Perhaps the greatest arbitrage opportunity discovered by hedge funds is this: doing private equity deals, but getting paid based on partnership terms that were developed for liquid markets.
The discrepancy in GP economics between private equity funds and hedge funds that pursue private equity investments has buyout GPs wondering aloud whether they’re competing against the newcomers on an equal playing field.
“They’ve figured out how to get paid more for doing less,” said Kelvin Davis, a partner at Texas Pacific Group, speaking about hedge fund involvement in private equity at PEI’s recent CFO and COO Forum in New York.
In an interview, The Carlyle Group co-founder David Rubenstein calls hedge funds “a better economic model for the GP which gives them some competitive advantages against us” with regard to private equity deals. He adds: “For LPs, it may not be the best structure.”
Hedge funds typically invest in liquid securities and offer investors regular redemptions. Like private equity GPs, hedge fund portfolio managers usually get paid “two and twenty” – a roughly two percent management fee plus 20 percent of profits. Unlike private equity, where the only meaningful profits are realised profits, hedge funds managers receive their “incentive fee” every year based on the market value of the fund.
Private equity partnerships usually require that GPs not pay themselves carry unless performance surpasses a preferred return of, say, 8 percent. Hedge funds typically have no preferred return, meaning that if the fund generates a 1 percent return, the GP takes home 20 percent of that. (However, hedge funds partnerships do have high-water mark provisions that require funds to weigh gains against any losses in previous years. One bad year can therefore cripple a hedge fund for years thereafter.)
In theory, the annual liquidity and lack of preferred return gives hedge funds two distinct advantages over private equity firms – first, in how much they can pay for deals, and second, in how much they can pay for investment talent.
Secure in the knowledge that even a buyout deal that yields a measly 1 percent will still add to the year-end bonus, hedge funds can afford to pay up for private equity acquisitions, some buyout GPs complain. One partner at a major buyout firm has calculated that a hedge fund that hits an 8 percent IRR on a deal can get paid as much as a buyout GP who hits 13 percent. And of course, the buyout GP gets paid years later.
This doesn’t even factor in the transaction and monitoring fees that financial sponsors typically charge portfolio companies. Buyout firms now largely share these deal fees with their investors. Standard hedge fund partnership documents don’t even mention such fees.
Rubenstein notes that as some hedge funds move into doing private equity deals, the smart ones will hire professionals with experience in buying and managing private companies. The superior economics at hedge funds may be a powerful lure for private equity professionals, allowing hedge funds to poach talent from traditional private equity firms.
‘Side pocket’ accounting
As one might imagine, functioning as a hedge fund while buying and owning illiquid securities is fraught with administrative complications. Private equity GPs know well how difficult it is to assign interim valuations to private companies. A hedge fund with a small carve-out for private equity may want to hold those investments at cost, but as investors come in and out of the broader fund, the value of the illiquid securities becomes an important issue.
One solution is