Hedge funds vs Private Equity Funds

http://ftalphaville.ft.com/blog/2007/07/09/5757/relative-values-private-equity-vs-hedge-funds/

Relative values: private equity vs hedge funds

Hedge funds and private equity have one big thing in common, says Lex. Both charge whopping fees — typically 2 per cent of assets under management and 20 per cent of investment profits. Otherwise, the differences are huge.

So which of the two asset classes is more valuable when a management company goes public? The obvious answer, according to Lex, is private equity:

First, its assets are tied up long-term. KKR, which plans an IPO, says 73 per cent of its assets are committed for as much as 18 years. While KKR is highly unlikely to hold any investment for that long, it does give huge flexibility to ride out tough times. And it provides a steady stream of cash from the 2 per cent management fee — alongside the bigger and more volatile 20 per cent share of investment gains.

Private equity funds can also juice fees with a charge for each deal and sometimes a cut for syndicating equity to third-party investors, which can take underlying management fees closer to 3 per cent, Lex notes.

By contrast, hedge fund investors can pull their money quickly if performance is bad, making the underlying fee stream less secure. In addition, poor investment returns can quickly inflict a double whammy on a hedge fund manager’s earnings — of weak performance fees and falling AUM as investors withdraw money.

Second, there is image. Private equity firms “feel more solid”, notes Lex:

They have established brands such as Blackstone and KKR, they buy full control of businesses people know, and buy-outs have largely avoided financial trouble in recent years. Hedge funds, for some, conjure up images of whizz-kids rolling the dice on behalf of clients, leading to high-profile blow-ups such as Amaranth and recently some mortgage funds at Bear Stearns.

Finally, private equity firms have a “cookie jar” of unrealised gains on their illiquid investments that should emerge as cash flow when the businesses are sold. (At least, that is the case in today’s strong market.)

But … dig a little deeper and hedge funds also have their charms.

They mostly lack the protection of long lock-ups. But in good times their AUM grows naturally because, unlike private equity, they do not constantly hand cash back to investors when they exit investments.

In the end though, both models live and die by their returns.
Fortress and Blackstone have a mix of other assets alongside their straight private equity funds. The coming IPOs of Och-Ziff, a pure hedge fund, and KKR, a fairly pure private equity manager, should give a clearer idea of relative valuations. Assuming hedge funds do not lengthen lock-ups significantly, “private equity should usually command a higher multiple”, says Lex.

However, investors also need to take cycles into account, it cautions:

The easy credit conditions that have fuelled the private equity boom are showing signs of strain and stocks are well into a long bull market. The flexibility of hedge funds to go short and mix up the assets they invest in might make the most blue chip managers look attractive in tougher times.

This entry was posted by Gwen Robinson on Monday, July 9th, 2007 at 10:38 and is filed under Capital markets, Private equity, Hedge funds. Tagged with blackstone, fortress, kkr, och-ziff. You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.