While convergence between hedge funds and private equity funds seems inevitable, funds must weigh both the benefits and the potential pitfalls of taking the plunge.
“Convergence” is a term increasingly being used in the alternative investments community to describe what many observers view as the inevitable coming-together of private equity and hedge funds. What forces are driving this trend toward convergence of these two investment sectors, and what is the likely impact?
Both industries are at a juncture where they find themselves looking for new opportunities for growth. Over the past several years, assets under management in hedge funds have swelled to more than US$1 trillion in roughly 9,000 funds. During the same period, the private equity industry also has grown substantially and now has about $150 billion in assets under management in roughly 3,000 funds.
Historically, hedge funds and private equity funds have been distinct alternative investment categories for investors. The single thing they have had in common is that they both represent private pools of capital. All other facets of their business are different, including the way fund managers invest their capital, the types of investors they woo to invest in their funds, the cultures within the organizations that manage the funds, and the type of employees they attract.
Traditional hedge funds generally seek market inefficiencies and pricing anomalies to achieve their absolute-return market goal. It’s not uncommon for a hedge fund to hold on to its securities for minutes, hours, or days, and to take both long and short positions in securities. Their portfolios are generally well-diversified, well-leveraged, and hold no more than a small interest in any single company.
Traditional private equity funds, in contrast, create value in their funds by working with or taking over the management of the companies within which they invest over a relatively long period. An investment may be passive or one where the private equity fund has significant influence over the investee company, including, in many cases, actual control of the company. The investee company may be a public entity or may consist of privately contracted equity stakes where no readily available market exists.
|Hedge Funds Vs. Private Equity|
|Hedge Fund||Private Equity|
|Term||Unlimited||Usually 10 to 12 years|
|Type of investments||Fairly liquid (including complex derivatives)||Illiquid|
|Investors’ liquidity||Open-ended fund, with periodic withdrawals possible||Closed-end funds. Distributions are made at the discretion of the general partner|
|Capital contributions||100% contribution at subscription date||Based on capital commitment drawdown over time|
|Management fees||Based on net asset value||Based on capital commitments|
|Performance-based compensation||Incentive fee taken annually on realized and unrealized gains, no “clawback”||Carried interest on realized investments, subject to “clawback”|
What Would Funds Gain?
To understand what is fueling the talk about convergence, we first have to define what it means. Convergence between the two sectors could be achieved in one of two ways: either as hedge fund participation in private equity-style investing, or as the management of private equity funds and hedge funds as separate investment vehicles under one roof.
Benefits for Hedge Funds. As more and more hedge funds are formed and markets become crowded from overparticipation, hedge fund managers have been seeking new opportunities for deploying their capital. The huge inflows of capital into hedge funds mean that they can deploy their capital diversely. Hedge funds historically have focused on investing in global equities, convertible and other fixed-income securities, high-yield bonds, distressed markets, and various derivative products. In addition, they have invested in real estate and have become involved in making bridge loans and other loans, including those traditionally made by banking institutions.
However, hedge funds seek absolute returns year after year, and they are finding it more difficult to produce double-digit returns in the markets in which they currently trade. Private equity investing produces opportunities for them to earn the higher returns they seek and is the next logical step in broadening their trading strategy.
Appeal for Private Equity Funds. For private equity funds, being teamed up with hedge funds also produces benefits. Given the nature of a private equity investment, the funds usually require longer lock-up periods that may deter investors. Most private equity investments are held for longer periods of time, and in some cases investors may wait more than a decade for a return to be realized. Some of these private equity investors may welcome the opportunity to invest in hedge funds to gain the liquidity that hedge funds provide. An affiliation between a private equity fund and a hedge fund would allow the private equity fund to direct investors to its affiliated hedge funds, allowing investors to diversify their holdings. This becomes advantageous for private equity investors when trying to subscribe into popular hedge funds that are no longer accepting subscriptions from new investors.
In addition, as private equity investments return capital, which in turn leads to distributions to investors, these same investors may now be able to invest that capital with the private equity fund’s affiliated hedge funds, ensuring that the investor’s capital stays in-house. Otherwise, if the capital is returned to the investor, there is a strong possibility that the investor will decide to invest it elsewhere. The ability to leverage a firm’s existing client base by providing investors with a range of investment alternatives can be quite advantageous to an asset management firm. Many private equity firms, including KKR, Carlyle, Texas Pacific, Blackstone, and Bain, have launched their own hedge funds to embrace the opportunities associated with convergence.
Greater Efficiencies. Combining hedge funds and private equity funds under one roof also may promote efficiencies in attracting talent and raising capital. These two types of funds generally compete on two main fronts: talent and money. Both strive to attract the best and brightest in the financial services industry, and both offer opportunities that allow entrants to succeed if they perform very well. As a result, people in the financial markets who are eager to earn a lot of money typically will gravitate toward working for or starting either a hedge fund or a private equity fund.
Moreover, both hedge funds and private equity funds typically are lumped into the alternative asset class. Institutional and high-net-worth investors looking to invest in this asset class generally divide their capital between the two types of funds, which puts the fund managers head to head against each other when trying to raise capital.
But can the convergence of these two groups work smoothly? While an affiliation between these sectors seems appealing at first glance, there are some potential issues that must be addressed before these industries move toward convergence.
Style of Investing. Although hedge funds historically have flourished in the industries they have entered, investing in private equity funds involves much more than selecting and trading stocks and other securities. Private equity investing requires a different mindset and set of skills. It requires investing in a company for the long haul and creating value in that company through hands-on management of the company’s operations and strategic direction. For fund managers, this typically includes taking a seat on the company’s board of directors or being one of the officers of the company and working day after day to build the value of the company.
Hedge funds currently may lack the skills or experience to turn around or build private companies successfully. They also may lack the in-house talent required to close complex private equity deals, which can take up to many months to put together and typically involve the compilation of numerous legal documents and consultation with lawyers, bankers, accountants, and other industry professionals. Hedge fund managers are very good at detecting the pricing inefficiencies in a company’s traded financial instruments. But they may not have the “right stuff” when it comes to creating value in a company through hands-on leadership.