PRINT THIS PAGE Hedge fund investment in private equity 02/11/2005. Source: Practical Law Company. Stephanie Breslow and Paul S Gutman, Schulte Roth & Zabel LLP 
The number of hedge funds worldwide now exceeds 8,000, and these funds control nearly $1tn (about €826bn) in assets, says the Practical Law Company. Hedge funds have recently begun to be active players in the private equity market, as they have become capable of taking large equity positions, have assumed more shareholder-activist stances, and have invested in what are, for hedge funds, non-traditional assets. With this in mind, this excerpted chapter of the PLC Cross-border Private Equity
Handbook 2005/06: - Sets out the structures, strategies, fee arrangements
and regulatory frameworks in which private equity and hedge funds exist, highlighting
the most prominent differences between them.
- Considers the inroads that
hedge funds are making in the historic territory of private equity.
- Looks
at the future of hedge funds as they participate more fully in private equity
transactions and with investors that have grown accustomed to private equity investment.
THE
BASICS: PRIVATE EQUITY FUNDS
Traditionally, the private equity fund
structure is used to invest in assets that require development or management over
a period of years, and that are not susceptible, on an interim basis, to being
marked to market (that is, the hedge fund methodology in which assets and liabilities
are marked to fair value on a periodic basis for purposes of fee calculations
and admission and withdrawal of investors). The private equity fund structure
facilitates investment in those assets by:
- Permitting the manager
to acquire and hold assets over a period of years.
- Prohibiting redemptions
and distributing proceeds only as assets are liquidated.
- Charging performance
fees based on actual cash proceeds received from the operation and disposal of
those assets, rather than (as is the case for hedge funds) based on marked-to-market
assessments of their value.
Structure
Private equity
funds designed for US investors are typically structured as US limited partnerships
or limited liability companies. Even if this type of fund is domiciled outside
of the US, a typical fund will be structured as either a partnership or an exempted
company (that is, a company formed in a particular jurisdiction that only conducts
business external to the jurisdiction, making it eligible for exemptions from
certain legal requirements that would otherwise be applicable to it if it conducted
business within the jurisdiction), but will choose treatment as a partnership
for US tax purposes. Usually, the fund's manager acts as the general partner or
manager of the entity, while investors take roles as limited partners or members
receiving liability protection. Proceeds are usually paid out to investors after
investments are sold, rather than at a fixed or regular time. Where appropriate,
parallel or feeder funds can be set up to address regulatory issues concerning
certain investors or investments, such as US tax-exemption or the investor's foreign
status.
Management
Managers of private equity funds earn
fees based on both performance and on the value of the portfolio managed. Typically,
an annualised management fee between 1.5% and 2.5% is charged. This fee is typically
calculated using the committed capital during the investment period and the value
of the fund's invested capital (or the cost of the unsold investments) from that
point onwards. In addition, managers of private equity funds receive a performance
allocation (usually equal to 20% of the profits from the investment) once profits
exceed a fixed hurdle rate, which typically ranges from between 8% and 10% of
either: - All invested capital.
- The portion of invested capital
that relates to investments that have been sold.
These types of performance
allocation arrangements usually include both "catch up" provisions that pay the
fund's managers a larger percentage of profits after the investors have received
their return of invested capital (on sold deals, if applicable) and also hurdles,
so that the manager recoups its 20% share of the hurdle.
Investors
Typical US private equity funds are sold by private placement and must
obey the limitations on private placements imposed by the Securities Act of 1933,
as amended (Securities Act). These limitations state that funds can only offer
investment opportunities to investors with whom the fund or its sponsor has a
pre-existing relationship and who are accredited investors. Accredited investors
are any of the following (Securities Act): - Individuals and families with
a net worth of US$1 million (about EUR826,378).
- Individuals with a total
income exceeding US$200,000 (about EUR165,276) a year.
- Families with a
total income exceeding US$300,000 (about EUR247,913) a year.
Certain
other business and tax-exempt entities are also granted accredited investor status.
The number of non-accredited investors that can participate in a private placement
is limited to 35 (Regulation D, Securities Act), but no such limit is placed on
the number of accredited investors. The Securities Act also requires any soliciting
materials to be complete and not misleading, and also closely defines the types
of disclosures that can and must be made in soliciting materials.
To
avoid extensive regulation, most private equity funds rely on one of the following
two important exemptions to the Investment Company Act of 1940, as amended (Investment
Company Act), which would otherwise require them to register as investment companies
and subject them to such regulation: - Section 3(c)(1), Investment Company
Act. Under section 3(c)(1), a fund can avoid registration if enrolment is limited
to 100 total investors for domestic funds, or 100 US investors for offshore funds.
- Section
3(c)(7), Investment Company Act. Under the more recent section 3(c)(7) exemption,
the number of investors is unimportant, as long as each is a qualified purchaser
(although most funds cap the number of investors at 499 to avoid potential registration
under section 12(g)(1) of the Securities Exchange Act of 1934, as amended (Exchange
Act)).
A qualified purchaser is either: - an individual or
family with US$5 million (about EUR4.13 million) of investable net worth;
-
any other entity with US$25 million (about EUR20.66 million) of investable net
worth.
In addition, many sponsors, in their role as the managers or general
partners of private equity funds, maintain exemption from registration as investment
advisers under the Investment Advisers Act of 1940, as amended (Advisers Act)
because they advise fewer than 14 funds or clients. (For this purpose, a private
equity fund counts as a single client, regardless of the number of underlying
investors; by contrast, under a new regulation which will take effect from 1 February
2006, hedge fund mangers must often look through their funds and count the underlying
investors, making it more likely that registration will be required (see below,
The basics: hedge funds).)
Adding another layer of regulation, the Employee
Retirement Income Security Act of 1974, as amended (ERISA) regulates "plan assets"
of pension plans, and can impose fiduciary liability and reporting obligations
on funds in which these pension plans invest. To minimise such obligations, a
private equity fund's sponsor must ensure that participation in the fund by benefit
plans remains below a 25% threshold. Alternatively, the fund must be operated
as one of the following: - A venture capital operating company.
- A
real estate operating company.
- An operating company.
To operate
a fund as one of the above, at least half of the fund's investments, as of the
time of the first capital draw down and again at each relevant annual testing
date, must be in companies over which it has active management rights.
Taxation
An important regulatory concern for private equity funds is that of tax.
Tax considerations drive the actual structure of the fund and the way it holds
its various assets. They also control whether investors participate in feeder
or parallel funds that can protect their individual tax objectives. As noted earlier,
funds formed for US investors are typically set up as US limited partnerships
or elect to have partnership status for the purpose of taxation.
In the
traditional sense, private equity funds are those that attempt to acquire interests
in private companies and privately held securities, often with a view towards
controlling a target company and influencing its management. However, many other
types of investment programmes can be pursued under a private equity style structure,
including: - Venture capital.
- Real estate investment.
- Distressed
investing.
Typically, the private equity model is appropriate for investments
that are illiquid and hard to price, including assets for which there is no market
and nothing against which to mark the ownership interest's value. Private equity
funds typically spend a fixed ramp-up period of about six months to a year, from
the first subscriptions to the last, after which they are closed to new investors.
New investors are generally able to enter the fund at the actual cost of the fund's
investments plus a predetermined interest factor. Sometimes, a manager reserves
the right to charge an additional premium if the fund's investments have experienced
demonstrable appreciation during the offering period, but this provision is infrequently
invoked. Instead, the imposition of an outside closing date is intended to limit
the "free look" benefits to late closers.
Duration
A
private equity fund operates and invests for a fixed investment period (typically
three to five years) during which new investments can be made, followed by a holding
period (typically an additional five to seven years) during which little new investment
is permitted, but existing investments are managed and developed. Once the holding
period has expired, all investments must be disposed of. Private equity funds
also regularly retain a clawback feature, by which investors that have paid a
performance fee to the fund's manager and have lost money on other fund investments
can receive compensation from the manager for that loss. A manager is typically
prohibited from marketing a new private equity fund until 70% to 80% of its most
recent fund has been invested, restricting the manager's ability to move and participate
in new investment activities and, effectively, tying the manager's fortunes to
his current fund.
Private equity firms traditionally rely on high commitments
of capital from their investors; it is not uncommon for a fund to have a (variable)
floor per investor of between US$5 million (about EUR4.13 million) and US$10 million
(about EUR8.26 million). After these large capital commitments are made, they
are then held and invested by the fund throughout the fund's fixed lifetime. There
are long stretches of time before the investor sees any return, let alone the
bulk of its capital contribution. Given this long-term investment horizon, institutional
investors (most often tax-exempt institutional investors, such as university endowments
and pension plans) tend to constitute the bulk of private equity funds' investor
base. These investors generally expect investor protections beyond those typical
in the shorter-term investment horizons of hedge funds, covering such matters
as: - Exclusive rights to investments.
- Time commitments from key
principals.
- Limits on formation of competing funds.
- Assurances
as to the concentration, type and leverage of investments.
THE BASICS:
HEDGE FUNDS
Traditionally, hedge funds have focused their investment
strategies on securities and other assets that are liquid and are susceptible
to pricing at marked-to-market values. As the assets can be valued and reduced
to cash, the funds permit investors to join or withdraw at regular intervals,
and managers take fees based on marked-to-market values. However, variations on
these traditional concepts have been introduced, and it is these variations which
make it possible for hedge funds to participate in what have traditionally been
viewed as private equity investments.
Structure
Typically,
a US-sponsored hedge fund structure consists of both: - A US-domiciled
limited partnership or limited liability company for US-taxable investors.
- An
offshore corporate vehicle domiciled in a tax haven jurisdiction (often the Cayman
Islands, Bermuda, the British Virgin Islands or the Channel Islands) for non-US
and US tax-exempt investors.
Depending on the investment programme and
whether it is practicable, given tax and regulatory considerations, to have both
funds invest in the same asset pool, a "master feeder" structure can be used.
In this structure, the domestic and the offshore fund feed into a master fund
that makes investments for both. Management
As with private equity funds,
hedge fund managers receive both:
- Asset-based fixed fees.
- An
additional incentive amount based on the funds' performance.
The incentive
amount is an allocation in the case of the domestic fund, and can be a fee or
an allocation in the case of the offshore fund (depending on tax-structuring considerations
beyond the scope of this chapter).
The asset-based fee is typically 1%
to 2% a year of the net assets under management, payable quarterly. The incentive
amount is typically 20% of the fund's profits over a high-water mark (this high-water
mark ensures that the manager does not receive an incentive fee until previous
losses have been recouped), payable annually. Unlike private equity funds, fees
are paid based on the marked-to-market valuation of the fund's portfolio, and
the amount and timing of incentive payments does not depend on the disposal of
assets.
Investors
Hedge funds operate within the same
regulatory framework as private equity funds. Like private equity funds, interests
in hedge funds are sold through private placement and sales must comply with the
restrictions on these placements under Regulation D of the Securities Act (including
the limitation that the number of non-accredited investors must not exceed 35
(see above, The basics: private equity funds)). Similarly, hedge funds avoid registration
as investment companies by staying within the boundaries of the exemptions in
sections 3(c)(1) and 3(c)(7) of the Investment Company Act. To avoid "plan assets"
issues under ERISA, most funds limit benefit plan participation to less than 25%
of total fund assets (the venture capital operating company, operating company
and real estate operating company exemptions that are often used by private equity
funds are not available for hedge funds because these exemptions require a higher
degree of active management rights in relation to investments than a hedge fund
typically possesses).
Due to recent changes to the Advisers Act, from
1 February 2006 managers of hedge funds that permit investors to redeem within
two years of investment generally must "look through" to underlying investors
when determining whether they advise more than 14 clients. If so, they must register
as investment advisers. This look-through requirement does not apply to private
equity funds.
Hedge funds often use exchange-traded futures as part of
their investment programmes. As a result, they come within the scope of the Commodity
Exchange Act of 1974 (CEA), which requires the registration of persons who solicit,
accept or receive funds, securities or other property from others for the purpose
of trading commodity futures contracts or commodity options contracts. An exemption
from the CEA's requirements may be available, depending on the qualifications
of the fund's investors and the extent of the futures used.
Historically,
the core investor base of hedge funds was high net worth individuals. However,
over time, hedge funds have become an accepted component of institutions' portfolios
as well. The increased presence of institutions, combined with trends towards
larger investments in hedge funds and decreasing expectations of liquidity (see
below, Hedge funds in private equity), have caused some hedge fund investors to
seek investor protections similar to those negotiated in private equity funds.
In general, however, the main investor protection provided by hedge funds is in
the redemption right, and hedge fund managers are less restricted than their private
equity counterparts in terms of their investment programmes and other activities.
HEDGE FUNDS IN PRIVATE EQUITY
As the hedge fund industry
has developed, some managers have expanded the traditional arena of hedged public
securities investing to cover a broader range of assets and strategies, including:
- Activist investing.
- Distressed investing.
- Investment
in private companies.
In some cases, these less liquid strategies are
limited to a portion of a fund's portfolio; in other cases, they comprise the
fund's core strategy, and fund terms are modified to address reduced liquidity
by incorporating some of the terms traditionally used by private equity funds.
These hybrid strategies and structures have blurred the line between private equity
and hedge investing and have enabled hedge fund managers to become meaningful
players in the private equity marketplace.
Side pockets
One
structure used by hedge fund managers to assist investment in comparatively illiquid
or hard-to-value assets is the "side pocket". A side pocket is, in essence, similar
to a single-asset private equity fund. Once an asset is designated for inclusion
in a side pocket, new investors do not share in it, and when existing investors
redeem from the hedge fund, they remain as investors in the side pocket until
it is liquidated (typically on the sale of the side pocket asset, or when a particular
event occurs - such as an initial public offering - that causes the side pocket
to become more liquid).
Management fees are typically charged on side-pocket
assets based on their cost (although some managers mark to market for this purpose).
Incentive fees are charged based on actual realised proceeds. Unlike a private
equity fund, side-pocket losses do not result in the clawback of fees (although
the fee charged against a side pocket is subjected to the high water mark for
investors that have not otherwise withdrawn from the hedge fund). There is also
often no outside date by which a side pocket investment must be sold.
Typically,
hedge fund managers that use side pockets agree to cap them at 10% to 30% of the
portfolio. Since there are many hedge funds managing US$1 billion (about EUR826
million) or more, the side pocket feature can itself create a potential reasonably
sized private equity vehicle within what is otherwise a hedge fund. Also, this
vehicle provides more flexibility to the manager, in some ways, than a private
equity structure provides, because there is: - No limit on the permitted
size of the fund.
- No requirement to liquidate the side pocket.
- Often
fewer restrictions on the size and nature of those investments than a private
equity fund would require.
Lock-ups
Another trend that
assists hedge fund managers in pursuing less liquid strategies is the trend towards
longer lockups Traditionally, hedge funds offered quarterly or semiannual liquidity
after an initial one-year lock up. However, in recent years, hedge fund managers
have begun to move from one-year lockups to initial or rolling lockups of two,
three or occasionally more years in duration. Investor resistance to longer lockups
is decreasing for a variety of reasons, including: - The high level of
investor competition for space in the funds of established, capacity-limited managers.
- Recognition that longer lockups enable a manager to pursue unconventional
strategies and potentially increase returns.
- Recognition that the potential
for outsized returns using conventional hedge fund strategies may be decreasing
as the universe and sophistication of managers grow.
- Recent regulatory
changes that require hedge fund managers to register as investment advisers if
they use lockups of fewer than two years.
Gates
Hedge
fund managers also increasingly impose "gates" (limits on the percentages of fund
capital that can be withdrawn on a scheduled redemption date). A gate of 20% (in
the case of annual redemptions) or 10% (in the case of more frequent redemptions)
is not uncommon. The gate provision allows the manager to increase exposure to
illiquid assets without facing liquidity crises as a redemption date approaches.
These three features (side pockets, lengthened lockups and gates) have facilitated
hedge fund investment in the sphere of private equity and minimised one of the
largest risks that has traditionally affected hedge funds: that is, the mobility
of hedge fund investors.
Other techniques
Fund managers
also retain the drastic options of either: - Suspending all redemption
rights.
- Paying redemptions in kind.
While these are safety valves
to be used only in the most dire of circumstances, they also limit the size of
the risk to a fund manager that the portfolio might suddenly disintegrate. This
private equity-like stability is highly desirable to fund managers, and allows
for longer-range planning similar to that possessed by private equity managers.
The result
The vast sums of capital now available to
and held by hedge funds has also resulted in increased activism by hedge funds
in their roles as stockholders. In early 2005, the hedge fund industry comprised
about US$1 trillion (about EUR826 billion) in assets, and there are many hedge
funds that individually control over US$1 billion (about EUR826 million), with
the largest groups controlling tens of billions each. While many of these funds
focus on passive investing, it is increasingly common for larger hedge funds to
hold meaningful stakes in public companies. These larger positions encourage activist
activity, either as part of a fund's intended strategy or as a result of portfolio
positions gone awry.
Unlike private equity funds, which only permit capital
to be invested during the first few years and are limited in their ability to
take in new capital, hedge funds typically do not have size caps, and all capital
is available for reinvestment. In addition, the liquid portion of a hedge fund's
portfolio can be quickly levered (using the fund's margin facility) or liquidated.
This flexibility allows activist hedge funds to rapidly deploy capital towards
large, concentrated investment opportunities when needed.
THE FUTURE
OF HEDGE FUNDS
As hedge funds move further into the private equity
sphere and as philosophies converge, hybrids have become more common. Crossover
funds combine private equity and hedge fund strategies within a single vehicle,
and often split the fee and liquidity structure accordingly. Other hybrid structures
can involve, for example: - Private equity liquidity (that is, having a
fixed term and no redemptions).
- Hedge fund-style marked-to-market fees.
These
hybrid structures can present marketing difficulties, especially in the case of
institutional investors that have earmarked allocations to hedge fund and private
equity strategies. However, they can be the best alternative when a manager's
investment style includes a range of liquid and illiquid assets, so that the ability
to limit liquidity (through the use of side pockets, lockups and gates) and minimise
marked-to-market uncertainty (through the use of side pockets) does not provide
enough flexibility.
As hedge fund managers join the private equity marketplace,
they are bringing with them some of the investment styles historically more common
in the hedge fund space, including, of course, the use of hedging to limit risk
exposures. In addition, these managers bring with them different methods of compensating
professional employees, resulting from the current-pay fee structure of profits
on the marked-to-market (non-side pocket) portfolio.
Compensation structures
in private equity funds must address the fact that incentive fees are back-end
loaded and subject to hurdles and clawback, and typically involve complex vesting
provisions to address the influx and outflux of employees at various times during
the funds' scheduled term. By contrast, the following apply to incentive fees
in a hedge fund (apart from its side pockets): - They are accrued annually.
- They can remain invested indefinitely in the fund.
- They may
(in the case of offshore funds) achieve tax deferral for up to ten years.
- They
are not subject to a hurdle or a clawback.
As a result, employees at
hedge funds are often less locked in than their private equity counterparts. These
differences have facilitated the acquisition by hedge fund firms or private equity
professionals who can help the firms manage their expanding private equity strategies.
It remains to be seen how the increased participation of hedge funds
in private equity investing will affect the private equity industry. However,
what is clear is that the amount of assets now available to hedge funds that wish
to engage in private equity investing has made them (and hybrids) meaningful players
in the marketplace.
This article was first published in the PLC
Cross-border Private Equity Handbook 2005/06 and is reproduced with the permission
of the publisher, Practical Law Company. For further information or to
obtain copies please contact Mark.Eaton@practicallaw.com,
or visit www.practicallaw.com/privateequityhandbook
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