This article helps to fill the gap in the hedge fund and private equity debate by focusing on the contractual basis of collective investment vehicles, the influence on funds’ investment strategies and the rationale for why private equity and hedge funds have chosen to play the role of activist investors in companies in which they invest. Policymakers are urged to review the economic effect of private equity and hedge funds on investors’ returns before imposing new regulation on the sector.
In recent years, hedge funds and private equity groups have come to represent a significant part of the current trading activity in the financial and mergers and acquisition markets in both Europe and the United States. The sheer size and amount of funds for investment are considerable and growing. For example, hedge funds, having first emerged in the 1950s as single fund investments, now number more than 9,000 funds globally holding more than $431 trillion in assets. Typically, these funds are structured by a team of skilled professional advisers, experts in company analysis and portfolio management, offering investors a wide range of investment styles. Fund managers employ multiple strategies as well as traditional techniques and use an array of trading instruments such as debt, equity, options, futures and foreign currencies. In recent years, hedge fund advisers have engaged in high-risk investment strategies, including restructurings, credit derivatives, and currency trading, in order to obtain superior returns for their funds. Even though hedge funds take a variety of forms, they are characterized by a number of common features such as the pursuit of absolute returns and the use of leverage to enhance their return on investment.
In contrast, private equity fund advisers invest primarily in unregistered securities, holding long-term positions in private companies. They employ, also, a wide range of investment strategies with varying levels of liquidity. Not only do private equity funds advance capital to new and developing companies, but provide investment capital for management buyouts, corporate restructurings and leveraged buyouts. During the 1990s, the venture capital industry grew in the United States with a record amount of capital raised in 2000. With the post-boom decline in the venture capital industry, beginning in 2002, buyout funds emerged as the leading investment style with their level of investment funds increasing rapidly worldwide. In 2006, buyout funds peaked with ‘mega funds’ capturing the largest amount of net new capital flow. The emergence of the buyout fund as the dominant investment style in this sub-sector, is attributed mainly to favourable credit market conditions, robust debt supply and low interest rates, changes in investor preferences, a proliferation of publicly listed private equity vehicles, and the increased demand by institutional investors for alternative assets (Thomson, 2007).
While hedge funds and private equity are both seen as alternative investments, private equity funds can be distinguished from hedge funds in terms of their investment strategies, lock-up periods, and the liquidity of their portfolios. Moreover, given their indefinite life span, fund managers have incentives to take large illiquid positions in the non-listed securities of private companies, such as Kohlberg Kravis Roberts (KKR) and Silver Lake of the US and Dutch buyout house Alpinvest which purchased a controlling stake of Philips’ semiconductor unit, NXP, for €8.2bn in cash. Investments made by private equity funds take place during the first three to five years of the fund, which is followed by a holding period which averages between five to seven years in which few new investments are made. Unlike private equity, the shorter lock-in period of hedge funds and their more flexible structure explains the dominance of highly liquid, short-term investments, which allows investors easier access to the withdrawal of their investment.
Despite these differences, it is becoming more apparent that private equity and hedge funds are converging in a number of ways. One noticeable incidence of convergence is the growth of hedge funds and private equity managers pursuing similar assets and investment strategies to secure superior market returns. For example, when hedge fund advisers are dissatisfied with traditional strategies and unable to obtain their expected rates of return, they have quickly adopted those techniques usually employed by private equity funds, such as corporate restructuring and buyouts, to achieve better value on their investments. Partly due to the overcrowding of the hedge fund marketplace, hedge funds started to capitalize on opportunities presented in the lucrative private equity market thereby clashing with first generation private equity funds. An example of this convergence is the bidding war between one of the largest private equity firms, KKR, and Cerberus Capital Management for the acquisition of Toys ‘R Us.
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