A step too far

During the heady days of 2006 and 2007, when hedge funds could do no wrong, some managers used their investors' capital to become limited partners in private equity funds.

According to sources, many of those same hedge funds are now trying to unload these interests on the secondaries market in a desperate search for liquidity to help them meet redemption demands.

A major difference between hedge funds and private equity funds is that hedge fund terms often allow investors to demand their money back on a quarterly or even monthly basis. Hedge funds can establish “gates” which lock up funds for certain lengths of time, but this is not comparable with the long-term lock-up provisions characteristic of private equity funds.

A well-established phenomenon is that of hedge funds attempting to unload direct private equity investments, often completed alongside buyout funds as a part of a syndicated deal or where the hedge fund also supplied mezzanine debt. A source adds that this activity was global: “In some instances, hedge funds took positions in emerging markets, not only in North America or the European Union.”

Less well known, and probably less widespread, was the practice of hedge fund managers taking a limited partner role in private equity funds.

In retrospect, many of the moves made during the boom times of 2005 to 2007 might appear foolhardy. But many on Wall Street now find it mind-boggling that hedge fund managers would think it a good idea to use investors' money to take LP stakes in private equity funds. Not only does such a commitment mean locking up capital for a decade or more, but the arrangement would also essentially force investors to fund two sets of fees – a hedge fund manager would charge management fees and carry to its own LPs after also paying fees and carry to the underlying private equity GPs.

This kind of fee-on-fee, long-term investment activity illustrates the amazing flexibility that some hedge funds were granted by their investors

This kind of fee-on-fee, long-term investment activity illustrates the amazing flexibility that some hedge funds were granted by their investors, as well as the highly opportunistic approach that some managers took to deploying capital.

Hedge funds generally have provisions in their fund contracts that allow for a portion of investments in “alternatives”, which could include investments in private equity funds, according to Jonathan Cole, a partner with Boston-based law firm Edwards Angell Palmer & Dodge.

Hedge managers that got into private equity investing, even spending capital in direct investments, were playing outside their area of expertise and displaying some hubris, Cole suggests.

As the markets crashed through the second half of 2007, and especially after the catastrophic demise of Lehman Brothers, hedge fund investors have rushed for the doors. Many have closed up shop, while others are scrambling for liquidity.

Secondaries specialists interviewed by PEI say many LP interests taken by hedge funds are already on the market. Other managers are choosing to sit on the sidelines, hoping to avoid the painful reality of a secondaries market in which funds are trading at 60 percent discounts and some of the mega-buyout funds are “unsalable”.

Private equity GPs may once have envied the investment mandates of their hedge fund cousins, with their ability to exercise so much control over the fate of investor money. But the legacy of that freedom may include the need to answer accusations of style drift. Managers may also be subject to lawsuits for having changed strategy midstream without informing investors and giving them the chance to leave the fund if they disagreed with the new direction.