Hedge Funds Friend or Foe to Private Equity Firms?

Hedge Funds Friend or Foe to Private Equity Firms? Executive Summary The lines have and will continue to blur between hedge funds and private equity firms. We will begin by defining in today s terms what is really a hedge fund and what is really a private equity fund. Within this context, we believe hedge funds will continue to provide increasing competition to traditional private equity GPs competing for investment opportunities as well as, importantly, top talent. However, based on our 20-year relationship with Farallon Capital Management, a successful $13 billion firm focused on absolute return through multi-asset class strategies, we can illustrate that hedge fund and private equity managers can benefit from a disciplined, collegial relationship. We will share lessons learned from investing together in private equity transactions and discuss implications for such relationships going forward. What is a hedge fund and what is a private equity fund? No discussion about the relationship between hedge funds and private equity funds should start without a few definitions and background. When faced with the need for a definition, we immediately pulled out our Webster s dictionary which defines a hedge fund as an investment group usually in the form of a limited partnership that employs speculative techniques in hope of obtaining large capital gains. Interestingly, this definition was written in 1967. With due respect to Mr. Webster, for the vast majority of today s hedge funds, this definition misses the mark and ignores the fundamental concept of hedging risk. Of the thousands of hedge funds (the CSFB/Tremont Index tracks over 4,000), most of these partnerships have distinct strategies that include important forms of arbitrage, market-neutral strategies, and long/short portfolios. Their performance is measured using Sharpe Ratios, and they are benchmarked against risk-free Treasury rates. They use creative and sophisticated techniques to minimize risk and volatility, and they focus on liquidity and diversification. On the other side of the table, we find the private equity industry. The term private equity is a rather recent creation, as the original moniker for these types of entities was a leveraged buyout firm. LBO firms used borrowed funds to acquire controlling stakes in companies, producing their returns from Mitchell Cohen Managing Director Melissa Ma Director Hellman & Friedman LLP Institute for Fiduciary Education 1

Alternative Investing 2005 the combination of (i) operating improvements, (ii) repayment of debt from cash flow or the sale of non-core assets, and (iii) the ultimate sale of the improved company to the public stock market or to a strategic acquirer. The private equity industry is filled with successful firms that continue to employ this approach to generate returns for their investors. However, in recent years, as more capital has flowed into alternative assets and partnerships have dramatically increased in size, we have begun to see a blurring of the lines. This phenomenon primarily is evident in the larger investment organizations the large or mega private equity funds and the multi-billion dollar multi-disciplined hedge funds, those organizations that are attempting to capitalize on their vast networks of relationships, their deep knowledge of particular industries, and, importantly, the significant amount of capital they have to deploy in an ever increasing competitive investment environment. Many of today s private equity firms take non-control positions, invest in PIPE s and provide growth capital; they invest in distressed debt and often in publicly traded securities. Likewise, many firms that would traditionally have been considered hedge funds are using portions of their capital to make long-only investments and are showing a willingness to invest in less liquid securities, (remember Mr. Webster s definition above). Some hedge fund managers increasingly are using distressed debt to control the equity in a buyout, often ousting a private equity investor. Other multi-billion dollar hedge funds are simply pursuing an opportunistic multi-asset class strategy, investing directly in real estate, private equity, mezzanine, and other alternative asset classes. In many instances, we posit that these hedge funds are no longer a distinct asset class or strategy, but rather an incentive compensation structure. The hedge fund and private equity industries have developed rapidly in recent years. In general, each provides investors with a product with attributes that can satisfy different parts of an institution s asset allocation model. However, we believe that in many situations these two circles will continue to intersect, creating competition and often confusion between these two asset classes. Hedge Funds - Increasing competition to private equity funds To understand the competitive threat posed by hedge funds to private equity funds, we did a rough review of all private equity transactions greater than $100 million closed in 2004 (Europe and US) to look at the spread of competitors in areas that we felt were historical private equitylike transactions. Please appreciate that our search was more art than science, as the definition of a private equity-like transaction is quite subjective. Our data showed that approximately 20 transactions or 6% of the total, representing between $10-15 billion in transaction value (~5-8% of total), were completed by firms we consider hedge funds (based on their historical roots). Compared to similar analysis we did just two year earlier, hedge funds barely hit the radar screen. Given the size of the market, it is not clear that this has had a material impact on the pricing for transactions. To put it in context, $10-15 billion represents only one or two mega private equity funds. We are not prepared to predict where this share will be two years from now; however, we do not believe it will decline from this level, and we feel that these players will continue to have an important presence in the market. Interestingly, the transactions highlighted above were concentrated in a few sectors, including infrastructure (e.g. power, gas, airports, and towers) and financial services (e.g. insurance). That being said, the migration to other industries is occurring, with transactions popping up in such areas as retailing, leisure/ hospitality, and media. While many of these transactions have a unique structuring aspect to them that might be attractive to traditional hedge funds (asset securitization opportunities, etc.), a 2 Institute for Fiduciary Education

Exhibit 1 Exhibit A: Comparison of Fund Economics COMPARISON OF FUND ECONOMICS Hedge fund managers Typically 1-2% and 5-20% incentive on LIBOR-like hurdles No fee pay back Paid annually High watermark Fully invested at all time Private equity managers Typically 1.5% and 20% carry on 7% hurdle Management fees and expenses returned first Wait years (2-4 yrs?) for exit and waterfall catch up Waterfall Invested over multi year period number of these transactions appear to be situations that would typically fall within a private equity player s sweet spot. We had a recent situation in which we competed directly with a group of hedge funds for an investment. Hellman & Friedman, along with three other private equity firms, partnered in a 12- to 18-month process to purchase a large power generation company in a transaction valued at over $3 billion. This transaction was extremely complex it involved an investment banker-led auction of a company that needed to install new management and separate from its parent company, had a complicated regulatory approval process, and a unique tax structure all characteristics which we believed were not conducive to traditional hedge funds. We were quite surprised that a consortium of hedge fund managers partnered to be our primary competitor. They were patient, hard working, innovative, and stayed in the process up to the end (even seeming like the winner with the high price at one point). In the end, our consortium won, not because of price or perceived better value-add to the company or management, but because we had a better legal and tax structure to consummate the purchase. As large firms, both in private equity and hedge funds, look to increase their scope, whether by geography, industry, or type of transaction, it is inevitable that they will step on each others toes or cross into each others territories. Equally important, they will compete with each other in attracting and retaining top investment talent. One of our large limited partners perhaps put it best when he said, Private equity talent is going to hedge funds because the payoffs are quicker. We said earlier that we view many hedge funds (mostly the multi-billion, multi-strategy funds) as an incentive compensation structure, not a separate asset class or strategy. As we all know, they can be a very attractive compensation structure (not to say that private equity doesn t have attractive compensation as well). Comparing the economics (Exhibit 1), hedge funds typically have similar or lower fees and carry structures but on lower hurdle and on a market-to-market basis (usually annually), meaning professionals receive a significant amount of their incentive compensation on a regular basis. (This would be compared to private equity partnerships, where incentive compensation is received in the future when investments are realized). The first wave of talent drain we have seen is Institute for Fiduciary Education 3

Alternative Investing 2005 at the post-mba and young Principal (prepartner) level. Given their younger tenures, these professionals are not yet emotionally and economically vested in a private equity fund/firm and have become attracted to hedge funds. These young investment professionals are attractive candidates to hedge funds who want to supplement their teams with people trained with more private equity-like skills (due diligence, valuation, strategic thinking, etc.). We also have begun to seen senior level private equity professionals make the jump to firms that are structured more like traditional hedge funds. Working with and benefiting from hedge funds the H&F experience with Farallon For the past 20 years, we have had a close relationship with Farallon Capital Management, a $13 billion fund focused on absolute return through multi-asset class strategies. Tom Steyer, the founder of Farallon, started as a Managing Director at H&F and then founded Farallon in 1986 with seed capital from H&F partners. Since then, we have maintained an arms length, but strategically beneficial, relationship, including: Mr. Steyer continues as a Managing Director and Member of the Investment Committee at H&F Small cross ownership across the two GPs; Personal relationships and linkages between many investment professionals of both firms Farallon often serves as our window on activities in the capital markets. Likewise, Farallon has industry experts who are attuned to deal activities in certain markets and who can be resources that can supplement H&F s areas of expertise. What Farallon can bring to a transaction as far as research and relationships often compliments our capabilities as a private equity firm managing complicated due diligence processes, structuring and negotiated control transactions, and being value-added partners to companies as they grow. To date, we have reviewed many opportunities together, including an acquisition of Universal Underwriters, a transaction in the insurance sector in which we recently signed a definitive purchase agreement. In this case, as in others, the need for capital was not the primary motivation for selecting Farallon as a co-investor, as there are many choices these days for coinvestment partners. Farallon brings significant value to transactions because of their industry expertise and network. For example, with respect to Universal Underwriters, our two firms have done a number of insurance deals together, and we have benefited from Farallon s deep expertise in this complex sector, including understanding such issues as capital adequacy and the quality of underwriting. As a result of being significant investors in the industry, Farallon has an extensive industry network which was invaluable when doing reference checks and customer calls, as well as management recruiting. Our relationship with Farallon is not without its issues and constraints. From our experience, there are a number of areas that you have to get right for there to be an effective, long-term partnership between hedge fund manager and private equity manager: Compliance and confidentiality How will you make sure hedge fund professionals are not tainted from discussions with their private equity counterparts and visa versa? Culture and compensation How will you provide incentives to professionals from each manager to work together and share ideas? Investor conflicts and separation How will you make sure your investors are comfortable with your relationship? Summary In summary, as firms in the alternative asset 4 Institute for Fiduciary Education

category grow and search for investment opportunities, it is inevitable that groups will run into each other. For many groups, the label of hedge fund or private equity fund has and will continue to become blurred. The threat of hedge funds to private equity managers will likely continue to be a small subset of funds the multi-billion dollar, multistrategy, multi-asset class firms, but who represent a meaningful amount of capital. By the same token, these same hedge funds can be friends and investment partners if private equity firms can appropriately leverage these firms industry expertise and other knowledge. Mitchell Cohen graduated from the McIntire School of Commerce at the University of Virginia Melissa Ma graduated from Harvard College and the Harvard Business School Institute for Fiduciary Education 5