Why convergence is taking place
There are an increasing number of similarities between the strategies used by managers of alternative investments and those employed by private equity managers. Alternative investment assets under management are estimated at one trillion dollars and spread over 8,000 funds, while the private equity industry manages only $150bn (e124bn), distributed among 3,000 participants. There is still a lot of land to be opened up, therefore, which could explain the growing interest in hedge funds.
Many factors suggest that, in future, we will see more large groups such as Blackstone which, among other things, has put together a hedge fund and a private equity fund. Likewise, large financial groups and diversified groups will launch their own alternative funds, as illustrated by Carlyle’s announced intentions.
On a less official level, a growing number of hedge funds are now engaging in transactions that traditionally were considered the domain of the private equity sector, similar to “buyout” deals, both in the US and in Europe. We believe that such a convergence could entail risks, particularly for the targeted companies and some of their shareholders. On another level, one may also question the quality of the expertise and skills of some of the hedge funds that initiate such strategies.
The traditional distinction between the two is still obvious: managers of alternative investments derive their profits by trading traditional types of assets, using leverage and derivative products, while private equity managers provide their own or borrowed capital to companies that are at various stages of development, and for various purposes. Such financing often involves taking over the company. If the alternative managers have long used evaluation methods suitable for private equity, indicating more of an ownership perspective than that of a financial investment, there was little question of seeing strategies that indicated a desire to control the company. Now, “activist” strategies are often used by hedge funds.
In reality, such strategies reflect a desire to manage the company being financed either by having a representative on its executive board or through an accumulation of voting rights (by an alternative manager alone or by a consortium set up for this purpose). This approach is now a part of the arsenal of alternative strategies and has generated significant returns in 2005.
Two reasons can be put forward: on the one hand, the huge amounts held by the hedge funds now confer on some of them enough financial power to play the role of private equity manager, as “financier”.
In a recent example, 70% of the outstanding shares of the Blockbuster Company were bought by a consortium of four hedge funds. The leader of this consortium not only has a seat on the company’s board, but has also managed to install two of his allies there. On the other hand, profits from certain traditional alternative strategies have eroded, forcing their managers to look for new opportunities in less traditional areas. Financing a company, making it profitable and/or increasing standards of corporate governance are the same strategies that will make it possible to substantially increase share value, and, consequently, profits in the event of disposal.
The notion of corporate governance is often crucial to an investor, because this, as much as the quality of the balance sheet, will be evaluated in determining whether to make potential investments. Indeed, shareholdings that are too diluted or have too little involvement in the company will not be able to correct a situation in which a company has squandered much of its value due to poor corporate governance, but an “activist” strategy might well be able to.
However, this drift toward private equity by alternative managers could be dangerous for a company and its shareholders. To illustrate one potential pitfall, one can point to the battle currently being waged by a powerful hedge fund to “persuade” a large American media group to buy back $20bn of its shares and to dispose of its cable division.
Regardless of what the hedge fund’s intentions may be in terms of taking over the group, the fact remains that, once its “decisions” have been applied, the share price should be 70% higher than today. Once this price has been reached, will the hedge fund sell its shares for “quick” profit-taking or will it do its best to consolidate the group’s longer-term profitability, an approach that is more traditionally associated with private equity?
The question raised is: does a more speculative approach risk causing damage? It is, therefore, necessary to examine the damages or other consequences a more speculative hedge fund approach might entail for a company and, on a larger scale, the markets. For example, hedge funds have been accused of ousting the CEO of the Frankfurt Stock Exchange from his job because of his attempts to acquire the London Stock Exchange.
Germany may end up with stricter regulations if the investigation concludes that this ousting was the result of a conspiracy against the CEO by shareholders.
On another level, private equity strategies use a longer investment horizon (three to five years). To avoid cheating the investor, it is absolutely essential that the fund analyst checks whether the liquidity of certain hedge funds correctly reflects these transactions, which requires an extended horizon and involves very illiquid assets. Therefore, one could hardly blame a fund involved in transactions of this kind for imposing a three-year “lock-up”.
On the other hand, a hedge fund that has monthly liquidity which buys up large blocks of “distressed” securities or goes into a private investment in public entity (PIPES) transaction should raise some legitimate questions.
Evaluating assets, taking over and managing a company in order to turn it around, all require very different skills than those associated with the management of financial assets. Do all the hedge fund managers who are tempted by these new opportunities have the background and the skills necessary for venturing into activities of this kind?
Thus, the convergence observed between certain hedge fund strategies and private equity strategies raises questions that are critical on several levels. The fact that powerful hedge funds are investing in this new playing field may signal the arrival of a new form of predator with a more short-term outlook, which has the potential of being detrimental both to the targeted companies and for investors. It is up to the analysts to discern the intentions of these funds and to subject them to rigorous analysis.
“Side pockets” allow managers to combine in one fund traditional hedge fund positions and investments, which have no regular pricing and have longer than usual realisation of their investment rewards.
The term of “side pockets” refers to specific classes of hedge fund shares commonly created at the discretion of the fund’s directors to hold specific illiquid investment. Offering documents usually limit the size of the side pockets, generally to 10-20% of the overall fund. Private equity (mainly venture capital or mezzanine lending) and activist investments are mainly included in these pools.
Even though offering memoranda have allowed the use of such mechanism for years, side pockets have gained in visibility over the last months and hit the headlines of several newspapers as an additional argument to warn potential investors about the opaqueness of hedge fund liquidity and underline a fertile terrain for frauds. Indeed, the contents of these pockets are rarely disclosed.
The relevant point here is that they can’t be redeemed until the underlying investments are liquidated. For illustration, say a hedge fund holds 10% of illiquid and unmarked investments. The redemption notice is monthly. If an investor redeems, he will receive 90% of his investments according to the redemption terms but can be stuck for years on the remaining 10% until these are liquidated by the fund. The prospectus’ redemption frequency could hence appear to be misleading.
Again, the solution lies in transparency. The analyst will have to be aware of the funds allowing side pockets. Secondly, their monitoring, especially the size relative to the fund, is key in the assessment of the “real” liquidity of a fund. Increasing investor acceptance should take place as long as the latter are informed of and accept the issues surrounding these side pockets.
Side pockets are increasingly becoming a standard feature of hedge funds wanting to take advantage of a broader range of strategies and investments. The growing belief from fund managers that non publicly traded securities present tremendous potential for growth and returns is not neutral to the fact that some managers could increase the size of their “side-pocket” facilities. By its simplicity, hedge fund structure is more optimal than private equity fund ones.
Like it or not, convergence is taking place between these two worlds… with its range of traps.
Jean Turrettini is analyst and portfolio manager at EIM, the Switzerland-based alternatives manager