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Converging classes

There has been an explosion in both the popularity of hedge funds and the amount of capital allocated to them for investments. This means they are increasingly encroaching on private equity territory, says Simon Davies.

Traditionally, private equity firms have purchased companies, taken them out of the public glare and made operational improvements to the business, before exiting their investments three to five years later.

Hedge funds, on the other hand, usually have flexibility within their funds to invest in several asset classes. Generally, a hedge fund may invest in debt, equity, commodities, foreign exchange, derivatives and everything in between. To manage high-risk investments and limit potential losses, they often make other investments connected, directly or indirectly, with the principal investment.

Both hedge funds and private equity funds are finding their traditional hunting grounds more competitive than ever before. 

For hedge funds, the surge in general liquidity available for debt investment has propped up asset prices at historically high (and relatively steady) levels, creating little volatility – on which hedge funds principally earn their returns.

For private equity funds, investor appetite is high, with the cost of raising capital at an all-time low. However, taking a group private now almost certainly requires winning a competitive auction. This has pushed prices paid skywards, with the prospect of decent returns becoming less certain. Not only that, but businesses now often have complex debt capital structures which may make it more difficult to execute a ‘take private’.

As a result, many private equity and hedge funds have been adapting to the state of the market in search of returns for their investors.

With the decreased cost of capital, private equity funds have been taking profit from their investments. They have been refinancing existing, more expensive borrowing and adding another layer of debt at the top of the capital structure in order to pay themselves a dividend.

Some private equity funds have also taken a shorter-term view of their investments.  The speed with which some companies are being reintroduced to the public markets, or recapitalised to earn required returns, implies that certain private equity funds have adapted their business model in search of value.

Hedge funds, unable to gain material value by investing in a small proportion of a group’s debt, have sought to invest more significantly to obtain control of certain decision-making processes through the covenants protecting the debt-holders’ rights.  They then extract value when they are called upon for consent – when the business is distressed, the debt investors may become the majority shareholders if a debt-for-equity swap ensues. This has led to hedge funds increasing the amount of time they own a particular asset.

It is no surprise that hedge funds and private equity funds have encountered each other in bidding for assets.  Their approach to a particular business may be different, but their aims are the same – to create proper value from an investment whose value is not reflected in the price paid for that investment.

Private equity funds and hedge funds have recognised a need to be more flexible about the amount of time for which they invest, the way in which they invest and the way they earn their returns.  Although the position is exacerbated by the current flood of money available for investment, the flexibility required is also a function of the increasingly complicated capital structures being applied to businesses.

In many potential corporate takeovers, the target’s capital structure, if not considered carefully, could prove fatal to a bidder’s offer. It is something that any adviser to a bidder or investor must now give more thought to and is a driving force in the way in which an adviser’s role is evolving. 

Simon Davies is a manager in the Close Brothers Corporate Restructuring Group and has worked on a broad range of restructuring and M&A transactions; representing debtors, creditors and private equity investors.