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Private Market Attracts Hedge Fund Trading

Date: Thursday, November 29, 2007
Author: Chidem Kurdas, HedgeWorld

NEW YORK (HedgeWorld.com)—Hedge funds and private markets for unregistered securities sound like a marriage made in heaven. But such places may be less a venue for offering hedge fund interests and more a new source of trade ideas.

Trading in private markets is an investment opportunity for hedge funds, especially as these are relatively inefficient markets and hedge funds take advantage of inefficiencies, said Barry Silbert, founder and chief executive of Restricted Stock Partners.

Mr. Silbert runs the Restricted Securities Trading Network, a wide-ranging private market where more than 1,000 transactions have taken place. The securities traded include insider stock options, convertible bonds and private investments in public equity. Mr. Silbert described hedge fund participation in the network as very exciting.

But can hedge fund shares be directly offered on this market? Not yet, and there are no definite plans. He would only say that they are looking at the possibility of allowing private equity and hedge fund limited partner interests to trade.

There are plenty of other types of unlisted or restricted securities; in theory, any illiquid instrument, from distressed company debt to collateralized debt obligations, can trade in private networks. Taken together, these securities make a vast market, and the liquidity crunch of the past six months has created more demand.

Restricted Stock Partners recently received funding from Pequot Ventures, the venture capital arm of hedge fund firm Pequot Capital Management Inc., for an expansion.

"We saw that illiquid securities are both an opportunity and a problem," said Lawrence Lenihan, co-head of Pequot Ventures, referring to Pequot Capital's experience in this area.

Banks, pensions, mutual funds and hedge funds hold large positions in illiquid securities but face uncertainty as to how to find a buyer should they want to sell. The RSTN offers a solution to that problem.

There have been discussions of trading collateralized obligations but the opacity of the instruments and lack of information is an issue. This market provides clarity, which is the key to liquidity, said Mr. Lenihan.

As Mr. Silbert sees it, this is the beginning of an exciting new market and potentially a new asset class. "Our market clearing and settlement capability can be applied to a lot of different illiquid instruments," he said.

The capital from Pequot is being used to automate the trading and settlement process and accelerate the growth of the network. It will allow anonymous trading but the RSTN will always have market makers.

A subset of illiquid securities come under Rule 144A of the Securities Act of 1933, according to which unregistered equity securities can be sold to qualified investors with a minimum of $100 million to invest. A group of investment banks recently partnered with the Nasdaq to create an exchange for 144A securities Previous HedgeWorld Story.

Such securities can also trade on the RSTN. Hedge funds can raise money this way if they are willing to pay an underwriter for the 144A offering. On top of that expense, any private network has a glaring drawback compared to the public market from the issuers' perspective.

Private transaction prices are at a discount to public market valuations. Studies indicate a discount range of 10% to 30%, Mr. Silbert said. This discount narrows if the issuer is planning to go public.

The second article in this series will compare private markets.