Private equity funds bristle as hedge funds muscle in
13 February 2006
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HEDGE funds are encroaching on what has traditionally been the hunting ground of private equity funds. Merrill Lynch chairman for Europe, the Middle East and Asia Bob Wigley sparked a heated debate at the end of last year about such convergence, stating that hedge funds were targeting what was traditionally the buyout firm's turf in Europe after testing the ground in the US.
But while hedge funds' involvement may signal an intention to take a more controlling interest in the companies they invest in, it may not turn out to be the revolution that was feared (or exalted).
It is also unlikely to be the gift horse many law firms unaccustomed to the private equity market hope. Despite hedge funds' image as operating on the edge of acceptable practice, they actually tend to favour established, heavyweight law firms such as Allen & Overy (A&O).
Over the past three years, the hedge fund market has witnessed exponential growth, with 8,000 funds now estimated to manage around $1tr (£570.39bn) of assets globally. But this growth has brought increased competition, which has seen hedge funds' returns pale in comparison to those of private equity funds.
As a result, many hedge funds have begun embracing alternative investment strategies and utilising longer lock-ins. This trend has been exacerbated further in the US, as the Securities and Exchange Commission (SEC) implemented new requirements from 1 February for hedge fund managers to register with the regulator unless their lock-ins exceed two years.
While this means that there is no longer such a thing as a 'typical' hedge fund, the majority active in the leveraged buyout market are focused on providing subordinate debt, such as second-lien and mezzanine debt and payment-in-kind securities (Piks). As such, they represent a more serious threat to providers of mezzanine and junior debt and their legal advisers rather than to private equity funds.
The most notable UK example of this was when a consortium of hedge funds (Och-Ziff Capital Manage-ment Group, Citadel and Perry Capital Management) helped finance Malcolm Glazer's £790m takeover of Manchester United FC by taking Piks in one of the acquisition vehicles.
There are few top-tier hedge funds active in the larger-cap private equity market - Cerberus Capital Management (Milbank Tweed Hadley & McCloy), Fortress Investment Group (Linklaters, Weil Gotshal & Manges), Oaktree Capital Management (Bingham McCutchen, Cadwalader Wickersham & Taft), Och-Ziff (A&O) and Perry (Sullivan & Cromwell) are considered the leaders.
To date, most cases of hedge funds bidding in this market have taken place in the US. For example, Cerberus (historically advised by Milbank in the US) successfully purchased MeadWestvaco's paper business for $2.3bn (£1.3bn) last year. But in its consortium-based bids for Toys R Us or Texaco Genco, the hedge fund lost out to consortiums of private equity funds.
Some hedge funds are taking a more 'active' approach to investing, with funds aiming to bring about or influence takeovers, distressed situations and share issues, and corporate management or governance issues.
Three hedge funds, including Eton Park Capital Management, have been the most active buyers of P&O shares in recent weeks and have been lobbying for PSA International to trump DP World's 520p-a-share bid. However, this looks decidedly unlikely following PSA's announcement on Friday (10 February) that it was bowing out of the race.
The active approach is causing conflict on Apax Partners' planned $1.6bn (£919m) acquisition of designer clothing company Tommy Hilfiger. Despite JPMorgan declaring Apax's $16.80 (£9.65) per share offer as "fair", Sowood Capital Management, which has a 6.3 per cent stake in Hilfiger, is challenging the sale. In an SEC filing, the hedge fund claims the deal "materially undervalues" the retailer. Hedge funds are beginning to lead or co-lead M&A transactions within Europe - activities previously the domain of private equity funds and corporates. Fortress (Linklaters Oppenhoff & Rädler) successfully bought out German property company Gagfah for $3.5bn (£2.01bn) in 2004. Fortress now plans to merge the company with housing group NILEG Immobilien Holding and then float it.
This trend is making its way to the UK. One of the first UK M&A transactions to be led by a hedge fund was Cerberus's and Fortress's (Milbank, Weil) acquisition of WestLB's interest in TV rental company Boxclever for an estimated £200m in January 2005. Later in the year, Perry (Sullivan & Cromwell), through consortium BCHP (Freshfields), entered the fray when it offered to acquire energy giant Drax Group. Hedge funds have not extended their reach to lead a public company acquisition in the UK, although this looks increasingly likely. Och-Ziff's and Perry's buyout of clothing retailer Peacocks is largely reported as any early indicator of this development.
A&O partner Andrew Ballheimer leveraged off his role on Glazer's controversial takeover of Man Utd (in which the firm also advised the consortium of hedge funds on their Piks) to land the mandate to advise Och-Ziff and Perry on the deal. The hedge funds took a 44 per cent stake in Henson, the bid vehicle incorporated for the purpose of the Peacocks takeover. Another 44 per cent of the equity is, however, held by Peacocks chief executive Richard Kirk, chief financial officer Keith Bryant and executive director Neil Burns, leaving control of the company largely in the hands of its executive. As one magic circle private equity partner said: "Peacocks is the exception that proves the rule" - 'the rule' being that the influence hedge funds are having on private equity is largely overrated.
In fact, private equity houses are beginning to fight back, with some of the largest houses establishing hedge funds of their own - Texas Pacific Group via TPG-Axon Partners, for example, or Bain Capital via Sankaty Advisers.
But perhaps one of the greatest challenges, which may result in an insurmountable barrier to hedge fund managers wishing to compete with private equity funds, is the perception, and in many cases the reality, that they lack the experience, expertise and manpower to run companies and create value over the medium to long term. Och-Ziff has had the most success in countering this following the hire of Anthony Fobel, former director at buyout firm CVC Capital Partners, and David Stonehill, a former private equity principal at Blackstone.
If more hedge funds follow suit we are likely to see a continuing convergence between hedge funds and private equity. But unless hedge funds invest sizeable amounts in restructuring and remarketing their position, they are likely to remain focused on liquid securities and debt providing, offering a greater opportunity for acquisition finance lawyers than those in the private equity domain.
but can hedge funds take over the world? Gemma Westacott reports