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When is a hedge fund not a hedge fund?08/03/2006. Source: SJ Berwin . Rob Day 
 Hedge funds have long played a role in financing private equity deals, says SJ Berwin, but their continuing move into the space more typically occupied by buy-out funds has generated considerable interest recently.
Some hedge fund groups have hired private equity deal-doers, and are actively seeking buy-out opportunities. That has prompted the more philosophical members of the alternative asset community to ask: When does a 'hedge fund' become a 'private equity fund'?
The reality, of course, is that 'hedge funds' have always been a disparate group - the funds that come under that umbrella have a range of strategies, from pure arbitrage, through market neutral stock picking (where returns are driven by the price of one asset rather than the market as a whole), to event driven positions (including merger arbitrage and distressed debt strategies). The activities of the funds have continued to grow, and a collective noun that seeks to distinguish the funds by reference to what they do is harder to justify.
And, as the range of investors into the asset class has also broadened, it is increasingly hard to differentiate 'hedge funds' as an asset class for wealthy individuals. In reality, the investor base is pretty mixed, as it is in the private equity world.
But there is one characteristic that unites hedge funds - their terms. Although they don't all have the same terms, there are some common themes that emerge: they are re-investing funds, they usually pay an annual incentive fee on unrealised profits (with investments marked to market) and some liquidity is offered to investors through redemptions (even if there is an initial lock-up period). Those terms are, of course, well suited to funds that invest in liquid assets - it is possible to mark the assets to market reliably and, if cash is needed for redemptions, it is possible to sell investments quickly.
But those terms are clearly not very well suited to illiquid investments, like shares in unquoted companies. Here, the traditional model is for funds to return cash to investors as soon as an investment is realised (rather than re-invest it), and to pay a carried interest on the realised profit on a cash on cash basis. Those terms are well suited to private equity, but not unique to it - increasingly, for instance, infrastructure, debt and real estate funds are adopting that model.
So, for so long as hedge funds stick with their traditional terms, it is hard for them to tie up a significant proportion of their assets in unquoted companies. Although some proportion of assets can be used to fund buy-outs, there will always be a natural limit on that imposed by the commercial terms of the fund - even if that limit can be stretched by modifying the fund terms a little (for example, by requiring investors to lock into the fund for longer).
Whether we will see more funds being raised for investment in an unspecified pool of liquid or illiquid assets - with two sets of terms applying, fixed on an asset by asset basis only once investment decisions are taken - is difficult to say, and so far that is rare in Europe. In the meantime, it is hard to see how hedge funds could re-focus their strategies to invest predominantly in private equity. And until they do, they are probably still called 'hedge funds'- even though they are adding welcome depth and liquidity to the buy-out market.
SJ Berwin is a pan-European law firm with a particular focus on private equity. It has offices in London, Frankfurt, Munich, Berlin, Madrid, Paris and Brussels. For more information on hedge funds, or any aspect of private equity, please contact Rob Day (rob.day@sjberwin.com), or visit our website at www.sjberwin.com
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