Hedge Funds and Private Equity Funds
Contents
Ø Hedge funds
Ø Private equity funds
Overview of hedge funds
q Hedge funds has no precise legal or universally accepted definition but most
participants agree that hedge funds have the following characteristics
1) Almost complete flexibility in relation to investments, including both long and
short positions
2) Ability to borrow money in an efforts to enhance return
3) Minimal regulation
4) Some illiquidity since an investor’s ability to get an investment back is
restricted through lock-up agreements
5) Investors include only wealthy individuals and institutions such as university
endowments, pensions funds, and other qualified institutional buyers.
6) Fee that reward fund managers for performance
Overview of hedge funds
Ø A typical fee structure for hedge funds includes both a management fee and a
performance, whereas a typical mutual fund does not require performance fee and has a
smaller management fee.
Ø Hedge fund management fees are usually around 2% of net asset value, and performance
fee are approximately 20% of the increase in the fund’s NAV.
Ø This 2% and 20% fee structure is significantly higher than for most other money
managers, with the exception of private equity fund managers, who enjoy similar high
fee.
Overview of hedge funds
Ø Hedge funds target absolute returns, which are investment returns that
theoretically do not depends on the performance of broad markets and the
economy.
Ø One of the historical claims made by hedge funds is that their returns are
“uncorrelated” with market returns for traditional investments such as stocks and
bonds.
History of hedge funds
Ø This category of investment management started during 1949 when Alfred W.
Jones created fund that utilized short selling of assets to hedge other assets that
were purchased to create an investment portfolio.
Ø His fund neutralized the effect of changes in the general market by buying assets
that were expected to increase in value and selling short assets that were expected
to fall in value.
Ø This created hedge that was designed to remove overall market risk.
Leverage in Hedge fund
Ø Hege funds frequently borrow (creating leverage) in order to increase the size of
their investment portfolio and increase returns (if asset value increases).
Ø For example, if hedge fund received $100 million from investors, the fund
manager might purchase securities worth $400 million by borrowing $300 million
from bank, using the $400 million of purchased securities as collateral against the
$300 million loans. This is called the margin loan.
How hedge fund leverage works?
• Direct form of leverage:
Ø Bank borrowing: Hedge funds can take out margin loans form banks. For
example, assuming 20% margin on security ABC, a hedge fund could buy $10
worth of securities by paying only $2 upfront and having the bank supply the
remaining $8 in the form of a loan.
• Repossession agreement (“repos”)
Ø Hedge funds finance debt securities purchase, a repo transaction involves one
party agreeing to sell a security to another party for a given price and then buying
it back later at a higher price.
How hedge fund leverage works?
q Implicit form of leverage
ØShort selling
• Short selling is the practice of selling securities borrowed from banks or other
counterparties. Fund raised from the sale of these borrowed securities are used to
buy other securities-a practice known as long/short trading.
Ø Off-balance-sheet leverage through derivatives and structured products
• Derivative includes options, swaps, and futures. Investors can gain much larger
risk exposure
Growth of hedge funds
q Hedge funds grew at a remarkable rate between 1990 and 2007.
Ø Diversification: Investors were looking for portfolio diversification beyond long-only
investment funds. Hedge fund provided this portfolio diversification to investors.
Ø Absolute return: Investors found the absolute return focus on hedge fund appealing.
Ø Increased institutional investment: Due to spectacular return many large institutional
investors such as pension funds and petrodollar funds substantially increased their
exposure to hedge funds
Growth of hedge funds
Ø Favorable market environment: Since the hedge funds rely on leverage to
augment returns, low interest rate, the availability of credit, flexibility in credit
terms, strong equity market performance and accommodating tax and regulatory
conditions fueled hedge fund boom.
Ø Human capital growth: some of the best financial and investing talent in the
world moved into the hedge fund arena.
Ø Financial innovation: Hedge fund’s ability to execute increasing complex and
high-volume trading strategies has been made possible by product and technology
innovation in the financial market and by reduction in transaction cost.
Hedge fund investment strategies
q There are four broad groups of strategies:
1) Equity based strategies: A hedge fund managers that focuses on equity long/short
investing starts with fundamental analysis of individual companies, combined with
research on risks and opportunities particular to a company’s industry.
2) Macro based strategies: A macro-focused hedge fund makes leveraged bets on
anticipated price movements in stock and bond markets, interest rates, foreign
exchange, and physical commodities.
3) Arbitrage driven strategies: 1) when same asset does not trade at the same price in all
markets; (2) two assets with identical cash flows do not trade at the same price; (3) an
asset with a known price in the future does not trade today at its future price,
discounted aby the risk-free interest rate.
4) Event Driven: Event driven strategies focused on significant transactional event such
as M&A transactions, bankruptcy recognitions, recapitalizations, and other specific
corporate events that create pricing inefficiencies,
Examples of hedge funds in Inda
ØTrue Beacon Global: An investment firm that operates as a Category III
alternative investment funds (AIFs), True Beacon focuses on minimizing costs for
investors and aligns its performance by charging fees only on the profits made
above a high-water mark.
ØEdelweiss Alternative Asset Advisors: this firm manages a range of AIFs,
including those that engage in strategies akin to those of hedge funds, leveraging
market inefficiencies and employing a diversified approach to asset allocation.
ØMotilal Oswal Asset Management Company: Known for its focus on equity
investments, Motilal Oswal also offers Category III AIFs that pursue strategies to
generate returns through active portfolio management, employing both long and
short positions.
Issues with hedge fund and performance
Ø 2008 was a watershed year in the hedge fund industry.
ØTransparency: Hedge fund investors historically have not required a significant amount
of investment transparency from hedge fund managers.
Ø Following the poor industry performance during 2008, some hedge fund decided to
reduce fee.
Ø Search for return: Hedge funds have traditionally been associated with alpha-based
returns, which are independent of market conditions, but increasingly, hedge funds
participate in the same investment activity as traditional fund managers.
Private equity firms
Private equity firms
Ø These are investment management companies that raise funds form wealthy
individuals, institutional investors, and sometime public sources to invest in
various type of assets including buying companies through leverage buyout
(LBO).
Ø Investment firms that engage in leverage buyout activity are called private equity
firms.
Ø Private equity firms are considered financial buyers, because they do not bring
synergies to an acquisition, as opposed to strategic buyer.
Overview of private equity
q Private equity can be broadly defined to include the following different forms of
investment:
1) Leverage buyout: Leverage buyout refers to the purchase of all or most of a
company or a business unit by using equity from a small group of investors in
combination with a significant amount of debt.
2) Growth capital: growth capital typically refers to minority equity investments
in mature companies that need capital to expand or restructure operations,
finance an acquisition or enter a new market, without a change of control of the
company.
3) Mezzanine capital: Mezzanine capital refers to an investment in subordinate
debt or preferred stock of a company, without taking voting control of the
control of the company.
4) Venture capital: Venture capital refers to the equity investment in less mature
non-public companies to fund the launch, early development, or expansion of a
business.
Characteristic of private equity transaction
Ø In a private equity transaction a company or a business unit is acquired by a private
equity investment fund that has secured debt and equity funding from institutional
investors such as pension funds, insurance companies.
Ø Relatively high level of debt levels utilized to fund the transaction increase the return on
equity for private equity buyers.
Ø If the target company is a public company, the buyout results in the target company going
private.
Ø The private equity firm’s targeted internal rate of return during the holding period for
their investment has historically been above 20%.
Targeted companies of private equity transaction
1) For a LBO transaction to be successful, the target company must generate a
significant amount of cash flow to pay high debt interest and principal payments
and, sometime, dividends to the private equity holders.
2) Robust and stable cash flow: private equity firms look for robust and stable
cash flow to pay interest that is due on large amounts of debt and ideally, to also
pay down debt over the time.
Targeted companies of private equity transaction
3) Leverageable balance sheet: If a company already has significant leverage, and
if their debt is not structured efficiently, the company may not be good target.
4) Low capital expenditure: since capital expenditure use up cash flow available
for debt service and dividend, ideal target companies have found balance.
5) Quality assets: a good target company has strong brand and quality assets that
have been poorly managed.
6) Asset sales and cost cutting: A target company may have assets that are not used
in the production of cash flow.
Private equity transaction’s participants
1) The private equity (a) firm selects the LBO targets (b) negotiate the acquisition price;
(c) complete the acquisition through closing event; (d) decides when to sell the
company.
2) Investment bank: Investment banks (a) introduce potential acquisition targets to
private equity firms; (b) help negotiate the acquisition price (c ) provide loan or
underwrite high-yield bond offering.
3) Investors: Institutional and high net worth investors become limited partners in a fund
organized by a private equity firms, as opposed to investing directly in the firm.
Difference between hedge fund and private equity
q Both private equity funds and hedge funds aim to deliver high returns to their investors, they differ
fundamentally in terms of their investment strategies, risk profiles, liquidity terms, and operational
approaches.
q Investment focus:
Ø Private equity funds: invest primarily in private companies or public companies with the intent to
take them private
Ø Hedge funds invest in a wide range of assets, including public equities, bonds, commodities. Their
strategies are more diverse and can include long/short equity, global macro, arbitrage, and event
drive,
Difference between hedge fund and private equity
q Investment strategies
Ø Private equity funds invest with the focus on restructuring, improving operation, and
driving growth.
Ø Hedge fund: employ a variety of strategies to take advantage of short-term market
movements and inefficiency.
q Liquidity:
Ø Private equity fund have long investment horizons and offer limited liquidity, on the
other had, hedge fund offer better liquidity.
Reading resources
• Chapters
• Overview of hedge fund
• Hedge fund investment strategies
• Hedge fund issues and performance
• Overview of private equity capital
• Book: An introduction to investment banks, hedge funds, and private equity
by David P. Stowell
