KEY DIFFERENCES BETWEEN HEDGE FUNDS AND PRIVATE EQUITY FUNDS

The last few years have brought an explosion in the number and size of hedge funds. Additionally, recent deals by private equity funds are much larger than in the past and include taking publicly traded companies private. And private equity funds are now doing larger "club" deals. Both types of funds

Although these funds do not represent long-term threats to each other, secured lenders must recognize that private equity and hedge funds have markedly different characteristics, goals and behaviors. The differences are most starkly illustrated when a hedge fund invests in the debt of a private-equity portfolio company. Knowing these differences will assist secured lenders in evaluating alternatives when the different types of funds end up in the same deal. The most fundamental difference: private equity funds seek to buy all of the equity of companies; hedge funds are not constrained to controlling equity investments. Highlighted below are other major differences between the two types of funds.

Time to hold: Whether investing in debt or equity, hedge funds typically demand a much more rapid exit strategy than private equity funds. Hedge funds generally seek a quick flip of their investments, often in as few as six months and most likely in no more than 18 months. However, some hedge fund investments are "loan to own;" that is, they buy debt at a deep discount with an eye towards converting that debt to equity, then monetizing that equity (through a recapitalization, refinancing, sale, merger or other disposition) in a short time period. This is a function of, among other things, the liquidity and leverage differences between the two types of funds. Investments by private equity firms often are held for five to seven years, sometimes longer. The time-hold differences directly affect the exit strategy, risk tolerance and desired rate of return of the two types of funds. What does all this mean to secured lenders? Simply this: if hedge funds buy debt held by your bank group, be prepared for a transaction that results in distributions of both debt and equity to the secured lenders.

Liquidity and leverage: The different hold periods are driven in large part by the different use of leverage and liquidity demands for the types of funds. Put simply, hedge fund investors generally are able to withdraw their investments more frequently than private equity fund investors. For hedge funds, volatile withdrawal demands force a focus on short-term returns and may lead to shorter hold periods.

Strategic direction: Private equity funds, having longer hold periods, are very interested in the strategic direction of the companies and industries in which they invest. For that reason, prior to making an investment, private equity firms engage in a significant amount of research regarding both the targeted company and the industry in which it operates. Once an investment is made, private equity firms devote substantial "hands-on" time to further develop strategies, assess and evaluate results, and make changes on account thereof. This generally translates into active participation on a board of directors. Hedge funds assess target companies' strategies with a different focus, one tied to hold periods, returns and company and industry hedging strategies. However, hedge funds are increasingly seeking board seats and seeking to influence management decisions made by companies in which they have invested.

Due diligence methodology: The degree of due diligence performed is another distinction. Although both investors have well-developed methodologies for performing due diligence, typically hedge funds rapidly execute due diligence because their exit strategy may be vastly different. Due diligence performed by private equity funds typically takes longer and may be more detailed. A high-level of financial sophistication exists with both types of funds; consequently, each takes a customized approach to due diligence.

Risk tolerance: Whether prospectively investing in a healthy or distressed company, the risk tolerance level of the private equity fund is measured carefully to include both short- and long-term risk evaluations. The private equity firm is able to adjust its tolerance for risk as market conditions change. With the longer period of time to maturity of the investment, a more risk-averse investment style and resources dedicated to the operations of the company, private equity firms have a lower tolerance for risk than hedge funds.

Mark to market: The hedge fund frequently marks its investment to market and utilizes this valuation methodology in its decision making regarding exit strategies. Private equity funds tend to use long-term valuation methodologies when valuing their investments.

Desired return on investments: Hedge funds strive for higher levels of return than private equity funds. However, there may be significant differences in how private equity and hedge funds define "return." Hedge funds typically rely upon a fairly straightforward methodology pursuant to which return is based on the difference between invested value and sales proceeds. The private equity firm's desired return on an investment may be adjusted based on several factors, including market share, profitability, revenues and valuation metrics.

Control: When they buy the equity of a target company, private equity firms may replace the company's senior management. However, finding top-notch management is, in many instances, more difficult than finding the right investment. Even if senior management is retained, the private equity fund will control the board of directors. Thus, the equity sponsor has a direct impact on the strategic direction of the company. Newly appointed directors are often principals of the private equity firm. In the case of many hedge fund investments, management may often be left alone while the hedge fund works towards a buy-and-sell trading position in debt or equity. The trading position often is protected through esoteric and complicated hedging strategies. However, in a "loan to own" investment, the hedge fund may mimic the private equity fund with respect to both management and board involvement.

Assessment of EBITDA, leverage, liquidity and other standard financial metrics: Although hedge funds and private equity firms likely calculate EBITDA, leverage, liquidity and other standard financial metrics in the same manner, given their different risk appetites and hold periods, they have different views regarding where a particular company's financial metrics should be at a specific stage of a deal.

Industry focus: Volatility is valued by certain investors and avoided by others. Hedge funds view volatility as an advantage and an accelerant to higher rates of return, especially given their ability to hedge their investments through company or industry counter "bets." Astute management, a competitive industry and a volatile marketplace can fuel the fire of high returns and profits. Hedge funds typically focus on underperforming companies because such companies are more volatile, creating a corresponding potential for higher returns.

Management fees: Management fees, like engaging in mark-to-market valuation, can cause additional profit-taking pressures. In the case of the private equity investment, the management fee usually is end-loaded and, as a result, emphasizes the long-term result of holding the investment. However, given the recent relative abundance of capital in the market, private equity funds have been aggressively refinancing their investments, using new leverage to pay dividends to their investors. The hedge fund calculates its management fee in a much shorter time frame and, combined with the mark-to-market pricing pressure, this furthers the aggressive nature of the hedge fund investment methodology.

Conclusion

Secured lenders invest in a company's debt, with a view towards a definite yield over a specific time period. Private equity firms generally invest in a company's equity, with a long-term view seeking large "equity-upside" returns. Hedge funds may invest in secured debt, unsecured debt or equity, and may hedge those investments through intra-company hedges or industry hedges, while seeking extraordinary returns. The hedge fund exit strategy may be a simple trade, as opposed to a complete corporate disposition. However, when "loan to own" hedge funds invest in debt securities of portfolio companies owned by private equity funds, the different funds' risk tolerance, hold periods, and leverage and liquidity issues inevitably will result in a culture clash. Depending upon the secured lenders' appetite for debt versus equity, the culture clash may result in the lender abandoning the equity sponsor and siding with the short-term equity flip strategy employed by a loan-to-own hedge fund. The authors are aware of certain recent deals where equity sponsors seeking new financing have imposed restrictions on a lender's ability to transfer debt to certain types of institutions. Knowing the major differences between the types of funds will enable a secured lender to anticipate behavior in transactions involving both types of funds.