Filling in an empty space
One unexplored area of space, in terms of investment, is the space between private equity and funds of hedge funds.
Until now, pension funds have had to choose one or other of the two classes of alternative investments. There are now signs that investment managers and their institutional clients, are beginning to explore the space between in the search for diversification and enhanced returns.
Currently there is the movement of hedge funds into areas which have been perceived as the exclusive province of private equity. One area where this is occurring is restructuring of companies.
Restructuring has proved one of the most profitable and reliable of hedge fund strategies. Distressed and event-driven strategies, in particular, have provided consistent double-digit returns over the past 10 years.
The CSFB Tremont hedge fund index shows that annualised returns from event driven multi strategies between 1995 and 2005 have been 11%, while distressed have been 13.5% over the same period.
There is nothing new about event-driven managers becoming involved in restructuring. One of the world’s biggest funds currently involved in company restructuring, the US-based Cerberus Capital Management, was set up 14 years ago. However, what is new is the blurring of the distinction between private equity and hedge funds.
Randall Dillard, partner at Liongate Capital Management, a fund of hedge funds manager, suggests the convergence of private equity and hedge fund activity is a natural development.
Dillard was previously head of Japanese bank Nomura’s merchant banking operation in London. “At Nomura we ran both a proprietary trading unit and a private equity unit, and we found there was tremendous synergy in running both,” he recalls.
Dillard distinguishes three players with an interest in restructuring - shareholder activists, private equity and capital markets trading in companies. “My view is that potentially all them could play in the restructuring sector,” he says
Hedge funds with distressed or event driven strategies are likely to have the necessary restructuring skills, he suggests. “The skills needed for restructuring are work-out skills rather than capital market skills. The manager needs experience of buying some form of the capital structure - whether it’s a piece of the company’s debt or equity - and working out debt for equity refinancing with the company’s bankers.
“Today, predominantly that skill set sits in the sphere of hedge funds.” Yet to call them hedge funds is slightly misleading,” he says. “Today it is convenient to group them under the umbrella of hedge funds, but 10 years ago you wouldn’t have called the people who do that hedge funds. You would have called them work-out specialists or event specialists or distressed asset buyers.”
Unlike hedge funds, however, work-out specialists cannot protect themselves against market risk, he points out. “They don’t really manage the risk. You can’t hedge distressed companies when you are re-structuring them, because you usually aren’t able to short or put some form of derivative that manages the market movement of their price.”
Generally, there has been a convergence of private equity skills and hedge fund skills in the area of restructuring, Dillard says: “The skill base between private equity and what people now label as hedge funds is very much bleeding into each other.”
Yet the differences remain. He says: “Each one has a set of experiences that are only part of the ability to do it successfully. A hedge fund manager may understand better how to influence managers in a situation where they don’t have 100% ownership and control better, mainly because they are coming at it from a shareholder activist point of view.
“That skill may be lacking in the field of private equity, because there they’ve put their own managers in and they don’t have to persuade. On the other hand, private equity are much better at restructuring the cash flows because they’ve done it since they’ve controlled the company.”
The common denominator is experience, he says. “The driver of who wins and who does not in the restructuring market is experience. The ability of coming into a situation and knowing that you have done it more than once before, and knowing the pitfalls and how the likely scenarios are to play out is essential,” he says.
Hedge funds and private equity both have this depth of experience, he says. “Hedge fund managers, or managers who have operated in the event or distressed space, are doing it very successfully, and some of the highest level of returns are in this area.
“The skills of private equity people are also very conducive to this type of work-out level because usually it means there is a deficiency of management or strategy, or they’ve taken on too much borrowing.”
Yet private equity has grown too greedy to be interested in the restructuring of smaller companies, he says. “So far private equity has not tended to concentrate on the restructuring space, and the reason is that private equity got so rich that they just looked for much bigger deals. They didn’t try to change the cash flow, they just took it private and held it and then when it was making more money sold it off.
“But re-structuring is very much like the old private equity players of yore who would take over a company and work to change the capital structure and the underlying cash flows.”
For the same reason, pension funds generally prefer private equity investment because they are more familiar with it and because they believe it to be more transparent than hedge fund investment.
Yet private equity is, in some respects, as opaque as hedge funds, Dillard suggests. “If a hedge fund were to tell a pension fund that it was going to invest in illiquid assets where there’s not an objective price and where the fund can’t get their money back for eight years, that’s going to frighten them. Yet that’s what private equity does.
“But because the private equity model has mainstream approval and is generally perceived to be successful, pension funds are comfortable with it.”
Whether restructuring funds are managed by private equity or hedge funds, they share the characteristics of both. Not all restructurings are winners, and to take full advantage of this space between private equity hedge funds, institutional investors would have to invest in a non-correlated portfolio of hand picked deals.
“The secret of both the hedge fund industry and the private equity industry - what they don’t tell pension funds - is that most of their deals generate average or below average returns,” says Dillard. “There are a few deals that do really well, and a top performer would have to offer a portfolio of all the ones that are better deals. Today nobody’s offering that type of product.”
Yet some asset managers are considering a fund of funds which would draw on the skills of event-driven and distressed managers involved in the full cycle of restructuring, from near bankruptcy to IPO.
Pioneer Alternative Investments Management (PAI) which is 100% owned by Pioneer Global Asset Management part of the Italian banking group UniCredito, is currently developing a restructuring fund which, it says, will fill the product gap between traditional funds of hedge funds and private equity. This ties in with work it has been doing on developing a fund of hedge funds that focuses on corporate restructuring and turnarounds.
PAI says the proposed fund of hedge funds will allocate to between 8 and 12 specialist managers who are involved in a range of active restructuring plays, with a particular focus on balance sheet restructurings, operational turnarounds, equity value creation - that is, equity stakes in companies requiring a wake-up call but with high potential - distressed securities and event-driven special situations.
The proposed fund is positioned as a diversifier for institutional investors such as pension funds, says Kerry Duffain, head of consultant relationships at Pioneer Investments. “There’s a lot of money being directed at private equity at the moment, excess liquidity is potentially leading to private equity houses paying a significant premium for companies. The restructuring fund is investing with managers who are using distress situations to enable them to buy at a discount.”
Duffain says the idea was largely client-driven. “We were in discussion with a number of large institutional pension funds who were looking for new investment opportunities. At the time there was a lot of institutional interest in things like infrastructure funds.
“We ran our idea of a restructuring fund past a number of investment consultants and large multinational players and they said they thought the idea was extremely interesting because it seemed to fill a gap between the private equity and hedge fund space.”
The proposed fund would have a lock-in period of three years. This is unlikely to deter pension funds, Duffain says. “Some of the assets that institutional investors have been traditionally invested in, like property and private equity, do lock in the money for some time. Given the nature of this type of investment there has to be a lock-in. It takes time to restructure a company. But I think that institutional investors like pension funds feel more confident with long term investment.”
The thinking behind the proposed fund is the belief is that private equity returns have peaked, the conditions for recapitalisations are less attractive and that borrowing multiples are dangerously high.
At this stage in the business cycle, with rising interest rates, a growing number of defaults, widening credit spreads, and a large pool of underperforming companies, restructuring offers institutional investors an alternative within alternative investments.
Mark Barker, co-chief investment officer, funds of hedge funds at PAI, says the proposed restructuring funds can be seen as the other side of the coin from private equity. “There are two points in the economic cycle when it’s attractive to get involved from a private equity point of view. One is at the start of a period of dramatic earnings growth.”
The other is the point where companies start to get themselves into a degree of distress.
“The classic private equity shops are clearly positioned for the former space and the distress restructuring houses clearly for the latter.”
At this point in the business cycle, Barker says: “Investors are looking for opportunities for medium term returns that will take them through the next phase of the economic cycle. That’s really what the positioning of this whole sector is about.”
The opportunities are always there, he says, but the current conditions are creating a ‘sweet spot’ for institutional investors. “Re-structuring opportunities are taking place at all times, but we feel that the pipeline is approaching a glut in the not too distant future, and we’d rather be there early.”
here are a number of ways to take advantage of this sweet spot, says Barker, since restructuring embraces a wide range of approaches. “We are approaching it primarily from the distressed side but the level of activism within restructuring is variable,” he says.
“Our core interest in the area is in the active long-term restructuring, so we are looking at businesses with a good business franchise, poor balance sheets and quite often mediocre management. We would be restructuring over an extended period of time while generally holding the company privately.”
Yet the question is, will pension funds invest in the space between what is perceived to be a risky skill set - hedge funds - and a less risky skill set - private equity?
Duffain does not pretend that the space between is for everyone. “This type of product is going to appeal to pension funds which have already made an investment in alternatives and are comfortable with investing in hedge funds.”
Yet restructuring may be an area of investment that is intuitively more attractive to pension funds than hedge funds, she suggests. “One of the problems with diversified fund of hedge funds investments for trustees is that there are so many strategies with varying degrees of complexity. This is a pretty straightforward plain vanilla strategy. It’s a clear story that pension funds can understand.”