As published in Financial Times
March 7, 2006
A culture clash that could hurt high-end returns
By Edwin Goodman
While the private equity community of venture funds and leveraged buyout funds controls about $200bn in assets, hedge funds manage about $1,300bn and are expanding rapidly. Similarly, there are only about 1,000 private equity groups, strongly outnumbered by the 6,000 hedge fund management firms. Although there are as yet no comprehensive data available, anecdotal reports suggest hedge fund capital has begun an incursion into private equity that is proceeding apace. This is a bad idea whose time has come.
Talent and capital have long been flowing toward the hedge fund arena in search of higher returns. This is in spite of the fact that returns for hedge funds since early 1994, when the CSFB/Tremont Hedge Fund Index started, have been similar to the S&P.
Not so with private equity. According to Thomson Venture Economics and the National Venture Capital Association, annual performance over the 20 years to June 30 of last year was11 per cent for the S&P while returns were 14 per cent for all private equity. Of late, hedge fund returns have been more disappointing, about 4.36 per cent for the 10 months to October last year.
Unlike private equity funds, many hedge funds have enormous flexibility as to their investment prerogatives. Therefore they are free to look far afield for lucrative investments. With hoards of cash and rich incentive packages they are able to buy private equity talent. Hedge funds are about to become big private equity players. But they will not make attractive returns.
The obstacles they face are cultural, operational and structural. Hedge fund investors have a public-market trading sensibility. They make big financial bets in quoted companies within liquid markets and can execute investment transactions in minutes. They can realise large profits on small price movements. Consequently, hedge fund investors are interested in daily, and sometimes hourly, performance data. Unhappy investors have the option of withdrawing their capital, usually on 45 days' notice.
All this is worlds apart from the private equity arena, where it may take five years or more to discern the value of a position let alone release liquidity. Interim valuations are difficult to determine and, in any case, private equity investors are locked in and illiquid for up to 10 years.
In a firm that combines hedge fund and private equity operations, one wonders how hedge fund professionals will view their private equity colleagues when the latter cannot point to any realised profits several years after launching their investment programme.
Whatever individual co-operative successes may develop between hedge funds and private equity investors, the overall impact of the incursion of hedge fund capital is likely to be negative for two reasons.
First, the influx of capital and the addition of many more participants all create an increasingly efficient and competitive market. Entry-level pricing for investors will be driven up and, axiomatically, returns will decline. This will be most evident at the high end of the market where the largest private equity groups and hedge fund interests will compete for deals.
The second problem will be the disruption of asset allocation models, one of the critical tools of institutional investors. Institutions go to great pains to arrive at optimal capital allocations. Arguably, they optimise the opportunity to realise attractive returns through risk management, achieved through diversification. But now the alternative asset allocation component of the models, which usually includes commodities (such as timber or coffee), real estate, private equity and hedge funds, will be compromised. It will be increasingly difficult to place alternative asset allocations in discrete silos based on distinct investment strategies. Therefore, investors in alternative assets will have to rethink this approach.
If unpredictable capital flows make it impossible to fasten on to the best strategy, institutional investors may have to refocus on selecting the best fund manager. That would be a development harkening back to the mid-1980s, when private equity was the last bastion of the investor-as-generalist, and institutional investing in the alternative assets sector centred more on intuition and on close relationships with fund managers. After 20 years of using much more formulaic investment strategies, such an adjustment will prove exceedingly difficult.
Combine all these developments, and they presage a five- to seven-year period of low returns for hedge funds that expand beyond their traditional focus and for private firms operating at the high end of their investment sector.
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