Private Equity vs Hedge Funds

C K Kok provides a brief write-up on the features of these collective investment schemes

 

The past few years have witnessed the rise in the popularity of new investment vehicles – hedge funds and private equity funds. In this article, we will highlight the salient features of the most common form of these investment vehicles in the United States of America and the United Kingdom.

 

 

PRIVATE EQUITY FUNDS

 

Characteristics

A private equity fund is a collective investment scheme. Private equity funds are invested in the equity capital of unlisted companies or in listed companies, in the latter case, with a view of taking them private.

 

A private equity fund usually has a finite lifespan of about 10 years, with a possibility of pre-determined extension with the agreement of the investors.

 

 

Legal Structure

Private equity funds may be structured as on-shore investments or offshore investments. They may also take the form of limited partnerships, unit trusts or investment companies. The choice of structure as well as domicile of a private equity fund is determined primarily by the tax environment of the investors, the objective being to maximise the tax efficiency for the investors as well as the fund.

 

The most common structure for private equity funds targeted at United States based investors is a limited partnership as this structure subjects the investors, but not the fund, to taxation. Similarly, the prevalent structure for private equity funds in the United Kingdom is a limited partnership established under the Limited Partnership Act 1907.

 

The partnership laws in both jurisdictions require a limited partnership to have at least one general partner and at least one limited partner. The general partner is responsible for the management of the partnership business and is liable for the debts and obligations of the firm (and if there are two or more general partners, such liability is joint and several).

 

Limited partners are not permitted to participate in the management of the firm but enjoy limited liability and are severally liable for the firm's debts to the extent of their registered investments.

 

When a limited partnership structure is adopted, the promoter of the private equity fund usually establishes an incorporated subsidiary as the general partner while the investors become the limited partners of the fund.

 

The relationship between the partners of a private equity fund is governed by a partnership agreement which, amongst other matters, sets out the lifespan of the fund, the basis on which profit is to be shared, the investment mandate and the investment decision making process (typically a committee comprising the fund manager's personnel and in some cases, a number of representatives of the investors).

 

The general partner may either act as the fund manager or appoint a related or unrelated entity to be the fund manager. In the latter event, the general partner will represent the fund and enter into a management agreement with fund manager. This agreement will inter alia set out the responsibilities and basis of remuneration of the fund manager.

 

 

Remuneration of Fund Manager

The fund manager usually receives a fee for monitoring the progress of the investee companies. In addition, a fund manager that has a proven track record may receive transaction fees for identifying and completing the acquisition of each investee company.

 

The general partner is entitled to receive a priority profit share which it uses to pay the management fees to the fund manager.

 

In addition, the general partner or a "carry vehicle" (a special purpose limited partner of the fund established by the general partner) is entitled to receive "carried interest". Carried interest is a performance fee that is based on a percentage of the capital gains made by the fund from its investments. Carried interest is usually payable only after the capital contributed by the limited partners has been returned to them together with a specified minimum return (known as "hurdle rate") on their investment.

 

 

Investors

In both the United States of America and the United Kingdom, investors in a private equity fund are sourced from sophisticated investors, comprising institutional investors and high net worth individuals.

 

The investors acquire limited partnership interests of specified amounts in the private equity fund. The commitment of the investors is not paid to the fund manager immediately but is drawn down as and when the funds are required to acquire investee companies.

 

To ensure that a transaction is not held up by delays in receiving capital contributions from the investors, the fund may have in place a bridge finance facility that can be drawn upon.

 

Two common measures may be adopted by a fund manager to mitigate the risk that an investor fails to meet his capital call. The partnership agreement may impose an obligation on the other partners to fund the missed call. Alternatively, the fund manager may have arrangements with a 'funder of last resort' to do so.

 

 

Financing an Acquisition

The acquisition of investee companies by private equity funds is financed by a combination of equity and debt. The equity portion is drawn from the funds provided by the investors and the debt portion from borrowings.

 

Borrowings by private equity funds may range from plain vanilla type loans to complex structures that involve a variety of senior and subordinated debts that are raised through a single or a series of holding companies of the investee company.

 

 

Withdrawal of Investor

Partnership agreements for private equity funds usually do not permit an investor to withdraw his investment. In other words, an investor is obliged to remain as a limited partner for the life-span of the fund or until all investments made by the fund have been divested. The absence of an exit route renders an investment in a private equity fund an illiquid form of investment.

 

An early exit by a private equity investor is usually effected through a sale of his partnership interest to another investor. A secondary market is developing for such investments due to the impressive returns on investment achieved by private equity funds.

 

 

Transformation of Investee Company

Although private equity fund managers are rarely involved in the day-to-day running of an investee company, they invariably appoint representatives to the board of directors of the company.

 

The fund manager, through its board representatives, sets the direction and develops strategies for the transformation of the investee company. This may involve appointing new management personnel, restructuring or expanding operations and disposing of non-core assets.

 

As most of the measures adopted by private equity fund managers to enhance the value or profitability of an investee company are medium-to-long range measures, private equity funds are generally regarded as long term investors in a company.

 

According to the United Kingdom Financial Services Authority ("FSA"), the "control that private equity fund managers exercise as owners of the companies that they invest in is what truly defines the private equity business model" (Paragraph 3.94, Private equity: a discussion of risk and regulatory engagement, Discussion Paper 06/6, November 2006).

 

 

Divestment of Investee Company

A private equity fund may dispose of its investment in an investee company by various means, the most common being through a flotation on a stock market, a trade sale i.e. a sale to another company or a secondary sale i.e. to another private equity fund.

 

If the measures taken to transform the investee company have been successful, the disposal will earn substantial profits which are distributed to the limited partners after payment of carried interest and various fees.

 

 

HEDGE FUNDS

 

Characteristics

A hedge fund, like a private equity fund, is a collective investment scheme. The objective of a hedge fund is to achieve the highest absolute return for its investors rather than to measure its performance against any specified benchmark.

 

The expression 'hedge fund' originates from the practice adopted by the fund manager to sell short some stocks while investing long in others, hence 'hedging' market risk.

 

Although a large number of hedge funds still take 'long/short' positions in equities, it is nowadays common for hedge funds to invest in other securities, such as debt instruments, commodities futures, derivatives and currencies as well as a combination of such securities.

 

Unlike private equity funds, hedge funds are "open-ended" or "evergreen" as they do not have a finite life span. Further, the size of hedge funds may be expanded by accepting new investments from existing or new investors.

 

 

Legal Structure

As in the case of private equity funds, the choice of structure and domicile of hedge funds is driven primarily by tax considerations.

 

The most common structure for a hedge fund targeted at United States based investors is a limited partnership as it subjects the investors only to one level of taxation. In this structure, the fund manager would be the general partner and the investors, the limited partners.

 

In a discussion paper entitled Hedge funds and the FSA (Discussion Paper DP16, August 2002), the FSA noted that the tax and regulatory regime in the United Kingdom were unfavourable to the setting-up of on-shore hedge funds. As such hedge funds that make investments within the United Kingdom are often established and administered in offshore jurisdictions.

 

Investors in hedge funds acquire an interest in the hedge fund (or in one of several feeder funds that funds the hedge or master fund). The responsibilities of the fund manager include making and divesting investments, monitoring performance and handling subscriptions and redemptions. Some of these functions may be out-sourced to on-shore entities if the fund is based offshore.

 

The relationship between the partners in a hedge fund is governed by the terms of the partnership or subscription agreement. Such agreements may set out the investment mandate of the fund, i.e. the types of securities or instruments that the fund may invest in, procedures for redemption and restrictions thereon. Hedge fund agreements often confer wide powers on the fund manager to make investment decisions.

 

 

Remuneration of Fund Manager

The partnership or subscription agreement sets out the basis of remuneration of the fund manager. The fund manager usually receives a management fee and a performance fee, both of which are paid at specified intervals. The former is usually based on a percentage of the assets being managed.

 

Performance fee on the other hand, is usually based on the profits earned by the fund manager for the fund. "High water marks" and "hurdle rates" may be imposed to give impetus to the fund manager to maximise returns for the fund.

 

A "high water mark" represents the highest value of the investments made by the fund. The fund manager is only entitled to performance fees if the value of the investments of the fund exceeds its previous highest valuation.

 

A "hurdle rate" is a specified minimum return that must be achieved before the fund manager is entitled to performance fees.

 

 

Redemption of Investments

Investors are generally permitted to withdraw from hedge funds by redeeming their investments. The right of redemption may be unfettered or be subject to various 'lock-up' mechanisms such as a minimum period during which redemption is not permitted, limiting the periods during which redemption can be made, and imposing a limit on the amount that may be redeemed during a redemption period.

 

The right of an investor to redeem its investments in hedge funds renders such investment a more liquid form of investment than private equity funds.

 

To ensure that the hedge fund has sufficient liquidity to meet redemption requests, fund managers invest a significant portion of the fund in relatively liquid investments. Hence, unlike private equity, hedge funds are perceived as short term investors.

 

 

Investors

Like private equity, investors in hedge funds are usually sophisticated investor comprising of institutional investors and wealthy individuals.

 

 

INCREASED FINANCIAL CLOUT

The financial clout of hedge funds and private equity funds has been enhanced by two developments in the industry. First, the creation of "fund of funds", i.e. a fund that invests in other funds rather than directly in securities and instruments has enhanced the funds that are available to fund managers, in particular, those with proven track records.

 

Secondly, private equity funds have combined their resources to form consortiums to acquire assets for substantial sums of money. Recent transactions by consortiums of private equity funds include the acquisition of Freescale Semiconductor by the Blackstone Group, Carlyle Group, Permira Funds and Texas Pacific Group for US$17.6 billion, Biomet Inc by Blackstone Group, KKR, Texas Pacific Group and Goldman Sachs Capital Partners for US$10.9 billion and 80.1% of the semi-conductors business of Phillips by KKR, Silver Lake Partners and AlpInvest Partners for €8.3 billion.

 

 

GAZING INTO THE CRYSTAL BALL

 

Effect of Sub-Prime Mortgages

The greater volatility in stock markets throughout the world brought about by the sub-prime mortgages crisis in the United States of America may result in heavy losses for hedge funds that have invested heavily in listed securities. This may result in a shift by investors from hedge funds to private equity funds. The tightening of liquidity in the global economy may also affect the ability of fund managers to raise funds from investors.

 

 

Regulatory Oversight

Private equity funds and hedge funds as well as their fund managers are presently lightly regulated. Concerns have been expressed that the light regulatory environment raises the risk of fraud, insider trading, market manipulation and conflicts of interest. The adequacy of risk management procedures and asset valuation mechanisms has also been called into question.

 

It is likely that rules or voluntary codes will be introduced to address some of these concerns. In particular, funds that are to be offered to retail investors will be subject to enhanced regulatory oversight and greater operational transparency.

 

 

Retail Play

Presently investors in private equity funds and hedge funds are predominantly institutional investors and high net worth individuals.

 

Switzerland, Hong Kong and Singapore have amended their regulatory requirements to enable hedge funds to be offered to retail investors. The London Stock Exchange is expected to follow suit. It is likely that other major capital markets will jump on the bandwagon to avoid being left behind.

 

 

KOK CHEE KHEONG ( This e-mail address is being protected from spambots. You need JavaScript enabled to view it )

 
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