Cayman Islands: Are Hedge Funds In Private Equity Concerning?

Over the past five years, the hedge fund market has witnessed exponential growth, with over 8,000 funds now managing an estimated $1 trillion of assets globally. As a result, hedge funds are at a juncture where they find themselves looking for new opportunities for growth. In seeking these new opportunities hedge funds have begun to encroach on the hunting ground of private equity funds, by providing debt or equity financing for the acquisitions of unlisted companies, including taking large, sometimes controlling, equity positions and assuming more shareholder-activist stances. How does this affect hedge fund investors?

Historically, hedge funds and private equity funds have been distinct investment categories for investors. The basic characteristics of a hedge fund include the use of short-selling of some stocks to minimize the risk in holding long-term stock positions, the use of leverage to enhance returns and a performance fee as compensation (usually 20% of the increase in net asset value). Additional features include investment in liquid assets - generally publicly traded - and periodical subscriptions and redemptions. Hedge funds seek market inefficiencies and pricing anomalies in order to achieve the goal of an absolute return.

Private equity funds, in contrast, create value by working with, or taking over the management of, the companies in which they invest - for the long term. A private equity fund operates and invests for a fixed investment period (typically up to five years) during which investors commit substantial amounts, which are drawn down to fund investment opportunities when these materialize.

This is followed by a holding period during which little new investment is made but existing investments are managed and developed. Once the holding period expires, the investment must be disposed of. Managers of private equity funds receive a performance allocation (usually equal to 20% of the profits made on the sale of investments) that is paid upon the sale of investments, after investors have received back the value of their contributions and, typically, a preferred return.

In both types of entities, managers typically receive compensation by keeping a share of the fund’s profits in the form of a performance fee or carry. The difference, however, is that performance fees in private equity funds are back-end loaded, payable on the realization of an investment and after investors have received a preferred return. By contrast, performance fees for hedge funds are accrued and paid at least annually.

Hedge funds can take advantage of more flexible sources of financing. Unlike private equity funds, which only permit capital to be invested during the first few years and are limited in their ability to take in new capital, hedge funds typically do not have size caps, and all capital is available for reinvestment. In addition, the liquid portion of a hedge fund’s portfolio can be quickly levered (using the fund’s margin facility) or liquidated.

This flexibility allows activist hedge funds to rapidly deploy capital towards large, concentrated investment opportunities when needed. In making private equity investments, hedge funds are therefore free from the pressure to make investments that private equity funds are subject to during the commitment period. There is also no outside date by which such illiquid investments must be sold. And there is no limit on the permitted size of the illiquid investment - although hedge fund managers tend to cap illiquid investments at 10% to 30% of a hedge fund’s portfolio.

The lack of liquidity in private equity investments is the one characteristic of private equity-style investing that does not sit with a typical hedge fund structure, which requires hedge funds periodically to strike a net asset value to allow scheduled subscriptions or redemptions based on the fund’s net asset value. Striking a net asset value can be problematic when a hedge fund’s investments include illiquids.

But there are a number of structures a hedge fund can adopt to fit illiquid assets into its portfolio without impacting the balance of the hedge fund’s operations. These include: the use of side pockets, used where the illiquid investment constitutes a material portion of the portfolio; the imposition of longer, sometimes rolling, lockups, where investors are locked into the hedge fund, without a right to redeem, for two, three or occasionally more years in duration; or the use of gates, which are limits on the percentages of fund capital that can be withdrawn on a scheduled redemption date.

Furthermore, hedge funds generally retain the ability in certain circumstances to suspend all redemption rights and pay the redemption price in kind. Finally illiquidity is becoming more common in the industry due to a number of factors, including recent regulatory changes in the United States that require some hedge fund managers to register as investment advisers if they use lockups of fewer than two years.

The flexibility of hedge fund financing combined with less rigid objectives makes hedge funds an efficient tool for private equity investment. They also provide relatively small investors access to such investments. Some argue that private equity investing requires a different mindset and skills. Private equity firms have tended to attract investment bankers - able to invest in a company for the long haul and create value in that company through the handson management of the company’s operations and strategic direction. Hedge funds in contrast have attracted traders who are more interested in short-term investment strategies. But in truth private equity investments are often a natural complement to a number of hedge fund strategies - distressed investing, event-driven investing, multi-strategy investing and real-estate investing.

Hedge funds have evolved since the term was first coined in 1949. They offer a huge variety of strategies and use hedging techniques well beyond short-selling of stocks (and sometimes none at all). The move into private equity investment is yet another chapter in the evolution of this supremely flexible and efficient investment vehicle in its effort to produce returns for investors.

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