Seeking greater returns, hedge fund managers are increasing investments in private equity opportunities such as real estate and non-public companies, leading some industry observers to predict a convergence between the two.
Are hedge funds a threat to private equity? Will investors benefit? These were some of the questions addressed by an industry panel at the Venture Capital & Private Equity Conference held February 4 at Harvard Business School, and moderated by Professor Nabil N. El-Hage.
According to New York-based Freeman & Co., private equity represented 7 percent of hedge fund investments last year, or about $65 billion. That figure could go north of $100 billion this year.
The group discussed whether what their firms are doing represents a convergence of these two types of investing or merely a diversification of the investment options available when trying to get the best returns for clients.
Michael Klein, a managing director of Aetos Capital, which offers hedge fund and other investment opportunities, came down on the side of diversification, especially given the current market environment.
| There are a lot of information advantages in having people with expertise in different places in the capital markets. |
| —Michael Klein, Aetos Capital |
"I think that the environment we're currently experiencing is a more challenging one," Klein said. "On a global level, the market has a lot of liquidity, global asset prices are very highly valued, and returns as a result have come down. . . . More and more, sophisticated institutions are willing to pay up for Alpha (outsized returns relative to risk), and to index their greater exposure in their portfolios. This results in seeking out managers that can find arbitrage opportunities, find places where money can be made without requiring those managers to be in a strict style box."
A nice mix
This sort of diversification in particular makes sense for the private equity firm model, he said. "There are a lot of information advantages in having people with expertise in different places in the capital markets. It's a great diversifier of your revenue streams. Hedge funds and private equity have different revenue streams, so it provides a nice mix of revenue streams for your business. And this diversification is also useful, as alternative firms seek to have a life beyond a single generation of founders and seek to continue to grow."
From a private equity perspective, Martin Brand (HBS MBA '03), an associate at the Blackstone Group who works with hedge fund investing, said the firm has an investment committee of specialists in different classes of hedge funds, which guarantees useful information sharing.
Oliver Goldstein (HBS MBA '97), a senior managing director for Eton Park Capital Management, discussed the challenges of working in both these types of businesses and managing the differing compensation models of private equity and hedge funds.
His firm is primarily a hedge fund firm with 30 percent in "side-pocket" investments. (Side pockets are separate accounts used by hedge funds to hold illiquid, difficult-to-value private equity investments.) With side pockets, "our economics match our investors' economics; we get our carry when investments are realized either public or otherwise."
One challenge is managing a liquid strategy next to an illiquid strategy, said Claudio Siniscalco (HBS MBA '04), a principal of Audley Capital, a hybrid investment firm based in London.
"One of the issues you'll face is that . . . if everyone is working at the same pace, the illiquid book could easily balloon to outvalue the liquid book. So that's a great cause for concern when thinking about managing these sorts of investment strategies."
"We have a side pocket in our liquid fund that participates in all the liquid investments we make," he continued. "Additionally we have opportunistic capital, which is there to be spent when we find something and that could resemble a blind private equity pool over a certain amount of time."
Different strategies
Given how new a phenomenon this is, it shouldn't be surprising that companies are handling convergence issues in various ways in terms of cultures and investment strategy, Klein said.
Oliver also pointed out that some types of private equity probably wouldn't be included in a convergence investment play. He mentioned that his firm would never be involved in control-oriented buyouts, for example.
The session ended with a discussion on the opportunities for a more permanent funding structure for private equity, so that firms investing in private equity aren't constantly caught in the fundraising cycle and then waiting long term for returns. 