Competitive convergence

Author: | Published: 1 Apr 2007
Email a friend

Please enter a maximum of 5 recipients. Use ; to separate more than one email address.

A booming mergers and acquisitions market, low interest rates, a credit market eager to lend, unprecedented amounts of money flowing in from investors, and the mandate and rewards of earning outsized returns have thrust hedge funds and private equity firms into the centre of the investing spotlight. Have these factors also propelled the convergence of hedge fund and private equity investing?

The traditional landscape

Historically, hedge funds and private equity funds have taken markedly different approaches to investing. Each has had a distinct culture, attracted different types of investment professionals with distinct skill sets, catered to a different class of investor (or at least to distinct asset allocations from investors), and had different investment styles and goals in terms of time horizon and targeted percentage return.

Hedge funds

Hedge funds are traditionally fast-paced environments where trading professionals with a focus on public securities, whether equity or debt, move in and out of investments after short holding periods to generate returns. The nature of the investments is market driven. The strategies used are plentiful and could include growth opportunities, distressed securities, direct lending, emerging markets, income securities, arbitrage situations, securities hedging, short selling and value opportunities, to name a few. Some of these strategies employ leverage and derivatives and some do not. Many hedge funds employ a combination of these strategies and have open-ended business models with near carte blanche authority from investors to invest in almost any way possible to earn returns. In light of these strategies and this flexibility, hedge funds generally track the market and research companies and investments through publicly available information, not usually conducting much due diligence on an investment target in a manner typical of a private equity firm looking to acquire and operate a company. Some hedge funds have found their way into activist situations where they are using their holdings in public companies to influence corporate governance, but their activities in this regard stop well short of seeking to control (through acquisition or otherwise) and operate companies. Generally, and other than through activist endeavours, hedge funds leave management and boards to run companies and the hedge funds work to execute and protect their trading positions.

Hedge funds traditionally raise money from wealthy individuals and institutions that are allocating a portion of their capital to alternative investments in search of higher returns and who, while willing to lock up capital in the near term, are not necessarily willing to make long-term commitments. In the past, the hedge fund investor base was largely but not entirely wealthy individuals, while recently more institutions have been investing greater amounts and spurring the growth of hedge fund capital under management. In recent years hedge funds have been seeking (and investors have been accepting) extended lock-up periods, which is providing hedge funds the flexibility to extend their investment hold periods and alter some of their investment strategies.

Private equity firms

By contrast, private equity firms are traditionally long-term investors who use their investors' money as well as leverage raised in the debt markets to acquire companies (which might include buying a private company directly from a seller, buying a division from a large conglomerate to create a free-standing entity, taking a public company private or restructuring a company and its balance sheet), operate and grow them, and then sell them or take them public, typically three to five years after the initial acquisition. Executing on this approach requires investment professionals who are focused on mergers and acquisitions, financing and operations and who drill down on time-consuming due diligence during the acquisition phase and then participate in the operations and management of the acquired company, including by sitting on boards of directors and functioning as de facto, if not actual, officers throughout the term the investment is held and nurtured. By definition, the private equity approach is a long-term approach. In light of this, private equity funds traditionally raise money from institutions (although wealthy individuals certainly invest as well) who are seeking higher returns (even higher than the returns expected from hedge funds) and are willing to be subject to ongoing capital calls as deals are executed and sit with investments that remain illiquid for years.

Hedge fund activism

Prompted in part by the explosive growth in the number of hedge funds (there are about 9,000 worldwide), the corresponding unprecedented capital flowing in from investors (capital under management by hedge funds is about $1.3 trillion worldwide) and the need for the larger funds to differentiate themselves from the pack as more and more funds enter the marketplace with overlapping market driven investment strategies, a cross-section of hedge funds has in recent years been acquiring large stakes in public companies. By holding these investments for a longer time than the funds might have in the past, they seek to influence management and corporate governance through their shareholder positions. This is known as shareholder or hedge fund activism and its goal is to bring about greater returns by asserting a voice in the boardroom to prompt, for example, a dividend to shareholders from cash reserves, the sale or spin-off of a valuable corporate asset, or a change in the composition of board members.

While this type of activity requires more company-specific attention from an activist hedge fund and a time commitment not to trade out of the investment, it is not truly private equity activity, at least in the traditional sense, in that the hedge funds are exerting pressure on management and boards to take an action for the near-term benefit of the shareholders rather than seeking to operate the business. This activism can be positive for public companies in that the activist can bring about or impede action to prevent waste (reigning in executive pay, for example) and create or enhance opportunities (pursuing acquisitions or dispositions, for example). On the other hand, this type of activism can also impede the long-term strategy that a public company and perhaps its broader shareholder base have embraced at the expense of the short-term profit maximization sought by the activists.

Whether or not viewed as positive or negative, and whether or not welcomed by public companies and their broad shareholder base, hedge funds have and will continue to employ shareholder activism as an investment strategy. This strategy at its inception represented a precursor or shift from a true trading mentality towards a more patient, time-consuming, company-specific exertion of influence by hedge funds and prepared hedge funds to take the next step and enter the private equity arena.

Hedge fund and PE convergence

The market in recent years has seen consistently increasing convergence between private equity firms and hedge funds. Several flagship private equity firms have recently established, or are establishing, their own hedge funds. On the other side of the equation, a number of notable hedge funds have begun to venture into arenas traditionally considered the exclusive province of private equity firms, moving beyond providing financing or playing an activist shareholder role in companies to making long-term equity contributions in deals and even acquiring entire companies. A recent survey conducted by the Association for Corporate Growth (ACG) and Grant Thornton polling hedge fund and private equity professionals bears this out. According to the ACG/Grant Thornton survey, only 5% of private equity respondents and 6% of hedge fund respondents felt that there was no significant overlap between the two.

Each of Texas Pacific Group (through TPG-Axon Partners), Bain Capital (through Sankaty Advisers), KKR, The Carlyle Group and Blackstone, to name a few, have started hedge funds in recent years or have announced plans to do so soon. On the flip side, a host of hedge funds in recent years (Cerberus Capital Management, Fortress Investment Group and Oaktree Capital Management among them) have engaged in a number of private equity investments, including making bids for entire companies. The Kmart-Sears merger (orchestrated by hedge fund manager and Kmart stockholder Eddie Lampert) and Cerberus's purchase of a controlling interest in GMAC are two of the most commonly cited examples, but a number of other hedge fund acquisitions have been consummated or announced in the last few years, with numerous additional hedge fund bids falling short but nonetheless influencing the deal landscape.

Factors fuelling the trend

This apparent convergence can be attributed to a number of factors. On the hedge fund side, funds have pressing investment mandates, lofty performance objectives and enormous capital reserves and need to find attractive avenues in which to deploy their cash. As more and more players enter the hedge fund arena and competition among them grows, and as fresh public market-driven opportunities become harder to find, funds are increasingly looking beyond traditional hedge fund strategies to keep pace with their historical (and historic) returns. The private equity arena offers a range of these potential investment prospects and also offers hedge funds an opportunity to diversify their holdings. In many instances, even hedge funds traditionally dealing exclusively in short-term investments have found the long-term equity commitment and lack of liquidity associated with private equity acquisitions palatable, given an attractive potential return. And, as individual hedge funds have grown in size over the last decade, a fair number of funds are now suitably capitalized to pursue large acquisitions.

From the perspective of private equity firms, establishing hedge funds could offer unique benefits beyond those available through typical private equity investments. Hedge fund investments provide a private equity firm the opportunity to diversify its holdings and investment returns in hedge fund activities are measured annually rather than over the several-year life of a typical investment in a private equity portfolio company. Hedge fund activity also offers managers greater flexibility than their private equity investment models ordinarily permit, allowing for investments across a wide array of asset classes and capital structures. Hedge fund activity might appeal to a different class or type of investor, potentially expanding a private equity firm's universe of capital sources and its market share of investment capital.

Impact on investors

There is speculation that this convergence will have an impact on the decision-making process of investors both in hedge funds and private equity firms. In many cases, investors in hedge funds target those funds for the short-term investment horizons that accompany active trading strategies, the high degree of liquidity and the short lock-up or redemption periods. Conversely, private equity investors normally view their investments and the investments made by the private equity firms as long-term commitments that lock up cash for a long time yet offer a potentially higher return. Of course, many investors commit capital both to hedge funds and to private equity firms. A considerable degree of convergence might frustrate investors' desire and ability to diversify their investments. The more hedge funds resemble private equity shops and vice versa, the less distinct investments in either become, which might be a reason that, at least in the case of private equity firms starting hedge funds, the private equity and hedge fund activities have been kept separate in distinct funds as opposed to the blended hedge/private equity strategy that seems to be being deployed by some of the hedge funds that have entered the private equity arena.

Competition or cooperation?

A good deal of attention has been given to the degree, if any, of competition between hedge funds and private equity firms that convergence has prompted, particularly competition for acquisitions in the private equity arena. With large war chests of capital and a new-found interest in bidding for, acquiring and controlling companies, hedge funds potentially represent heightened competition that private equity funds (which already compete against each other and strategic investors for acquisition targets) must contend with, especially in the large deals for coveted acquisition targets. Competition has the potential to present itself in several ways: an increased number of suitors seeking to acquire the same target, escalated deal prices as suitors outbid each other to win deals (an obvious benefit to sellers of companies), accelerated timelines to complete deals in an effort to outpace other suitors and increased competition to attract capital from investors.

However, although convergence and hedge fund participation in the private equity arena has been highly publicized, the degree of competition might be exaggerated. A few of the largest hedge funds have competed with the largest private equity firms for mega-deals, but a great deal of hedge fund participation in (or convergence with) the private equity arena has been in the form of financing. So funds are cooperating rather than competing with private equity firms. Hedge funds have certainly expanded beyond their public market strategies and investments, and empirical and anecdotal data reveal that most hedge funds are participating in private equity by offering creative financing packages across capital structures – whether through providing lead financing, second-lien financing, PIK notes, mezzanine financing or some combination of these. This type of activity benefits the hedge funds by expanding the scope of their traditional investment strategies and benefits private equity firms because private equity deals are funded largely with leveraged capital raised in the debt markets or from other third-party financing sources. In addition to debt financing, hedge funds also represent a source of co-invested equity where a private equity firm might lead an acquisition and seek to defray risk or share the burden of writing a large equity check in a multibillion-dollar transaction.

One area in which convergence is creating, and might create greater, competition between hedge funds and private equity firms is competition to attract top investment professionals. Hedge funds are seeking to lure practised private equity personnel and private equity firms are looking to find qualified traders and securities specialists from investment banks and skilled hedge fund managers to operate their newly created hedge funds.

The ultimate degree of competition between hedge funds and private equity firms, both for business and personnel, will largely be a function of the ultimate degree of convergence. Some observers have predicted a landscape in which the distinction between hedge funds and private equity firms will eventually blur so much that the market will perceive both together as alternative investment vehicles, but most experts predict that the extent of any convergence going forward will be much more modest.

Watching the landscape

While hedge funds might provide some direct competition on big-budget acquisitions, they are far more likely to act as financing sources, co-investors or members of consortia, and not as directly competing bidders. Similarly, although private equity funds are likely to continue to establish hedge funds and to commit some degree of capital to these funds, their primary focus will probably continue to be on traditional private equity acquisitions, with their attendant long-range investment horizons and more ambitious targeted rates of return achieved by buying controlling or complete equity interests and operating and managing portfolio companies.

Eric Schwartzman is an M&A partner and co-chair of Latham & Watkins' corporate department in New York. Christopher Snyder is an M&A senior associate in New York