by Adam Kroll, Piper Jaffray Middle Market Mergers & Acquisitions
It is no secret that hedge funds have started peeking behind the
curtain into the private equity community at increasing rates over the
last few years. With 9,000 hedge funds now managing more than $1
trillion this year, the pressure and difficulty to generate alpha is
increasing, making it especially difficult to stand out from the crowd
when attempting to attract investor dollars. As that happens, buyouts
become more interesting. Notwithstanding that hedge funds seek low beta
portfolios, their managers are compensated on absolute return, and
buyout shops have more of it today. Simple capitalism suggests that
hedge fund managers see private equity returns as an opportunity to
boost their own fund performance, attract more capital and, yes, earn
bigger paychecks.
There are three key similarities that exist today. Hedge funds and
private equity funds both consist of a general partner charged with
managing the capital of limited partners under partnership agreements
that can be negotiated any way the parties choose. Second, there is
substantial overlap among the limited partners (pensions, endowments,
and high net-worth individuals). And third, general partner
compensation structures are almost identical for hedge funds and
private equity.
There are four notable structural differences between the money
managers. First, private equity funds obtain capital commitments and
issue capital calls when funds are needed for a particular investment.
Once that money is invested, there is no second bite at the apple;
hedge funds get the money upfront and recycle it until redeemed.
Second, private equity partnerships have definite lives with relatively
tight investment mandates; other than temporal lock-ups, hedge funds
typically do not. Third, hedge funds are notorious for using leverage
to generate returns, while buyout funds typically cannot. Fourth,
private equity funds predominantly take active management roles and
control positions, while hedge funds historically do not seek active
involvement.
A review of recent history, however, indicates that hedge funds are
capable of successfully entering the world of the illiquid. Hedge funds
entered the middle market lending arena as an extension of their high
yield and distressed lending activities. The last recession and credit
tightening created perceived market inefficiencies. Enter hedge funds.
The onset of hedge funds taking control positions in distressed names
led to restructured equity ownership (commonly referred to as the
“loan-to-own” program). With a foot in the door, hedge funds became
more active in commercial lending and facilitated the incredible boom
of CLOs, CDOs, and CBOs. What is most impressive is that middle market
leveraged lending activities effectively created liquidity in a
previously illiquid market. Hedge funds also boosted, if not created,
the corporate credit derivatives market, adding even more liquidity.
Business Development Companies then started raising large amounts of
capital, giving closed-end mutual fund status to middle market lending
and buyout firms.
While few will argue with the mantra of “past performance does not
guarantee future results,” investors (institutional or otherwise) often
put their money behind managers with strong historical results. A brief
review of state pension funds will tell you three important things: (i)
allocations to hedge funds are increasing, (ii) expected hedge fund
absolute returns are far lower than expected private equity returns and
(iii) pension funds are consolidating investments into fewer managers,
and hedge funds are taking greater share. In the aforementioned
interview, Mark Anson stated CalPERS will ultimately pick 30 to 40 key
partnerships (versus 450 funds managing $25 billion of CalPERS
alternative investment allocation). According to the Russell Investment
Group’s annual survey on alternative investments, “Between 2003 and
2005, the percentage of institutional investors using hedge funds grew
from 23% to 27% in North America …” This puts additional pressure on
both hedge fund and private equity managers to generate stand out
returns to attract additional money and keep what they have.
The ironic implication, however, is that long-run profits will fall for
everyone (the investing world’s Wal-Mart effect). According to
Marketwatch, Thomas H. Lee commented, “… the expectations of investors
have diminished since [I] began working in the private equity business
in the 1970s. His firm has generally promised investors a 40% return in
exchange for locking up their investments for 10 to 15 years. The
entrance of hedge funds and institutional investors has diminished
those expectations.”
Nonetheless, if hedge fund managers are going to enter the buyout
market, the question becomes, how? Illiquidity and concern over
mark-to-market valuation are always considered the obstacles. There is
one certainty: hedge funds do not lack creative financial engineering
skills. The market conditions alone benefit hedge funds. As we reported
in the last issue of M&A Monitor, 2005 transaction volume was up 4.5%
to just under 7,000 transactions, while total values were up 10.5% to
$812 billion. For right now, this leads to the appearance of better
liquidity. Consider the real estate analogy that our homes were once
thought of as illiquid and during recent history buyers were showing up
within days of listing. Hedge funds are increasingly turning to
side-pocket allocations incorporated into LP agreements.
Side-pockets are reaching 30% of assets and do not require frequent
valuations; carried interest is typically only taken when profits are
realized. Furthermore, low beta total return typically involves
arbitrage or hedging strategies. Private equity investments, certainly
not as efficient, can open the door to pure play long position in a
pair trade to a public equity or debt short position. Managers are
generally increasing the lock-up period; many new large hedge funds
have lock-ups that go out four years, and even five years in the case
of Eddie Lampert’s ESL Investments. This, of course, is far short of a
typical private equity fund, so the problem is not entirely solved.
In M&A we talk a lot about synergies. Think about cost-saving
opportunities between private equity and hedge funds. Hedge fund
managers may raise their own private equity funds. Both are highly
scalable businesses raising capital from the same institutions; the
human capital is of course readily fungible. Such sibling relationships
are already popping up, causing the line between buyout managers and
hedge fund managers to begin to blur. Consider Cerberus, the $18
billion hedge fund that has been very active in private equity. Recall
they competed with a number of buyout shops for Toys “R” Us, including
KKR. More recently, Cerberus partnered with investors to acquire its
share (665 stores) of the carved up Albertson’s sale. Going the
opposite way, it has been publicized that Carlyle, Bain and Blackstone
have each launched their own hedge funds or fund of funds to peek
behind opposite curtain. It’s also worth noting that the PIPE market
was essentially created by private equity firms. Thus hedge funds and
private equity funds may likely end up as “siblings.”
On the other hand, if hedge funds don’t help themselves, they might as
well help out their private equity cousins. Hedge fund activism is at
least likely to create a symbiotic relationship with private equity
firms by agitating more assets into play for M&A/buyouts. First,
private equity can serve as a white knight alternative to hedge fund
activism. This was most recently seen when Carl Icahn threatened a
hostile bid for Fairmont Hotels & Resorts. The company turned to buyout
fund Colony Capital as its white knight. Second, the push for public
firms to divest non-core or undervalued assets will put more assets in
play for buyout funds.
This was recently evidenced by McDonald’s and Wendy’s being pushed to
spin-off Chipotle and Tim Horton’s, respectively; they chose the IPO
route. Similarly, Eddie Lampert’s decision to divest Orchard Supply
from Sears Holdings, opened the door for Ares Management to take a
$58.7 million stake in the $463.7 million recapitalization of the
company. The chatter in the market also supports this conclusion.
George Roberts, co-founder of buyout fund KKR, in a January 19, 2006
article in The Oregonian, stated they would have no trouble investing
capital raised in their new fund in part because they “… increasingly
have been fed deals as hedge fund managers have agitated for higher
returns ...” Mark Anson (former CalPERS CIO) echoed Roberts in a
January 27, 2006 interview with The Deal, stating he also believed that
restructurings at public companies would create opportunities for
buyout funds.
The substantial debate is likely to continue over whether hedge funds
belong in the private equity world. Ultimately, the decisions will be
made by selling shareholders and their respective management teams with
the advice of M&A advisors. Sellers will consider both price and the
long-run best interests of the firm. The reputation of hedge funds as
fast traders will continue to precede them as they enter private
equity. The transition, if successful, will need to prove itself over a
number of years for hedge fund managers to exhibit themselves as good
shareholders who are willing to wait the possible four to eight years
before realizing returns.
Private equity investing is not for everyone. For the near-term at
least, it is likely that most hedge funds will stick with what they
know best: public equities, credit, commodities and derivatives. But as
these hedge funds moved into the unlikely worlds of reinsurance,
mezzanine lending and market making, before long, many are likely to
stop peeking behind the private equity curtain and jump all the way in.
Many will make friendly entrances, as co-investors with buyout funds,
some will be the siblings to existing hedge funds and others will be
foes competing for attractive buyouts directly. Some may be a combination of all three.
by Adam Kroll, Piper Jaffray Middle Market Mergers & Acquisitions.
You can reach Adam directly at adam.b.kroll@pjc.com or 312-920-2149.
You can also visit www.piperjaffray.com
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