The Convergence of Hedge Funds & Private Equity

By Yaser Anwar, CSC of Equity Investment Ideas

Last week Roger Ehrenberg had a great post pertaining to the convergence of HFs into PE. I commented on his blog & liked what I said, so I’ll reprint it here.

1) Control- When they buy the equity of a target company, private equity firms may replace the company’s senior management. However, finding top-notch management is, in many instances, more difficult than finding the right investment. Even if senior management is retained, the private equity fund will control the board of directors. Newly appointed directors are often principals of the private equity firm.

In the case of many hedge fund investments, management may often be left alone while the hedge fund works towards a buy-and-sell trading position in debt or equity. The trading position often is protected through esoteric and complicated hedging strategies.

I’m sure readers remember the Steven Cohen interview with WSJ- I bring it up because he talks about how he’s been holding investments longer than he used to, as returns have shrunk due to the sheer size of funds fighting to generate alpha. Similarly- in a “loan to own” investment, the hedge fund may mimic the private equity fund with respect to both management and board involvement [read: Carl Ichan, Daniel Loeb- more HFs are leaning towards some sort of activism- while I don’t know the MCD 5%+ shareholder’s name he’s been on MCD’s back to raise dividends/buybacks. More recently Steve Cohen saying he will not back FCX’s bid for PD- I’m not sure about you but I’ve seldom seen SAC act activist, they like to keep things quite.]

2) Strategis Direction- The above point brings me to the strategic direction- Private equity funds, having longer hold periods, are very interested in the strategic direction of the companies and industries in which they invest. For that reason, prior to making an investment, private equity firms engage in a significant amount of research regarding both the targeted company and the industry in which it operates.

Hedge funds assess target companies’ strategies with a different focus, one tied to hold periods, returns and company and industry hedging strategies. However, hedge funds are
increasingly seeking board seats and seeking to influence management decisions made by companies in which they have invested.

The average pension fund is looking to make just 8 percent, after deducting fees, on its hedge fund investments, according to a recent study by the Bank of New York and Casey, Quirk & Associates, a consulting firm. That is a far cry from the returns of more than 25 percent generated by celebrated managers like Mr. Soros and Michael Steinhardt at their peaks.

Update– Also hear the 2 minute podcast of Michael Covel on September 5th, 2006, where he talks about Paul Tudor Jones and why PTJ returns have been reduced (due to investors wanting preservation and not as much as risk as before)

Now that the performance bar has been lowered, there is less incentive for managers to make more aggressive bets, consultants said, especially when they can still charge the same steep fees they did in the past.

So when Roger said the trend for compensation is more PE like for HFs, I agreed for the most part. However, investors in hedge funds are resigned to paying dearly for top hedge fund talent thanks to the law of supply and demand. Sure there are lots of HFs underperforming but then there are stars like Peter Thiel- who over three years has notched a 200% return for original investors, and I’m quite sure investors will pay very handsomely to be in his fund.

To read Roger’s response to my points, click here.

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