Hedge Fund Convergence: Strategy versus Structure

Strategy convergence across asset management firms in general and hedge funds in particular is one of the most important and defining trends of the past year. This was most recently highlighted by DE Shaw's increased investment in building a true private equity operation within the $23 billion hedge fund behemoth. And it is, without question, a trend that will continue for the forseeable future. Given its potential for substantially re-shaping the asset management landscape, I have written about several issues either impacting or impacted by the convergence phenomenon over the past six months:

1. 12/07/06 - A Tougher Gate at DE Shaw: Investor Protection vs. Opportunism
2. 09/15/06 - Fortress Going Public? The Writing's On The Wall
3. 08/14/06 - Hedge Funds as Asset Management Complexes - The Day Has Come
4. 08/04/06 - Side Pockets - Use or Abuse?
5. 08/01/06 - Convergence Redux
6. 07/21/06 - Broadening the Multi-Strategy Mandate - Where do Hedge Funds end and Private Equity Funds begin?

Gating restrictions, strategy diversification, institutionalization, side pockets, blurring of the lines between hedge funds and private equity are just a subset of the issues arising from this transformation. To be clear, this is a very complicated, multi-faceted topic. And I'd like to introduce a new, yet critical distinction to the discussion: strategy convergence vs. structural convergence. While strategy convergence is clearly taking place, structural convergence appears to be lagging behind, with serious implications for investors.

For purposes of this post, let me define these terms as follows:

Strategy convergence - hedge funds investing in progressively less liquid assets with private equity firms investing in progressively more liquid assets, leading to a blurring of the historical distinctions between hedge fund and private equity investing

Structural convergence - hedge funds and private equity firms investing in a similar array of assets, with incentive fee/lock-up/redemption characteristics based upon the nature and liquidity of the assets being managed, i.e., quarterly payment of incentive fees on liquid pools and realization-based payment of incentive fees on illiquid pools

The bottom line is - strategy and structure are different, and is something that will need to be reconciled as convergence continues to take root. I believe it is knowledge of this disparity - in structure, in compensation, in liquidity, in culture -  that pushed Jeff Larson's Sowood to separate its private equity activities from its (conventional) hedge fund activities. Why? Because there are very good reasons for why hedge fund and private equity structures have evolved they way they have, and are largely centered around the nature, liquidity and investment horizon of assets in the portfolio. And this distinction has been known for quite some time, probably most commonly manifested through the use of side pockets by hedge funds for certain illiquid investments (which are separated from the more liquid, main fund).

But if hedge fund and private equity assets are commingled in order that structure becomes blurred, it is not hard to imagine how the deck eventually becomes stacked in favor of the hedge fund manager. Why? Because hedge fund managers generally receive quarterly incentive-fee payments versus private equity managers receipt of realization-based incentive fee payments, regardless of the characteristics of the assets in their portfolio. And why is this? Let's first explore the natures of the key risks facing both hedge fund and private equity managers, and then figure out the impact of convergence on these risks. Three of the principal risks facing investors in hedge funds and private equity funds are liquidity risk, timing risk and redemption risk.

Liquidity risk: In conventional hedge fund investing, much of a portfolio could be converted to cash without much trouble. Assets are marketable, there are buyers, sellers and observable prices, and, if need be, can be sold and distributed to investors. This is clearly not the situation with private equity investing. Therefore, all things being equal, would an investor prefer a dollar of returns from a portfolio of assets readily convertible to cash or a portfolio of assets with highly uncertain realizable values? It stands to reason that an investor would place greater value on returns generated from a portfolio with substantially less liquidity risk, arguing for more regular and even potentially higher hedge fund incentive payouts than private equity incentive payouts.

Timing risk: An issue somewhat related to liquidity risk, but different still. Even if one holds a portfolio of liquid assets but chooses to hold on to them for a long time, risk is higher than if one were able to monetize the portfolio more rapidly. It just happens to be that private equity investors, in general, don't have this choice. They can hold onto investments for years on end, by necessity. Conventional hedge fund investors, conversely, have far shorter investment horizons and, therefore, less timing risk. If you think about it, the ultimate investment strategy would be a super high frequency statistical arbitrage program that exploited a broad array of price anomalies across liquid markets thousands of times each day, and ended up net flat at the end of trading (meaning no overnight exposure). This is a strategy that requires little capital, possesses almost zero liquidity risk and almost zero timing risk - in essence, a cash machine. I've known some guys that have done this on relatively small amounts before getting squeezed by other market participants, and it is a beautiful thing. But this isn't reality. Fact is, conventional hedge fund investing has vastly less (though clearly non-zero) timing risk than private equity, and this is yet another reason why one would expect hedge fund incentive fees to be paid more frequently and even trade at a premium to private equity fees.

Redepmtion risk: Clearly related to liquidity and timing risk, redemption risk relates to how easy/difficult it is for an investor get his/her money out of a fund. With conventional hedge funds it stands to reason that redemption terms should be pretty flexible, as the portfolio's nearness to cash and the shortness of the investment horizon argues for redepmtion on, say, a quarterly basis. This is in stark contrast to private equity funds, which hold principally illiquid assets that can't be readily converted to cash under almost any circumstance. Therefore, one would believe that it would be almost impossible to redeem a private equity fund in advance of its maturity, as the illiquid assets need to be converted to cash over time in order to generate returns and distributions for investors. This would also make an investor more willing to pay hedge fund incentive fees more frequently than private equity incentive fees.

Other differences exist, but these are three of the big ones. So given the disparity in nature between hedge fund and private equity investing, what is the problem? The problem is that the risk profiles of hedge funds and private equity funds are beginning to converge, rendering the historical distinctions in incentive compensation and redemption structures obsolete. And this is neither a trifling distinction to the hedge fund investor nor the IRS, which appears to be waking up to convergence (read: hedge funds investing in increasingly illiquid, less marketable assets) which could threaten the favorable "trader" tax treatment afforded hedge funds under IRC Section 162.

And as institutionlization of the hedge fund marketplace continues to progress, it is not hard to see how the most powerful and desirable institutional investors begin to clamor for separate fund structures, compensation schemes and redemption provisions based upon portfolio risk profiles, not whether they are managed under the rubric of a "hedge fund" or a "private equity fund." If a hedge fund is investing in PIPEs, doing venture capital financings, investing in LBOs and other less liquid activities, does it stand to reason that they should be receiving quarterly incentive fees based upon a mark-to-market(?) figure for net asset value? Why should their compensation scheme be any different than the private equity funds realization-based model for these types of investments? Answer: they shouldn't. And this is the rub.

Hedge fund? Private equity fund? These are increasingly artifical distinctions that will eventually be expunged from the investment vernacular. How about "alternative asset managers?" Can you tell me where hedge funds end and private equity funds begin, and vice versa? I can't. So let's stop using language and labels that mis-represent what's really going on here. There is a race for alpha, a somewhat small group of investment professionals that will be able to lay claim to this alpha and a limited number of ways of realizing this alpha. And given the flood of assets into the alternative investment asset class, these professionals will increasingly be pushed to use their skills - be they investment, management, legal, etc. - in other areas. And institutional investors want this. But my betting is that they won't be willing to live with the asymmetry between hedge fund compensation structures and illiquid asset investing. They just won't. They might today. They might tomorrow. But they won't over time. Just my two cents.

Comments

[Roger]

Yaser, I'd like to add a few points of clarity to your interesting comments.

With respect to control, there is a natural conflict between how private equity and hedge fund firms operate. In the case where control is at issue, hedge funds are sharply limited if not completely unable to exercise the types of trading strategies you describe. Why? Because they are considered "affiliates" in the eyes of the SEC, at which point pretty much everything they do is in plain sight and requires full disclosure. So if control is really the point, then private equity and hedge fund firms are in exactly the same place. If you are talking about a hedge fund having a, say, 4% stake in a company with liquid stock and options, then you've got an entirely different story. Hedge funds moving into private equity are starting to look like and act like private equity firms - look at Fortress, look at Appaloosa, look at DE Shaw. The world has changed. My point is that if hedge funds are going to play this game, they should be paid for playing this game - the right way, by matching payouts with value realization.

With respect to strategic direction, I'd look at my response to the issue of control. I think they are essentially the same thing. The hedge fund manager is doing the private equity homework just as if they were a private equity firm if they are going for control. This is why David Shaw just hired a bunch of "real" private equity guys to build his portfolio, because, in general, the competencies are different. So in the realm of true private equity investing, I see the due diligence and homework being done by both types of firms as being similar.

There is no question that supply and demand is what is driving pricing (and supporting the existing asymmetry between value realization and payout) in today's hedge fund marketplace. It is simply my contention that the pendulum will swing back, and at that point it will be the institutions which invest in both hedge funds and private equity who say "stop." And at that point the rules of engagement will change and strategies and payouts will be bifurcated by liquidity, not by what a firm calls itself.

[Yaser Anwar]

Roger some excellent points, I think another issue where some HFs and PEs are converging are:

1) 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.
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.

I'm sure readers remember the Steven Cohen interview with WSJ- I bring it up because he talks about how he's been holding investments longer than he used to, as returns have shrunk due to the sheer size of funds fighting to generate alpha. Similarly- in a “loan to own” investment, the hedge fund may mimic the private equity fund with respect to both management and board involvement [read: Carl Ichan, Daniel Loeb- more HFs are leaning towards some sort of activism- while I don't know the MCD 5%+ shareholder's name he's been on MCD's back to raise dividends/buybacks. More recently Steve Cohen saying he will not back FCX's bid for PD- I'm not sure about you but I've seldom seen SAC act activist, they like to keep things quite.]

2) Strategic Direction- The above point brings me to the strategic direction- PE 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.

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.

The average pension fund is looking to make just 8%, after deducting fees, on its hedge fund investments, according to a recent study by the Bank of New York and Casey, Quirk & Associates, a consulting firm. That is a far cry from the returns of more than 25% generated by celebrated managers like Mr. Soros and Michael Steinhardt at their peaks.

Now that the performance bar has been lowered, there is less incentive for managers to make more aggressive bets, consultants said, especially when they can still charge the same steep fees they did in the past.

So Roger when you say the trend for compensation is more PE like for HFs, I agree for the most part. I think you will agree with me that Investors in hedge funds are resigned to paying dearly for top hedge fund talent thanks to the law of supply and demand. Sure there are lots of HFs under performing but then there are stars like Peter Thiel- who over three years has notched a 200% return for original investors, and I'm quite sure investors will pay very handsomely to be in his fund.

Thanks for sharing your expert insights.