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The Convergence of Private Equity and Hedge Funds - White _ Case

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The Convergence of Private Equity and Hedge Funds - White _ Case Powered By Docstoc
					December 2004




The convergence of private equity and hedge
funds in Asia                                                                                                By David Goldstein, White & Case




                                   Despite their similarities, private equity (or            management fees are paid on both invested and
                                   committed funds) and hedge funds have always              uninvested commitments until the end of an
                                   been viewed as distinct disciplines in the alternative    investment or commitment period, after which
                                   asset industry. Over the last few years, however,         funds cannot make new investments. Cash is
                                   market factors have resulted in the convergence           distributed to investors upon realisation of fund
                                   of these two parts of the industry, with both the         investments, and current income, if any, is either

                                   committed fund side and the hedge fund side of            retained by the fund for reinvestment or distributed.

                                   the alternative asset industry taking on                  Investments by committed funds tend to be long-

                                   characteristics of the other. Investment style ‘drift,’   term and illiquid in nature. That is the main reason

                                   personal interests of investment managers, the            why these vehicles have traditionally not offered

                                   interest of asset managers in offering a broad            any means to redeem interests short of a legal,

                                   array of products, and fund raising imperatives           tax or regulatory issue making it inadvisable for

                                   are some of the many factors driving certain hedge        the fund to keep a particular investor in the fund.

                                   funds to seek private equity investments. Perhaps
                                   more interesting, however, are the steps committed        Hedge funds likewise include a tremendous array

                                   fund managers are taking to make themselves               of fund types, such as long/short, fixed income,

                                   more attractive to hedge funds who are seeking            macro, merger arbitrage, other event driven, fixed

                                   to invest in committed funds. Several key trends          income, distressed securities, convertible arbitrage,

                                   are emerging and new terms and mechanisms are             and market neutral strategies. Hedge funds are

                                   being adopted by committed funds in order to              structured to provide liquidity for their investors

                                   compete in this changing landscape.                       by being either ‘open-end’ or listed ‘closed-end’
                                                                                             vehicles. Open-end funds provide liquidity in the
                                   Committed funds and hedge funds                           form of redemption rights and offer new interests
                                   – preliminary notes                                       periodically, unless investment managers
                                   The term ‘committed funds’ includes funds in              voluntarily close the fund to new investors. Before
                                   many different types of strategies, including             considering certain mechanisms funds employ to
                                   traditional private equity, venture capital, distressed   slow down the possible flight of capital from a
                                   debt, real estate opportunity, real estate core or        fund, liquidity options in open-end funds might
                                   core/value and mezzanine among others. However,           be monthly, quarterly, semi-annual or annual or
                                   these funds share a few key characteristics that          longer. The key point for a fund manager, however,
                                   distinguish them from hedge funds and other               is that the underlying trading strategy of the fund
                                   types of ‘open-end’ funds. The primary shared             must be consistent with the liquidity options it
                                   feature is that they represent long-term investments      provides. Closed-end funds issue securities that
DAVID GOLDSTEIN                    for their equity holders, with no redemption rights       are listed on an exchange or are otherwise tradable,
        PARTNER                    and little or no liquidity for their interests. Capital   therefore providing their investors with liquidity
        NEW YORK OFFICE
        1 212 819 8757             commitments to the funds are generally drawn              to the extent of interest in the secondary market.
        dgoldstein@whitecase.com   down over time on an as-needed basis and                  Closed-end funds are the fund manager’s ultimate



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December 2004




dream: permanent capital. However, institutional investors tend to           inundated with a steady flow of information and investment
avoid closed-end funds since they can trade at a discount to their           opportunities, perhaps bored with their core business and looking
net asset value.                                                             for a new challenge, decide to venture into the deal world. One of
                                                                             the most notable examples of this phenomenon is Edward Lambert’s
Strategic convergence – building alternative asset                           acquisition of Kmart and then Sears in the United States.
platforms
Many large money centre firms including global banks and Wall
                                                                             Hedge fund managers have also entered the deal world by investing
Street investment banks have concluded that managing hedge funds
                                                                             in private equity managers as stake, seed or lead investors. While
is synergistic with their other asset management businesses and an
                                                                             hedge fund managers have sought deal-making capability in the
important part of their product portfolio. For example, in the second
                                                                             past, the present trend is remarkable for its breadth, and it shows
half of 2004, JPMorganChase acquired Highbridge Partners and
                                                                             no signs of abating. Much of this trend’s strength is attributable to
hedge fund administrator Tranaut Fund Administration; Lehman
                                                                             the need of hedge fund managers to deploy effectively the large
acquired GLG Partners; and Merrill Lynch prepared a bid for the Man
                                                                             amounts of capital flowing into hedge funds. Hedge fund managers
Group. Also in Europe, BNP Paribas bought a 50 percent stake in
                                                                             have driven a tough bargain, often taking significant portions of the
Fauchier Partners, a boutique UK fund manager and announced that
                                                                             carried interest while paying a reduced carry on their capital. They
the new venture, BNP Paribas Fauchier Partners, is looking to acquire
                                                                             have sought, with mixed success, varying degrees of control over
managers of funds of hedge funds.
                                                                             investments and their terms, representation on portfolio company
                                                                             boards, and termination rights more favourable than third-party
The steady income and cash streams from a hedge funds’
                                                                             investors would typically seek. Hedge fund managers have
management fee may prove to be the biggest attraction for the banks,
                                                                             aggressively sought co-investment rights from committed fund
smoothing earning from other parts of their operations. In fact, some
                                                                             managers, creating potential conflicts of interest for these managers.
investment bankers have discussed lowering the performance fee
                                                                             For the managers of committed funds, the lure of an endorsement
rate of their firms’ hedge funds in exchange for a higher management
                                                                             from a successful hedge fund manager and the related boost to fund
fee. The certainty of this cash flow, compared to the relative uncertainty
                                                                             raising efforts in a difficult market are enough to cause the committed
of the performance fee, is likely to increase the value of a hedge fund
                                                                             fund manager to seek out these arrangements, despite the
manager and definitely make it easier to value the manager, leading
                                                                             compromises entailed.
to transactions that can thrill the hearts of investment bankers such
as mergers and acquisitions or IPOs involving hedge fund managers.           Committed fund managers – changing their terms
The recent IPO of Cohen & Steers, a New York-based manager of                to attract hedge funds as investors
mutual funds that invest in real estate investment trusts may serve          Why is the current fundraising environment so difficult for so many
as an example of this new enthusiasm by investment bankers for               committed funds relative to hedge funds? A good way to sum it up
this industry.                                                               is that for several years committed fund investors have suffered a
                                                                             deadly combination of low returns over prolonged periods of time
One of the most significant trends in the alternative asset industry         without a foreseeable exit strategy for their investments. The liquidity
is the activity of hedge fund managers in the committed fund space.          offered by hedge funds and the superior returns recently generated
Distressed investing strategies has played a significant role in this        by many hedge fund managers has made investing in committed
trend. These strategies provide a logical extension from hedge fund          funds less compelling than it was five to 10 years ago. In this
structures to committed fund structures because many distressed              environment, committed fund managers, especially new managers
managers want to hold investments for longer periods than traders,           raising their first fund or those managers under intense pressure to
while others want to play an active role in restructurings and other         raise money in order to close transactions, have taken some unusual
distressed securities transactions. As distressed managers started           steps to attract hedge fund investments, including aggressive
to look at real estate investments, the need for committed, locked-          deviations from traditional committed fund terms.
up capital also became evident. Other managers suffer from ‘style
drift,’ unable to find suitable investment opportunities within their        Preferred interests – one of the most aggressive moves taken by
discipline. Sometimes this happens because hedge fund managers,              committed fund managers to attract hedge funds as investors has



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been to offer a class of interests in the committed fund in preference       distributions must be paid out upon redemption, and once a
to the traditional class of investor interests. This other ‘preferred’       redemption date has passed, the interests exercising their redemption
class benefits from a priority upon liquidation and a cumulative             rights have priority to all distributions until the redemption amount
dividend distribution in preference to distributions to the ordinary         is satisfied, including priority to any other preferred (or ordinary, if
class of equity and in respect of the carried interest. It also benefits     applicable) interests still held by the redeeming interest holder.
from the huge cushion of the ordinary interests below it, getting 100
percent of the cash flow until their preferred distribution is received.     Mandatory redemption – the corollary, of course, to an investor’s
In cases where this structure has been used, the preferred class has         redemption right is the committed fund manager’s right to buy out
represented approximately 30 percent of total capital. A majority of         the preferred interest holders prior to the optional redemption date.
the portfolio will have to under-perform in order for the preferred          This redemption right generally arises after the second anniversary
class to receive less than their distribution targets.                       of a closing and is priced at a premium to the purchase price plus
                                                                             cumulative unpaid dividends. This feature has the effect of encouraging
The preferred class of interests is entitled to a preferred return at a      the general partner to make regular distributions, to the extent
rate comparable to or higher than the ‘pref’ the ordinary class would        possible, in order to minimise the premium payable in the event of
typically receive. This return is cumulative and all arrearages, on a        a mandatory redemption. If the general partner has a generous
compounded basis, must be paid out before the ordinary interests             number of investment opportunities, the balance to be struck is to
receive any distributions. After the preferred interests receive their       make regular distributions to the preference class but not the common
cumulative distributions, including arrearages, the next dollars go          class, so long as the general partner can stand proceeding without
to the ordinary equity holders until they catch up to the return realised    carried interest distributions. On the redemption date for a given
by the preferred holders. The fund sponsor will have to wait for             tranche of securities, the security holders can each elect to redeem
distributions in respect of its carried interest until an amount equal       their interests or convert them to common interests at an amount
to all of the capital invested has been returned to the investors. Then      equal to their invested amount minus any premium paid for the
the general partner receives distributions of next dollars at the rate       preferred interests (and as adjusted in accordance with any anti-
of up to 80 percent until it has ‘caught-up’ and received a 20 percent       dilution protections that have been invoked).
cumulative carry. Thereafter, dollars are distributed in a traditional
manner, with the limited partners sharing equally based on capital.          Ability to accumulate cash – in these hybrid transactions, investors
                                                                             have generally concluded that making a cumulative preferred
Optional Redemption – some committed fund managers have                      distribution to the preference class before any distributions can be
agreed to provide liquidity to their investors, representing a serious       made to the common interest holders and especially the fund sponsor
departure from traditional committed fund terms. This term has               or general partner has been considered sufficient to assure that the
proven most significant to hedge fund investors, who by their nature         investors’ interests and the general partner’s interests are sufficiently
are uncomfortable with long-term relationships. Redemption rights            aligned. In most deals, the preferred interests holders have even
have been paired with other terms that have made them more                   prevented the general partner’s interests from taking distributions
palatable for the committed fund manager to agree to. For instance,          for tax payments in order to further assure that the use of cash is
a committed fund offering redemption rights should be able to retain         consistent with the interests of all parties. The preference class has
cash, rather than distribute it, in order to be able to satisfy redemption   also imposed stricter investment limitations than is typical in a private
requests as they come due. (Always one step ahead, hedge fund                equity fund. These limitations seem to be influenced by the
managers have sought mandatory distributions of cash reserved in             collateralized debt obligation sector, with transactions outside the
excess of the amount necessary to fund redemption requests and               parameters set out in the fund’s governing documents requiring the
anticipated cash outflows from investment operations, in order to            consent of a super-majority of the preference class.
prevent committed fund managers from redeeming them prior to a
big realisation. (See paragraph on mandatory redemption below.))             As an alternative to accumulating cash, the fund’s governing
The optional redemption rights are spaced out over two or three              documents should provide that the fund can issue additional new
years, so that no more than approximately 10 percent of the fund’s           interests. The difficulty with this approach is addressing whether the
capital can request redemption in any one year. Cumulative                   new interest holders will share in the fund’s investments existing at


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December 2004




the time the new capital is raised. However, this issue does not have      return multiple was below a certain hurdle, the carried interest
to be resolved between the new holders and the preference class if         percentage for that investment would be reduced to 15 percent.
the proceeds of the new equity raised are going to be used to redeem       Finally, an investment realised after the fourth anniversary with a
the preference class. Debt issuance possibilities are limited without      sub-par return (which is higher than a ‘sub-par’ return for an
the consent of the preference class, unless the proceeds from the          investment realized in years three and four) would result in a 15
new debt is used to take out the preference class entirely.                percent carry with respect to that investment. To keep the general
                                                                           partner from getting too far ahead, the carried interest percentage
Enhanced Liquidity – Hedge funds have insisted, with some success,         applied to any realisation would be an average of the appropriate
in requiring committed funds to increase liquidity options available       carry percentages weighted by the amount of capital invested in
for investors in addition to redemption rights. In some instances,         each deal compared to the aggregate invested amount. This weighted
funds have created mechanisms to effect ‘Dutch auction’ procedures         average would be recomputed upon each realisation. Losses would
or agreed to provide information to secondary purchasers in order          be allocated pro rata to each realisation in order to prevent them
to facilitate their due diligence prior to purchasing fund interests.      from being applied to the low-yielding investments or high-yielding
These arrangements address both hedge funds’ liquidity needs and           investments, to the detriment of either the investors or the general
the committed fund managers’ desire to avoid redemptions to the            partner.
extent possible.
                                                                           Conclusion
Realign incentives – an entirely different approach was taken by           The convergence of private equity funds and hedge funds, and in

one committed fund manager seeking to attract hedge fund                   particular the strategic convergence noted earlier, has accelerated

investments. In this case, a lead investor accounting for 20 percent       rapidly in the West and in Japan. The factors that contributed to this

of the fund’s commitments negotiated for a redemption right arising        trend in those regions exist in the rest of Asia, while other factors,

on the third anniversary of closing at a price equal to the fair market    such as fast-moving investment styles, huge capital inflows and

value of its interest, but not in excess of a 10 percent annually          savings rates, and a pool of investment professionals eager for
compounded return. In addition, the fund’s general partner was             innovation, make it equally or more likely that convergence in Asia
incentivised to seek fast dispositions by an innovative carried interest   will be more pervasive than what has been evident in the West to
formula. For investments realised within two years of acquisition,         date. These commercial considerations, and the very sensible
the general partner will receive carried interest at the rate of 25        regulatory currents stirring in Hong Kong and the progressive
percent. If the amount realised was more than a certain multiple of        regulatory atmosphere in Singapore, are creating the right
the invested amount, a carried interest of 30 percent would be             environment throughout Asia for the creation of a new generation
calculated on that gain. For investments realised after the second         of asset management firms.
anniversary of the investment date but before the fourth anniversary,
a 20 percent carried interest would be calculated. However, if the                                                         www.whitecase.com




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Description: Open-end fund (LOF), full name is "Listed Open-Ended Fund". Is a listed open-end funds issue, investors can either purchase a specified network and the redemption of Fund shares can also be traded on an exchange of the Fund. But if the designated outlets investors purchase shares in the fund, you want to throw the Internet, need to go through some custody transfer procedures; Similarly, if the exchange line to buy shares in the fund, you want to redeem at a specified network, but also the custody transfer to go through certain formalities.