Foray of the Hedge Funds

When is a hedge fund not a hedge fund? Perhaps when it starts gobbling up companies and thereby causes serious unease in the private equity world.For months now the financial world has been abuzz about the convergence of hedge and private equity investing. True, many of the large hedge funds have long managed separate private equity businesses, such as Caxton-Iseman, an affiliate of the huge Caxton Associates. What’s new is the increasing tendency of managers to put hedge fund money into private equity deals.What’s the big deal? First, such transactions raise all kinds of issues for investors, including possibly lower returns and muddled asset allocation. Second, private equity managers are suddenly faced with a whole new group of competitors, whose skill sets and expectations may significantly alter the landscape. That’s a nice way of saying that the PE players don’t think the hedge funds know what they are doing.Hedge fund managers are typically trading-oriented and invest for short-term returns. The concept of buying a company and holding it for six years – roughly the life-cycle of many private equity investments – is as foreign as inviting Bill Donaldson in for lunch.Larry Schloss, formerly Global Head of Private Equity at Credit Suisse First Boston, knows a great deal about this subject. He recently started up his own private equity firm, Diamond Castle Holdings, and is aggrieved to find hedge funds trespassing on his turf. In his view, this is not a positive development.Mr. Schloss points out that private equity investors not only buy and sell companies but engage in an interim step crucial to the success of the deal. In almost every transaction, the buying entity gets involved with the management of the target firm. They review budgets, change key personnel, realign manufacturing, set compensation, and so forth. This is not what hedge funds typically do. As Richard Bartlett of Resource Ltd. puts it, hedge funds analyze markets, while private equity players analyze businesses.Why would the hedge funds choose to sail in uncharted seas? Because they literally have so much money, they don’t know what to do with it. Too much money chasing any kind of investment usually puts a lid on returns, and hedge funds are feeling the pressure.A recent study by the consulting firm Casey, Quirk & Acito projected that institutional investors are likely to boost their investments in hedge funds from the current $60 billion to $300 billion by 2008.This rise is coming primarily from those notable party latecomers, the pension funds. The study also projects that the institutions will lower their target returns to 8% annually.Even with reduced targets, the funds are going to have to dance pretty fast to meet expectations and to put all that money to work. As a result, they may continue to ramp up their private equity purchases. This raises some interesting issues, according to Holland West of Shearman and Sterling, who is of counsel to many of the leading hedge funds.One is liquidity. One of the obvious differences between private equity and hedge fund investing is that investors are usually locked into PE deals, whereas they can usually jump out of hedge funds with relatively little notice. That’s because hedge funds tend to invest in highly liquid publicly traded securities that can normally be quickly sold to raise cash, while private equity firms own illiquid investments.Suppose a hedge fund invests in private equity, doesn’t do very well, and consequently sustains sizeable redemptions. The fund will be forced to liquidate its stocks and other marketable securities, leaving the remaining investors with a private equity portfolio. That is not what they signed on for.Also, since private deals should only be valued at the lower of cost or market value, returns on the fund may be understated, shortchanging investors who bail out prematurely. Further, fee income will be deferred until the increased value is realized, complicating accounting and performance data.One hedge fund that has moved into this arena in a limited way is Atlanta based GMT Capital, which runs about $800 million. The president of GMT, Tom Claugus, was formerly with Rohm & Haas, the chemical company. His operating background has tempted him to scout out acquisitions of several small companies, but he has been frustrated.Mr. Claugus acknowledges his clients are not enthusiastic about his suggested forays into private equity transactions. Also, he sees complications, including the lack of liquidity and the amount of time and attention needed to successfully turn around a business. But, like many others, he views such deals as having potentially better value than public securities.No doubt the private equity and hedge fund folks will continue to warily circle each other. A recent announcement from private equity giant Carlyle Group that it intends to re-enter the hedge fund arena suggests that inroads are in both directions. Certainly a bull market would temper the concerns. Meanwhile, the sparring will go on.Ms. Peek is a former managing director of Wertheim Schroder, now a part of Citigroup.

Foray of the Hedge Funds

Foray of the Hedge Funds

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