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Vital questions must be asked of HEDGE FUNDS

Copyright 2004 The Financial Times Limited
Financial Times (London, England)

November 30, 2004 Tuesday

Vital questions must be asked HEDGE FUNDS: COMPLEMENTARY OR INCOMPATIBLE?: The trend for private equity firms to establish their own hedge funds is growing, reports Brian Bollen

By BRIAN BOLLEN

The increasing interest of private equity houses in hedge funds underlines the growing acceptance of the hedge fund's status as a fully established alternative investment, more than half a century after the first of its kind appeared on the scene.

But several questions need to be asked. Do private equity and hedge funds make comfortable bedfellows? Are the similarities between them more important than the differences? Are they complementary or mutually incompatible? There is no obvious shortage of opinions.

The nascent convergence between private equity and hedge funds makes sense, says Edward Wu, senior research analyst at Couchman Capital LLC in New York. "Blackstone, KKR, Bain Capital and TPG, among others, have either already established - or are considering establishing - in-house hedge funds."

The private equity firm can offer proprietary in-house industry and company knowledge built up through years of investing, says Mr Wu.

For its part, the hedge fund offers the opportunity for the firm to earn fees from a pool of capital that is much more liquid (not locked up for several years), that can generate superior risk-adjusted returns with low correlation to overall market volatility and capitalise on its in-house knowledge of private companies (applying that knowledge to the public equity domain).

"Of course, there are conflicts to manage - most obviously, insider trading problems to the extent a firm owns parts of a public company with inside knowledge and trades on that knowledge," he concedes. "But it appears that those conflicts may ultimately be managable."

Dan Strachman, managing partner of Answers Company, a New York-based money management firm that offers investment management services to individuals and institutions, expresses the view that private equity firms are launching hedge funds not because they are looking to have a better stream of revenue, but because they believe in the hedge fund product.

"There may be a better stream of revenue but they're doing it because they believe it's a good business model," he says.

"For the most part, people are interested in solid, good products and the private equity firms believe they have the customer base to lay it out, to expand their own offering."

Private equity firms that have established their own hedge funds are piggy-backing upon the success and recent popularity of the hedge fund as a fund-raising technique, says Joseph Omansky, president and 80 per cent owner of New Jersey-based Sky Fund LLC, a hedge fund rating service.

But one comment from him raises doubts about the appropriateness of the relationship. "Approximately 10 per cent of private equity deals are successful. However, those that are successful are blockbuster deals, more than making up for the losers. Such extreme volatility is the opposite of what defines a successful hedge fund: low-volatility, steady, uncorrelated returns over time."

Nevertheless, the trend for private equity firms to establish their own hedge funds is a growing and popular one, adds James Hedges, president of LJH Global Investments in New York.

"Likewise, private equity firms are backing hedge funds, and funds of hedge funds. This will continue, and it makes all the sense in the world. These two types of companies are going to increasingly merge, and the lines between private equity and hedge fund investing will blur."

As well as boosting returns, either in terms of the fees they could charge other investors for entry and management, or the underlying investment returns they might make.

"I'd also say that they need to have a full breadth of investment choices open to them in order to make money for their investors," he adds. "Being able to invest in public and private and negotiated transactions enables them to have the full palette."

Meanwhile, Resurrection Advisors in New York has been working with several private equity firms looking to enter the hedge fund space. According to buy-side partner Kevin Pollack, the main motivations are:

-Weaker private equity returns and reduced ability to raise capital for new private equity funds.

-Greater demand for hedge funds.

-The highly attractive and potentially lucrative fee structure of hedge funds.

-Their ability to bolster returns to their investors.

-Their desire to diversify, which is particularly important given reduced private equity returns.

-Their desire to capitalise upon existing expertise.

-The potential to leverage off of their name, track record, infrastructure and investor base.

By engaging in mergers and acquisitions and/or joint venture transactions with existing hedge funds, rather than starting from scratch, private equity firms can, according to Resurrection:

-Capitalise on an existing hedge fund track record (unless a "superstar" is launching his or her own fund, investors usually prefer a track record of several years as that adds substantial credibility, evidence of fund stability and a more extensive record of performance to evaluate).

-Reduce the risk of the costly turnover that occurs from organic growth by bringing on a team with a more vested interest in long-term success.

-Leverage-off an established brand name in the hedge fund space.

-Cross-market their other investment opportunities, such as new private equity funds, to current investors in the target hedge fund.

For a firm with a strong brand in private equity, "it makes good sense to leverage this into hedge funds," concludes Oliver Tant, head of KPMG's private equity group. In many cases, the same department, even the same person, from a financial institution is responsible for investing in both private equity funds and hedge funds."
Private equity firms that have established their own hedge funds are piggy-backing upon the success and recent popularity of the hedge fund as a fund-raising technique, says Joseph Omansky, president and 80 per cent owner of New Jersey-based Sky Fund LLC, a hedge fund rating service.

But one comment from him raises doubts about the appropriateness of the relationship. "Approximately 10 per cent of private equity deals are successful. However, those that are successful are blockbuster deals, more than making up for the losers. Such extreme volatility is the opposite of what defines a successful hedge fund: low-volatility, steady, uncorrelated returns over time."


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