Home > California CPA Magazine > October 2007 issue > Two Become One—Private Equity and Hedge Fund Convergence

Two Become One—Private Equity and Hedge Fund Convergence

California CPA magazine: October 2007

All Signs Point to Continued Trend of Private Equity and Hedge Fund Convergence

by Dan Reid

Nearly a year has passed since Grant Thornton and the Association for Corporate Growth first discussed the growing trend and potential impact of private equity and hedge funds converging in their whitepaper, Blurring of the Line: Private Equity and Hedge Funds are Converging. And while the trend toward convergence strongly continues, several new trends have developed.

The Need For a Robust Due Diligence Process

Generally, private equity investments tend to be relatively illiquid. As a result, private equity investors must take a longer-term view of their portfolio companies. This view may be only five to seven years down the road, but one may run into a down cycle in the company’s industry or the economy in general during this period.
  Private equity investors historically prepare to ride out these bumps through extensive due diligence prior to closing the transaction, understanding that this process helps uncover any issues that might impact the purchase price or valuation of the company and identifies potential issues that might arise during the holding period.
  Due diligence has always been an important concept, however, hedge funds are new to the private equity type investing game and and sometimes shortcut the process.
  Now that hedge fund investors have adopted a private equity strategy, they are more often employing a traditional due diligence process. We are seeing fewer private equity-like hedge funds omit this very important step in the transaction process.
  Hedge fund investors understand the need for due diligence to better understand the target company and incorporate their findings into the terms of the transactions. Once a transaction closes, the buyer controls the company and generally has an illiquid investment. Any shortfalls in expectations, such as uncollectible accounts receivable, obsolete inventories and poor customer relations will impact future earnings and value.
  If the buyer has not built into the purchase agreement mechanisms to adjust the purchase price or recover damages under indemnity provisions, then these shortfalls impact the ultimate return the buyer will realize on this investment. More and more, they understand that post-closing, they will pay a steep price for not having obtained insight into various issues and potential problems during the due diligence phase.
  Additionally, hedge fund investors are realizing the benefit of developing a comprehensive transition plan and forward-looking plan based on their findings. This is important since, in many cases, it will be necessary to work through these problems.
  This can take the form of providing additional capital, temporary working capital lines or accessing alternative financing, or in some cases, it may mean providing human capital in the form of time and resources to work with the portfolio company during the “rough periods.”
Alternatively, and certainly a better option, a full due diligence process will give an investor the ability to anticipate such problems and take action to avoid them. Often, these steps are necessary to realize the maximum value on a long-term alternative in a private equity investment.

Hiring of Experienced Private Equity Professionals

More frequently, the individuals running the private equity strategy at a hedge fund are professionals hired individually or en masse from existing private equity funds, which makes a great deal of sense since they understand the nuances and characteristics of making and holding private equity investments and portfolio companies.
  While this will likely lead to more competition to hire qualified professionals, it likely won’t lead to a brain drain on private equity because there are so many qualified people out there to choose from. Meanwhile, the trend of hedge funds hiring experienced leveraged buyouts professionals is a positive sign in terms of a movement toward best practices.
  It seems this trend will continue with, perhaps, even a trend toward hedge fund families acquiring niche private equity firms to fill these rolls.

Tightened timeframes to complete transactions

Even with an increased focus on due diligence, private equity professionals have noted that already tight timeframes to complete transactions are becoming even more compressed as a result of hedge fund investors’ tendency to accelerate the process.
  Private equity players are concerned that they will be at a disadvantage if they conduct their normal processes while a potential hedge fund investor competing for the same target company puts forth a faster timeline to closing. Over time, hedge fund investors’ continued realization of the need for complete due diligence will extend out their time to close.
  In the short term, there may be instances where a bidder who is willing to shortcut the investigation process wins some deals based on a shorter closing period. However, should one or two of these deals run into unforeseen problems, investors will likely be less willing to use a compressed timeframe.

Increased competition

In discussions with clients and others in the private equity community, we continue to hear about greater competition and higher prices for acquisitions, as well as increased competition for limited partner’s capital when it comes to fundraising. Both of these issues are discussed on panels at almost every merger and acquisition conference.
  This trend doesn’t seem to be abating anytime soon, as it is a logical result stemming from more players in the private equity type investment space.

Evolution of Partnership Agreements

We have seen hedge fund firms ask to include more traditional hedge fund terms in the partnership agreements for their new hybrid funds and private equity funds. It remains to be seen how far this trend will go, whether it will be accepted in the marketplace and what impact it will have on traditional private equity fund partnership terms.
  Today’s credit markets will likely produce another trend. Hedge fund families often have the ability to finance entire capital structure under one roof. Anytime we enter into a market of tighter credit availability, sellers become concerned about a buyer’s ability to obtain the necessary financing to close the deal. There have been several instances in the marketplace where hedge fund families have cited their ability to provide one-stop financing as an advantage to provide sellers with a certainty to close. How much impact this has on the selection process for determining the winner in a competitive bid process remains to be seen.
  Convergence continues to evolve as existing trends develop and new ones appear. At the same time, new questions and issues arise. We still have not seen how the limited partner investment community will react to convergence in the long term, and we may not see any measurable impact until another year or two. Despite the uncertainty, though, the trend itself does not seem to be going away. 

Dan Reid is a partner and national practice leader of Transaction Advisory Services with Grant Thornton in San Francisco. You can reach him at dan.reid@gt.com.