Hedge funds activism is a recent trend where hedge funds following an Event-Driven strategy invest in private equity-like assets, meaning taking major stakes in private companies. Activism is not just a matter of investments, but mainly a change in fund structure, terms, capital allocation, strategy and other elements that are making hedge funds more and more close to private equity funds. This article is aimed at analyzing this convergence from both a structural and performance point of view, in order to understand and explain this recent trend. The final objective is to assess whether hedge funds following an activist strategy are creating more value for investors than private equity funds.
Hedge funds and private equity funds have long been considered two distinct alternative investment categories, differing in their structures, investment strategies and other terms. Recently the alternative investment industry has been rapidly changing and the boundaries between hedge funds and private equity funds have started to blur. Once completely separate asset classes, these two investing companies are now converging; some hedge fund advisers are taking a more active role in the companies they invest in, redirecting capital raised to territories that were historically exclusively occupied by private equity funds. Although this convergence is making investments more and more similar, some differences in value creation still remain.
Private equity funds: what they are and how they work
Private equity investments are intended to seek opportunities among private companies that need private funding. Therefore private equity investors can be classifies as individuals or entities (family offices, funds or funds of funds) investing in private companies through different vehicles and following different strategies.
Private equity is a century-old industry that saw its peak in the 2000s before the crisis had a strong impact on this market. The global fundraising reached its peak in 2008 just before the crisis, accounting for almost $700 billion capital raised; current levels are over $500 billion and constantly growing since 2010. Venture capital funds are the largest in number but real estate and leverage buyout remain the biggest in value.
Private equity has always been an interesting industry for several reasons. Firstly, it is a big industry in terms of volumes: the number of private companies not listed on stock exchanges makes it the biggest asset class in the world. Secondly, the quality of private companies is considered being better and therefore they are considered “sleeping beauties”, with high potential of improvement. Lastly, investors feel more related to the entrepreneurial spirit of private companies and can be more willing to put money in them, rather than securities.
From an investing point of view, private equity has some characteristics that differentiate it from public equity; the main ones are longer holding period, less transparent regulation, less liquidity, more active investment strategy and more complex transactions. They are considered an alternative asset class as they are opaque investments in real assets with higher leverage, low correlation to equity markets and sake of diversification. All these elements make private equity a riskier asset class, and it is therefore supposed to generate higher returns.
Investors engage their capital in a private equity fund, the vehicle through which a management company makes investments in private companies following different strategies. The main role of the management through the fund is to raise capital, look for investment opportunities, actively manage investments and find a valuable exit that generates profits for investors and managers. A private equity fund is usually organized as a limited private partnership. Investors are limited partners that passively commit their capital into the fund with limited responsibility, while managers can be general partners by committing a very small part of their capital into the fund and actively manage it with full responsibility.
Private equity fund managers are remunerated on the basis of both management and performance. They receive a fixed percentage of the total capital committed during the investment period (usually in the range of 1-2.5%) and a commission on the performance they generate to the fund, so called “carried interest” (usually around 20% of the returns); performance fees apply only if returns exceed a target, so called “hurdle rate” (usually around 5-8%). This remuneration system is aimed to align interests of investors to those of management.
Private equity funds generally have a limited life span around 8-10 years, reflecting the expected holding period of the portfolio investments, which are on average around 5-7 years. The funds all pursue higher returns than the market, employing different strategies: the two main strategies are venture capital and leverage buyout. Venture capital funds invest in companies in their early stages. They expect the business to generate losses in the initial period, with the expectation of growing future profits and market share. There are three main phases of a new business that can be financed through private equity funds:
- seed: financing is used to fund research and develop the initial concept of the business;
- start-up: financing is provided for the launch of products or services and marketing activities;
- early stage: funds are provided to companies that need to develop commercial and sales activities.
Returns on private equity deals are difficult to calculate, as funds are not valued on a monthly basis as hedge funds are, due to the structure of the investments. In fact, funds invest in portfolios that have a fixed life span and returns are calculated on the exit of the investments when they are realized.
Hedge funds: an interesting “structure of remuneration”
Hedge funds are a niche industry in the investing world. Today around 10,000 hedge funds exist, totaling $3,000 billion of assets under management, of which $100 billion are in the hands of activist hedge funds.
There are many characteristics that differentiate hedge funds from traditional investing vehicles and let us consider them as an asset class itself. First of all, hedge funds invest in particular financial instruments with specific operations and through several defined strategies. This can be described as “alternative investing”, versus “traditional investing”, characterized by higher liquidity, plain financial products and no leverage.
Investors can be divided in different categories, depending on their profile and their expectations mainly in terms of risk, return, diversification and time horizon. Lenders invest in hedge funds in different ways: direct investments in hedge funds, indirect investments through funds of funds, investments in hedge funds indices through managed accounts, direct investments in listed hedge funds by purchasing shares on the stock exchange, investments in shares of funds replicating the hedge funds returns (ETF – Exchange Traded Funds).
As for private equity funds, the management company is a separate organization from the fund. It is remunerated through both a management fee and a performance fee. The management fee is a fixed percentage of the NAV (Net Asset Value) of the fund, paid on a yearly basis. As for private equity funds, hedge fund managers receive also a performance fee, which is a fixed percentage of the realized profits; it is activated only if the return of the fund exceeds a minimum hurdle rate, whose reference is usually the risk-free rate. Differently from private equity funds, hedge funds performance fee also has a “high watermark”: it is a clause that suspends the performance fee after a negative return, until the fund recovers the loss, in order to limit the risk taking of the fund managers. Indeed, the structure of the performance fee can be seen as a call option for the managers: they have a potential gain with very limited potential loss and are therefore more willing to take risks, especially when the fund has already exceeded the high watermark downwards. The interesting element of the high watermark is that its effectiveness depends on the time basis of its calculation: when it is reset on a too small time basis (daily or weekly), positive returns are registered more often; on the contrary, if it is reset on a monthly or quarterly or yearly basis, it takes a longer period to restore positive returns. Common rates for the time being are 1.5-2% management fee, 15-20% performance fee and 5% hurdle rate. All this said, it is quite easy to understand why some argue that hedge funds are not even an asset class, but a “structure of remuneration”.
Investors generally have some constraints in order to reduce risks and increase liquidity. First of all, new subscriptions and redemptions have strict rules in order to withhold investors as long as possible: they are discontinuous and limited to some periods of the year – subscriptions usually happen monthly while redemptions are quarterly; in addition, redemptions are usually charged an exit fee around 3% and are limited in the amount at each exit date (so called “gate provision”, calculated as a percentage of the Assets Under Management, generally around 10-20%). Secondly, in the logic of withholding investors, investments have an initial lock-up period usually lasting 1 year, during which the investment cannot be withdrawn. The main objectives of withholding investors are increasing the liquidity of the fund and letting managers have some stability in terms of resources. Thirdly, investors have to provide the fund with a minimum capital, in order to protect smaller investors: in the US it is in the rage of 100 thousands to 1 million of USD.
The main aim of hedge funds is to take advantage of price discrepancies of securities or assets, without taking any risk, which is basically seeking arbitrage opportunities on the market. In this sense, they look for absolute returns through instruments that make them market-neutral, meaning they have low correlation to the market. Hedge funds operations are aimed at benefitting from rises and falls of stock prices, speculating on the convergence or divergence of two securities, or reducing the overall risk. These objectives are pursued by buying securities financed by credit lines, repurchase agreements, short selling financed by securities lending, leverage on long and short positions, or active trading, thanks to the key role of prime brokers. The instruments hedge funds use are one of their main characteristics, due to the high risk of those instruments, such as a wide range of derivatives on several underlyings with a heavy use of leverage and very short time horizon.
There are five most relevant strategies hedge funds follow: equity (both long and short positions primarily in equity and equity derivatives), event-driven (investments in companies currently or prospectively involved in corporate transactions), global macro (trying to take advantage of mispricing of securities on the stock, interest rate, foreign exchange and commodities markets), relative value (seeking arbitrage opportunities in the valuation of securities), multi strategy (emerging markets, regional markets, funds of funds and many others).
Event-driven hedge funds focus on distressed events, corporate transactions and arbitrage opportunities, or even invest directly in companies with the aim of taking control of them (“activist” hedge funds). Those funds use a strategy very close to private equity funds and are leading to a convergence of the two categories. They do not follow the market evolution, but their performances are primarily due to managers’ competencies in finding arbitrage opportunities within the corporate transactions industry. Due to the cyclicality of this industry, event-driven funds investing only in companies passing through specific corporate events are not able to diversify, which can lead to very low performances in periods of weak activity in this industry.
The common investment strategy of event-driven hedge funds is long/short selling of debt and equity securities, trying to exploit under- and over-valuation of those securities. The main reason for securities to trade at discount is the market perception of financial distress, usually confirmed by a public announce of bankruptcy proceeding, inability to repay creditors, too heavy loans or other negative events. Hedge funds focused on these events primarily invest in debt instruments (more than 60%).
There is evidence that hedge funds following an event-driven strategy may prefer distressed companies having bad balance sheet and financial constraints, with potential undervaluation but good and solid fundamentals, rather than normal merger transactions. This lets hedge funds take opportunity of the complex financial situation, being partly ensured by the fact that they are solid companies. In fact, there is evidence that hedge funds following this strategy are able to enhance the overall value of those firms, through the renegotiation of financial constraints, the reduction of conflicts with different classes of claimers, and the decrease in the frequency of inefficient liquidations of those companies.
In recent years, event-driven hedge funds are performing worse than hedge funds following other strategies, with a return of just 1.73% in 2014, and 2.81% in February 2015 being the highest monthly return since three years. One third of funds that closed in Q1 2015 were employing event-driven strategies.
The convergence: how hedge funds are pretending to be private equity funds
Recently, hedge funds have started entering the private equity territory by investing in illiquid assets, making longer-term investments, and using instruments that make them similar to private equity funds.
Generally, we talk about the convergence of hedge funds into private equity funds competitive arena, because hedge funds are more flexible in their strategies and less regulated, but we have to admit that few actually talk about the interest private equity funds may have in affiliating with hedge funds. As they are well known for their absolute returns, high diversification and (compared to private equity) liquidity of investments, these funds may be appealing to private equity funds.
The convergence can take place in terms of strategy and structure of the funds:
Strategic convergence: hedge funds can employ specific strategies based on characteristics of companies compared to typical securities hedge funds invest in, such as lower liquidity, longer holding period, and strategic interest. While managing illiquidity can be faced through a particular instrument, the “side pocket”, the longer holding period and the strategic interest are drivers for hedge funds activism.
Structural convergence: we refer to the similar frameworks in which the two funds operate: they are both typically private limited partnerships with a management commission structure. Hedge funds that invest in private equity-style assets usually use instruments such as lock-up provisions and hurdle rates.
Side pockets are single-asset funds investing solely in a company as a private equity investor, with the aim of isolating illiquid assets from more liquid investments resulting from other strategies, such as securities trading. The use of side pockets is usually capped to 10-30% of the portfolio, in order to be able to participate in private equity investments with some flexibility, while maintaining the structure of a traditional hedge fund. In some cases, side pockets may invest in quite large companies, making them comparable to medium-sized private equity funds on their own. Side pockets are not separate legal entities, but they generally have characteristics that make them more similar to private equity funds, such as: a longer term in the investment holding period (illiquid asset); lock-up provisions for investors; charging of management fees based on cost instead of mark-to-market – hedge funds are market to market, meaning they are evaluated on a monthly basis to reflect their market value, while private equity funds are valuated at cost, consisting in a valuation of the book value at the time the investment is realized; hurdle rates, as private equity funds do, in order to have control on the upside commissions (performance fees); the growing intention to pay performance fees only on realized gains. Some differences between side pockets and PE funds still remain: assets held in side pockets do not have to be liquidated or exited at certain dates; the number of investors in side pockets has no limits; hedge funds usually make a heavier use of leverage; hedge funds are much less regulated than private equity funds; losses reported on side pocketed assets do not affect the calculation of upside fees of other funds of the hedge fund – therefore, when a side pocketed asset reports losses and fees belonging to other activities have already been paid to the manager, there is no claw back for the side pocket. All this demonstrates high flexibility and low regulation.
A lock-up period is a time frame during which new subscribers cannot ask for redemption of their investments. The standard lock-up period for hedge funds is six months, while it doubles in the case of activist hedge funds; but the convergence is extending it to several years. This is partly justified by the length of those investments, which are typically realized by private equity funds in five to seven years. In order to maintain the appeal of the investment, managers are willing to lower management fees from the traditional 2% to 1.5%, sometimes coupled with a higher hurdle rate. This lets them avoid a reduction in the performance fee.
Gates are used by fund managers to cap the amount of capital that can be withdrawn on specific withdrawal dates. Usually the limit is around 10 to 20 or event 30% of the fund capital. Longer lock-up periods and gates are primarily intended to let managers effectively participate in illiquid investment strategies with longer holding period, without the risk of liquidity crisis caused by substantial and premature withdrawals by investors. There are other instruments such as the redemption frequency and redemption notice that are aimed at maintaining investors for longer periods.
Activist hedge funds do not seek arbitrage opportunities through long/short selling and trading securities, but they try to obtain representation in the board of directors of the target company, aiming at a majority shareholding with corporate interests. In fact, they do not simply trade securities, but they try to make an impact on the company structure, management and strategic direction. Activist hedge funds acquire a majority stake in the target company and pay dividends, making the price slightly decrease: then they buy some more shares at a reduced price (auto financing: they buy back the value they just distributed without decreasing the overall value of the company). Then the fund operates on the capital structure of the target, generally increasing leverage for higher returns, and on the balance sheet, by selling illiquid assets to make the capital structure of the company more flexible and the investment more liquid. Some funds may carry out mergers, acquisitions, divestitures, and other corporate transactions, making an impact on strategic decisions of the company. All these actions are taken to increase the value of the company, with the final objective of selling the company at a higher price.
There are several reasons why hedge funds are more and more similar to private equity funds. One of these is that they have to adapt to the current markets condition of decreased liquidity and increased volatility, making fund managers less sensitive to risk exposure and companies more appealing to them. Another reason may be the increased level of competition in the hedge funds market, partly due to the increase in capital commitments and expected returns by investors. Meanwhile, there are some elements that are boundaries to the remuneration of the investors and are therefore an incentive for managers to look for higher returns.
Risks of the convergence have to be considered as well. Gates, lock-ups and redemption policies are intended to limit the risk of liquidity through the retention of investors as long as possible, but no instrument is able to completely eliminate it. Liquidity is needed by fund managers to fulfil withdrawal requests and manage investments the most effectively possible. Moreover, longer holding periods can make it difficult to value portfolios, especially in case of multi-strategy funds. Lastly, managers investing in assets which do not represent their natural field, makes them less conscious and more risk-taking in those investments. The right of withdrawal is intended at protecting investors in these cases.
Main findings: how difficult it is to compare returns
In order to assess whether activist hedge funds are performing better than private equity funds, it is necessary to analyze the performance of both types of funds. Although market indices and reports are publicly and widely available, some limitations have to be considered.
Hedge funds present a series of biases that cannot be completely isolated when analyzing returns, such as the survivor bias (3% bias due to the exclusion of those funds that no longer exist), the selection bias (very well and very bad performing funds do not disclose information as they are not regulated), the backfilling bias (track records of funds in their initial “period of incubation” – several months to 3 years – are not included in databases yet).
On the other side, private equity data is less available than hedge funds, mainly because they generate returns when the investments are realized and the assets are liquidated, in several years, and therefore are not marked to market on regular and frequent basis as hedge funds are.
Moreover, there are some elements in the returns calculations that differ from private equity funds to hedge funds. For example, the volatility is a good proxy for risk and a statistically relevant element when valuating an investment; but when dealing with non-Gaussian distributions (hedge funds) or investments in real assets (private equity funds) this important metric is not easily observable and statistically not relevant. Adding structural and strategic peculiarities to differences in returns calculations, we can conclude that the two types of funds cannot be fully compared.
However, limitedly to researches available and data analyses performed, results suggest that activist hedge funds have been performing in line with private equity funds and their benchmarks (the public equity S&P 500 and FTSE Europe indices), but all the considerations evaluated around the convergence and reported in this article may question these results.
Conclusions: how subjective and case-sensitive value creation is
The purpose of the research was to understand whether activist hedge funds were able to create more value than private equity funds, through the investment in private companies. This objective was pursued by performing a comparative analysis of activist hedge funds and private equity funds historical returns. Further discussion was presented through the comparison of those returns to their benchmarks, represented by public equity indices.
The immediate results of the research suggest that historically activist hedge funds haven’t been performing better than private equity funds. In order to analyze returns as effectively as possible, different variables have been taken into consideration: time (in terms of investment horizon and returns), geography (US vs. Europe), strategy (activist hedge funds vs. event-driven hedge funds, venture capital vs. leverage buyout private equity funds) and size (for private equity funds only). Going deeper into the study, we understood that results are case-sensitive, being highly impacted by the choice of variables.
The results of this research give also a hint on hedge funds and private equity funds convergence in the near future. After considering all the elements and tools of the structural (i.e. side-pocketing) and strategic (i.e. hedge funds activism) convergence, the differences in funds terms (i.e. lock-ups) and investment horizon (several months vs. several years), and after comparing their returns considering geographical and benchmarking discrepancies, we can conclude that fundamental differences in investment strategies, deal making and investors interests will not make the two types of funds converge completely in the near future.
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