a serious headache, bankers say they will need to invest in staff with appropriate skills. Some appear to be doing so already. Och-Ziff, for example, has this year hired Anthony Fobel, formerly of private equity firm CVC Capital, and David Stonehill, a private equity principal at Blackstone Group.
“Hedge funds would appear to be providing increasing competition to private equity firms,” says Trident’s Mr Tyce, who notes greater competition for deals and the fact that some private equity firms have returned money to shareholders after being unable to find suitable new deals to plough profits into.
Not everyone is convinced, though. William Maltby, head of European financial sponsors at Deutsche Bank, argues that reports of hedge funds moving en masse into the private equity space are exaggerated. “We do see a small number of firms, notably Cerberus, moving into pure private equity. But they are still relatively few in number, and we certainly do not see a seismic shift.”
If anything, says Mr Maltby, the trend has actually started to reverse in the second half of this year. “Last year and during the first half of this year, flat equity markets and low interest rates made it difficult for hedge funds to generate returns, and the returns of 20% or higher enjoyed by private equity firms looked attractive in this environment. But with stronger public equity markets, higher interest rates and the credit market turmoil caused by the downgrade of GM, returns are now easier to generate in more traditional bond and equity markets.”
Cultural differences
Mr Maltby says that seeing hedge funds trying to buy just the equity tranche of a deal is still relatively unusual. “Hedge funds usually want to play in all layers of the corporate structure – equity, bank debt and subordinated debt – but there is still a cultural difference between hedge funds and private equity, which means hedge funds tend to be resistant to getting involved in a lot of due diligence. They also dislike having to be privy to price-sensitive information, which can mean they are locked out of the market for some time.”
The head of the financial sponsor desk at another bank agrees. “We simply don’t see hedge funds competing head-to-head with private equity firms,” he says. “There are a few hedge funds which have set up private equity groups, but in general hedge funds don’t have the appetite for duration that private equity investments need.”
Mr Maltby argues that in some ways the hedge funds actually provide useful support for the financial sponsors by investing in subordinated securities and so making more debt capital available. The only area where they might have some disintermediating effect on financial sponsors is in a situation where they have investments in a public company, and because of their activist approach they help to boost its share price. “This would obviously work against the interest of a financial sponsor that was looking to take the company private. But in general, I don’t believe hedge funds pose a threat to the private equity sector.”
Likely impact
If hedge funds are moving into leveraged finance, what impact is this likely to have on private equity firms and their investment bank backers? Steve Conway of UBS is fairly sanguine about the prospect for financial sponsors. “Private equity firms may lose the odd deal to hedge funds, but there’s already a lot of competition in that sector anyway,” he says. “Private equity is a very competitive area, with about 50 private equity firms with over $1bn to invest. As for the impact on banks, we have benefited from having the hedge funds as corporate clients. We’ll provide the same kind of services that we provide for private equity clients.”
But Mr Conway cautions that investment banks will need to look after hedge funds in their totality across the firm, not in the silos that they have sometimes been put into in the past. “We need to start handling hedge funds in a more holistic way.”
Related trend
The jury, then, is still out on the degree to which hedge funds really do provide a competitive threat to financial sponsors. One related trend that could increase competition, however, is the growth of infrastructure funds. Deutsche Bank’s Mr Maltby says these firms aim to target infrastructure as an asset class, benefiting from the shift in ownership and provision of infrastructure projects from government to the private sector. “Infrastructure funds typically target lower returns than private equity firms, and their aim is to buy up stable assets, then leverage them and sell them on,” he says.
These firms are arguably a bigger threat to the dominance of private equity companies than the hedge funds. Recent examples of infrastructure deals include a consortium led by Australia’s Macquarie Capital Alliance buying Dutch telephone directory firm Yellow Brick Road from 3i and Veronis Suhler for €1.8bn in May this year. This deal was done in direct competition with private equity firms Blackstone, CVC Capital Partners and BC Partners.
Macquarie also beat private equity bidders last year to take control of the television transmission business of NTL, Britain’s largest cable operator. Other infrastructure deals include the purchase by ABN’s Structured Capital Markets Team of the UK mental healthcare firm Priory Group. This was bought from private equity firm Doughty Hanson for £875m in July.
HEDGE FUNDS AND PRIVATE EQUITY:WHAT'S THE DIFFERENCE?
The legal, regulatory and structural barriers between hedge funds and private equity firms are relatively small, although historically they have operated in the market in very different ways.
Timothy Spangler, a partner in the investment funds group at City law firm Berwin Leighton Paisner, says traditional differences between the two sectors have included the type of manager that each attracts (with hedge fund managers typically coming from a proprietary trading background, while private equity managers tend to have a background in M&A); the different holding periods of investments (hedge funds typically trade in and out of positions much faster than private equity firms, and value liquidity more highly); and the type of investors who invest in hedge funds as opposed to private equity.
While some of these differences remain, others are breaking down. For example, historically hedge funds have tended to attract investment from high net worth individuals who need liquid investments that give them rapid access to their funds when necessary, while private equity has been favoured by pension plans, endowments and charities.
However, as institutional investors increasingly move into investing in hedge funds, and wealthy individuals are able to get access to private equity investments, this difference is becoming less marked.
The attitude of hedge funds towards liquidity, for example, is also bringing them closer to the traditional private equity space. “Hedge fund managers are now doing more to lock up their investors for longer,” says Mr Spangler, “and this has the effect of creating a sweet spot where they are not taking fully liquid positions but still staying relatively liquid.”
In other words, hedge funds don’t want a seat on the board of a company, or to be making day-to-day management decisions, but they may choose to provide interim liquidity to the company.
“Typically, hedge funds will be most active on the debt tranches, as we see the rise of the credit-oriented hedge fund which can bring debt-oriented skills to the table,” says Mr Spangler.
This concentration on the debt tranches means that hedge funds and private equity firms can still be regarded as bringing complementary approaches to leveraged finance deals.
“Private equity firms take on companies and aim to rebuild or restructure them, taking on an equity risk,” say Mr Spangler. “What we are seeing is not really a competitive threat to private equity, but a complementary approach where hedge funds provide debt financing.”
