Hedge Funds and Private Equity: Two Paths to Value Creation
Richard C. Dresdale President, Fenway Partnersn

The looming specter of increasing convergence within the alternative asset class has generated a heated debate recently in the trade press and among noted industry professionals. This discourse has been spurred by recent moves into the private equity space by some hedge fund managers, who are feeling increasing pressure to deploy the unprecedented amounts of capital they control. At the same time, some of the most recognizable names in private equity, including Bain Capital, Blackstone, Carlyle and TPG, have diversified their product offerings well beyond the traditional private equity space.

The recent behavior of hedge funds and private equity firms is raising questions about the future landscape of alternative assets. Can alternative asset managers from very different backgrounds successfully operate in overlapping spaces? Are the similarities between private equity firms and hedge funds more important than the differences? Are they complementary or mutually incompatible?

The discourse on convergence to date has produced no shortage of opinions on these issues and the discussion that follows here makes no pretenses of offering definitive answers to these questions. Rather, the purpose of this paper is to frame the issues by examining where alternative assets are today, reviewing the drivers behind their growth, and offering perspectives on how they may change in the future.

A Historical Perspective

The private equity industry has matured greatly over the past 30 years from the entrepreneurial cottage industry of the 1970s to today's world of branded mega-funds. In the early days, the founding partners of the small pioneer firms all knew each other and had years working together on deals and sharing investment judgments. The business was driven by individual initiative and intuitive deal making: the great investors drove outsized returns of 40% or more at times by pouring enormous amounts of their own energy, not excessive amounts of their own capital into investments. It should be conceded, however, that they were able to do this by virtue of debt to equity ratios frequently topping 10:1.

During the 1980s, the business evolved with the emergence of high-profile LBO artists. These deal makers generated headlines and brought notoriety to the asset class, but as the first true activist investors, they also taught corporate.

America the importance of restructuring and rationalizing business models.When Kohlberg Kravis Roberts & Co. and other pioneering firms began to undertake large public deals, the effective use of leverage and the importance of cash flow was still a mystery to corporate executives. Today these skills are taught in every business school in the country.

By the early 1990s, buyouts had become socially acceptable. CEOs across the country had not only become receptive to meeting with private equity firms once viewed as pariahs, but they had begun to actively turn to private equity sponsors when seeking to divest non-core or underperforming business units. The acceptability of private equity and the tremendous returns generated by the top deal teams drew a large number of new entrants hopeful of emulating their past success, as well as increasing amounts of capital from institutional investors. The crash at the end of the decade was born on a mixture of recklessness, carelessness, and complacency resulting from too many inexperienced players and too much available capital.

Private Equity Today

Today, private equity has recovered from the disappointments of the late 1990s and is a well-established asset class around the globe. With fewer opportunities to benefit from financial arbitrage, firms are increasingly bringing about operational improvements in the companies they control. The focus of most private equity firms today is on relative, not absolute, performance, which is another measure of maturation of the asset class. For many, brand value has become very important in the hope that establishing a strong brand will give sponsors an edge in attracting deals, talent and capital. In some cases, this means permanent capital as publicly-traded vehicles.

Such publicly-traded vehicles are likely to become a permanent feature of the private equity landscape. During the course of the last year, a number of firms have filed, or announced their intent to file for initial public offerings (IPO) of their funds through Business Development Companies (BDC). Although BDCs received a rather lukewarm reception initially, Ripple wood successfully floated its Japanese portfolio on the Belgium stock market and there have been media reports that KKR and Carlyle Group are considering following suit.

The theory behind taking private equity firms public is presumably to create a more efficient permanent capital base without the exhaustive effort required to build long-term relationships with Limited Partners. This concept, however, undermines the very foundation for private equity: its private nature. Traditionally, private equity firms have had the luxury of taking a long-term perspective, because they do not have to meet quarterly earnings pressures that public companies face. Whether today's emphasis on generating returns through relative, long-term, operational improvements to portfolio companies can survive an increasing emphasis on public vehicles remains unclear.

The BDC trend may, in part, be driven by the investment banks that already earn significant fees from private equity firms. For the investment banks, private equity is a powerful revenue stream, as it is for a widening group of consultancies, executive search firms and law firms. Private equity drives roughly 20% of the M&A market today, and the investment banks in particular have organized themselves to capture fees from advising on acquisitions, portfolio company transactions and IPOs (See Exhibit 1, on the previous page). KKR, alone, reportedly paid over $500 million in investment banking fees in 2004.

These larger fees are being generated in part because of heightened deal activity, but also the increasing size of the deals. According to statistics compiled by S&P, the size of the average buyout in 2000 was $351 million and by 2004 it was over $700 million. Larger transactions require larger funds (see Exhibit 2) and as fund sizes increase, the whole situation becomes more complicated. Many firms are feeling the pressure to add new people and open new offices in new geographies in order to effectively deploy this increasing amount of capital.

There is also another dynamic at work: many firms fear becoming over concentrated in one large deal, which has spawned the clubbing phenomenon as a risk sharing option. These consortium deals also allow firms to chase much larger companies. Most funds have an upper limit on how much capital they can commit to any one deal, typically around 10% of the existing fund.

Therefore, even a $5 billion fund, assuming that the firm could achieve a debt to equity ratio of 3:1, would not be able to bid more than $2 billion for any target company without clubbing together with other firms. A SunGard-size transaction with an equity check of $3.5 billion requires a group of buyout firms to pool their resources to make the necessary equity investment.

The willingness of firms to pool their resources in this way is good news for private equity in so far as more and larger properties are available at a time when many within the industry are fearful that overcrowding in the middle market is driving transaction costs up and returns down. However, the governance mechanisms of club deals are still dangerously untested by crisis. Whether most consortiums will be able to persevere through adversity, or whether they will explode or implode spectacularly at the first site of trouble remains unclear. But for the moment, the fireworks sure to result from failed club deals remain but a future prospect for the private equity industry.

Many industry observers say that the future of private equity is best reflected by the Blackstone model, which has evolved into an alternative asset supermarket offering investors a range of products. Since its founding, Blackstone has committed $14 billion in private equity investments and is reportedly raising another $11 billion for its next fund. In addition, it has over $9 billion of hedge fund-of-funds assets, $6 billion for real estate, $1.1 billion for mezzanine, and has more than $2 billion in CDOs. If nothing else, Blackstone's numbers are staggering.

Although there are few firms operating in the alternatives space on Blackstone's scale, there are a number of firms that are already emulating this strategy, and not just traditional private equity firms. For example, some specialized groups like Auda, which began as a private equity fund-of-funds, have added hedge funds. Similarly, Hamilton Lane, one of the most influential advisors in the marketplace, recently acquired a hedge fund-of-funds, Richcourt Advisors. This diversification is likely to become increasingly attractive as businesses pursuing a multi-platform strategy have potentially lucrative cross-selling opportunities. But the real question going forward is whether good managerial skills in one alternative asset class can translate into another.

Hedge Funds at the Gate

Private equity firms growing thirst for other alternative asset classes is not unique: hedge fund sightings are becoming more frequent in the private equity market. The degree to which hedge funds have become involved in the private equity space is hard to quantify, but data from Capital IQ for 2004 suggests that hedge fund participation in private equity deals has doubled the volume in each of 2003 and 2002.

Unquestionably, hedge funds have been the dominant driver of alternative asset management growth recently. Initially fueled by increased demand due to declines in the equity markets, assets have continued to pour into the industry as institutions, pensions, foundations and endowments seek to diversify their portfolios.

Today, about 9,000 hedge funds worldwide collectively control over $1 trillion in assets (see Exhibit 3), which is more than double the amount of assets controlled by a significantly smaller pool of managers at year end in 2000. By comparison, there are about 3,000 private equity firms with $150 billion under management today.

The large amounts of capital flowing into the hands of hedge fund managers recently have generated severe deployment pressures. Hedge fund managers have become more opportunistic and are increasingly looking at a range of investments that they would have traditionally strayed from because of illiquidity. These include syndicated loans, distressed debt, controlling or near controlling equity positions, mezzanine, etc. Therefore, many hedge fund managers clearly see private equity as an attractive companion investment platform. Private equity affords hedge fund managers the opportunity to invest much larger sums of money, as well as attract more money from new institutional investors seeking diversification. Hedge fund managers also see an opportunity to capitalize on perceived inefficiencies within the private equity sector. But most significantly, hedge fund managers see the opportunity in the private equity space to boost their returns, which have not kept pace with the influx of capital.

A recent analysis of asset class performance conducted by the Yale University endowment indicates this divergent trend between returns and capital being committed to hedge funds.

Investment returns in the average hedge fund are down about 1.6% for the year. Some have argued that the reason for the relatively poor returns being posted by many hedge fund managers are a consequence of capital overcrowding in most trading strategies. In short, the industry's growth has been self-defeating by eliminating the very opportunities hedge fund managers originally sought to exploit.

Participation in private equity offers hedge fund managers a new venue to pursue the outsized returns that once made their industry's reputation. Hedge funds are likely to be most prominent in providing debt financing for private equity transactions. Buyout firms, in turn, enjoy working with hedge funds on debt deals because they make quick decisions, are willing to take on situations where there are complex issues, and tend to have a generous outlook toward creditworthiness. Hedge funds' appetite for debt can also lead to control-style investments. While many hedge funds may inadvertently end up in control of a company through distressed situations, the largest hedge funds are not accidentally taking control positions. In what is a case study in hedge fund dexterity, ESL Investments gained control of bankrupt Kmart through its debt and, after Eddie Lampert was installed as chairman of the restructured company, he sealed an $11 billion merger with Sears. Seventy-six similarly large hedge funds, or half of those hedge funds with over $2 billion in assets under management today, are expected to devote 10-20% of their assets to control-style investing in the future.

These hedge fund managers will have several advantages over buyout firms. The most commonly cited include: access to considerably more capital; an ability to do hostile takeovers, therefore opening more deal flow opportunities; an ability to act faster on deals; an ability to take a large equity position in a public company prior to attempting an LBO; and an ability to recruit top talent by offering more attractive pay.

However, there are significant differences in the ways that hedge funds and private equity firms approach decision-making. For example, consider sourcing and negotiating transactions. Although almost every private equity firm in the market today makes claims to having a proprietary deal flow, at some point virtually all of them will compete in an auction, which require far more time to navigate the complexities than it takes to place a bid for a publicly-traded equity position. Additionally, whereas hedge funds tend to rely on making relatively quick decisions based on publicly available information, most private equity firms pride themselves on doing extensive due diligence before making the decision to invest, subjecting potential investments to a tremendous level of scrutiny in hopes of uncovering issues with the company that would not be apparent from a cursory examination of publicly available data. Furthermore, private equity firms generally emphasize collective decision making, and therefore collective responsibility for investments, in order to ensure that every partner has a vested interest in every investment, whereas responsibility, if not always the decision-making, at hedge funds is born by individual traders.

Another difference between how hedge funds and private equity approach sourcing and negotiating is probably a virtue of experience more than investment philosophy. Financing a private equity deal is a complex undertaking and only long experience and dedicated talent can optimize the advantages of favorable transaction structuring and acquisition agreements. Buyout investors have accumulated extensive experience sourcing and negotiating transactions. Since 1990 alone, there have been more than 17,000 U.S. buyout transactions, representing nearly $300 billion in assets. Their methods are tried and true.

In addition to the exhaustive due diligence and other differences described above, buyout firms stress control, an ability to add value and a long-term investment horizon as the cornerstones of private equity investing. These factors are inter-related and their importance has grown in proportion with the emphasis on operational improvements.

Owning and building value through long-term, hands-on ownership is a time- and resource intensive process. It requires dedication, knowledge, skill and experience to implement initiatives at a portfolio company aimed at redirecting strategy, generating top-line growth, improving productivity and controlling costs. Frequently, this requires enhancing the company's leadership, which often calls for the thoughtful use of diplomacy.

1.Strategy Redirection: most private equity firms seek out companies with flawed or incomplete business strategies that fail to drive performance to the company's fullest potential. Redirecting the portfolio company's strategy after acquisition is therefore crucial to seeing the actual performance of the company narrow with its potential.

2.Top-Line Growth: To ensure that a redirection of strategy is meaningful, private equity firms often have to invest in product innovation, brand repositioning, and enhanced distribution and sales force training at their portfolio companies. These initiatives are designed to generate top-line growth at the portfolio companies, and focus on the price, quality and service propositions from the perspective of the companies' customers.

3.Productivity Improvements and Cost Reductions: opportunities to improve productivity, such as through improved sourcing, more efficient manufacturing, and better asset allocation, are coupled with cost reduction programs to improve overall efficiency and achieve best-in-class benchmarks.

4.Management: These initiatives and goals are very difficult for a private equity firm to implement and achieve without excellent, cooperative management at the portfolio company-level. Business underperformance is most often traced to management, and private equity firms will often need to qualitatively enhance the management of a portfolio company themselves in order to achieve the results called for in the firm's investment thesis.

Conclusion

Some have argued that over the course of the next decade, hedge funds and private equity funds will be replaced by blended pools of capital called alternative investment funds. But as stirring to the imagination as this concept may be, it ignores the question of the consequences of various alternative managers losing sight of what they are good at. Private equity managers, for example, are not supposed to react to volatility in the same fashion that public market investors do. The more likely future is one of divergence, not convergence. Ultimately the way hedge funds and private equity firms generate returns are polar opposites. Hedge funds profit from volatility, private equity firms from its absence.

Richard C. Dresdale holds a Bachelor of Arts from Brown University.