Private equity and hedge funds

Date: Wednesday, October 29, 2008
Author: SJ Berwin & Ajay Pathak, AltAssets.com

Some politicians have fallen into the trap of bundling private equity and hedge funds together. That is a mistake: private equity is long term and long only, and that makes it fundamentally different, says Ajay Pathak of SJ Berwin. That is not to say that the two types of investment strategy cannot learn from each other, and they have done that in recent years.

In particular, some hedge funds have diversified their strategies to include longer term opportunities, have pursued activist strategies, and some have managed distressed debt in order to influence and restructure portfolio companies. They have also financed some leveraged buyouts.

Current market turmoil will accelerate this process of diversification. In particular, some private equity managers will increasingly explore pricing inefficiencies in the public markets by acquiring minority stakes in public equities. In distressed debt investing, the execution skills of hedge fund managers are being combined with the due diligence mindset and access to deal flow available to private equity houses.

Hybrid structures which combine technology from the private equity "investment" arena with the hedge fund "trading" world are increasingly being adopted to take advantage of some of these opportunities. For instance, some private equity funds are now providing a degree of liquidity to investors and are adopting a value based fee mechanism.

Hedge funds, on the other hand, are increasingly employing stricter redemption terms through the use of lock-ups, redemption gates and longer notice periods to enable the funds to invest in more illiquid or longer term investments. Many hedge funds now include side pockets which enable the segregation of illiquid investments from the liquid portfolio with separate terms more akin to a private equity model applying to the side pocket investments. Structures combining the traditional private equity carried interest model with a value based performance fee calculation are also being used for funds investing in a mix of liquid and illiquid assets.

Clearly, fund managers looking to adopt such hybrid structures or terms need to give careful consideration to their existing risk management processes as they expand beyond their traditional investment universe.

Another area requiring particular attention is that of valuation of complex or illiquid investments, particularly where a value based fee model is to be used - rather than the traditional private equity realisation model. Such valuations are often undertaken on a subjective "fair value" basis based on information received from the manager. This gives rise to a potential for conflict of interest, with the manager being able to influence valuations on the back of which the manager will receive its remuneration. In order to avoid this, investors will require managers to adopt a clear, reliable and independent valuation policy.

Although the market conditions over the next few months will see greater diversification by managers seeking to boost returns, hedge funds are unlikely to have a significant impact on the private equity market. They have different skills, different fund terms and different investment horizons. They are, and will remain, a distinct asset class and must not be bundled together - even if they do partner for some types of fund, and borrow fund technologies from each other.

SJ Berwin is a pan-European law firm with a particular focus on private equity. It has offices in London, Frankfurt, Munich, Berlin, Madrid, Paris, Brussels, Milan and Turin. If you would like further information on the firm's services to the private equity industry please contact Simon Witney in the London office on 020 7111 2222 or visit the website at www.sjberwin.com.