KUHN CAPITAL Monday, March 19, 2018
Dispatches from the front

Hedge Funds: the PE Party Crasher


Hedge funds are muscling into the sorts of deals that used to be the preserve of private equity players. Why is this happening and what does it mean for buyers and sellers of operating companies?

We’ve got some theories about all this but before we describe them, we’ll set the table with a brief history of the various flavors of investment groups that drive many M&A transactions.

The Birth of the Venture Capitalist
Way back in the Fifties and before, young companies usually found growth capital through the hardscrabble “friends and family” route. The result was that big ideas didn’t get funded, certainly not by banks looking for established cash flow, or stodgy corporations.

Then in 1957, a young HBS grad named Arthur Rock got together with a group of disaffected scientists from Shockley Semiconductor Labs in Palo Alto and liked their idea of developing the next generation computer chip. Rock shopped the idea to 35 companies before finding his angel in businessman Sherman Fairchild. The result: Fairchild Semiconductor, then Intel.

Rock went on to collaborate with the managers of other start-ups -- Teledyne, Scientific Data Systems, Apple Computer, General Transistor, etc. -- thereby defining the classic VC model. Pursued with vigor by Silicon Valley VC’s through the dot com boom, it calls for finding and funding entrepreneurs (often engineers) managing early-stage (even “zero stage”) enterprises. It’s a tricky business, frequently demanding gut calls on the potential of untested kids with "extreme" views.

Leverage That Buy-Out
Starting in about 1984, another private investment type, nearly opposite to the VC approach, emerged: the leveraged buy-out player as pioneered by New York-based KKR. With large pools of capital under management magnified multiple times by the application of debt to the seller’s formerly pristine balance sheet, the LBO shop hunted very big game like Nabisco. In contrast to VC’s, LBO players are single-mindedly later-stage specialists, unconcerned about betting on extraordinary management, more interested in financial engineering and stable cash flow to service debt. Think of them as loan analysts who outsource the debt to lenders, keeping equity as a finder's fee. While LBO players still stalk the land, some players oversold debt to banks, staining their reputation with some high-profile target company work-outs and bankruptcies. Thus, today the term “LBO” is less commonly used, and the term “take-over artist” is shunned.

Manage That Buy-Out
Meanwhile many venture capitalists -- especially those not equipped with engineering or scientific expertise -- were running out of investment opportunities and getting too big to chase small early-stage deals anyway. As a result, they found themselves increasingly attracted to a sort of hybrid VC-LBO model that combines a focus on management talent with an eye toward leverage.

These are “private equity” or PE groups architecting management buy-outs (MBO’s, or deals typically featuring new debt but now sharing some of the equity with the target’s managers). Among the first and now largest classic PE groups is Chicago’s GTCR. PE groups have an advantage over their LBO cousins with their ability to make allies out of management. And for many years they found opportunities in financing M&A "roll-ups" or bids for economies of scale in fragemented industries.

More recently, after having snapped up the low-hanging roll-up fruit, some large PE groups like Bain Capital have been criticized for the same excesses that bedeviled LBO firms. In this day of easy credit and low dividend tax rates, they will engineer deals that have them dividending back to themselves and management nearly their entire original equity investment immediately after close, leaving them as owner of a target company guttering in debt. If such a handicapped giant survives, it’s all upside for the PE group. If it goes down in a few years, well, the PE group is at least not out much.

Hedging, Anyone (or Anything)?
In yet another turn of the worm, now enter hedge funds. Previously an unrelated investment strategy, hedge funds started out as proprietary trading systems exploiting sophisticated models that arbitrage small differences in value expectations for widely traded financial instruments like those related to public equity, debt and commodities.

Like VC’s and LBO shops, hedge funds first specialized in answering the needs of large institutional investors (pension funds, insurance companies, etc.) to allocate, say, five percent of their portfolios to “alternative” investments with perhaps higher risk but counter-cyclical to traditional investment vehicles or with a stronger upside potential. (The name “hedge” comes from the funds’ practice of offsetting big bets with counter-positions, earning a margin on the cost differential, or expected future sale price differential between the two.) Hedge funds too have had their moments of excess, using huge amounts of leverage to magnify microscopic pricing differentials, the most spectacular such failure being Long Term Capital. (Notice how debt seems to be the downfall of all maturing investment strategies.)

What’s new is that in the last few years, hedge fund are increasingly straying from their traditional financial instruments and into all manner of investing -- aircraft leases, collateralized debt obligations, bank loans, utility company financing, anything that can be traded and hedged. They’re being pressed afield by their investors’ unyielding demand for above-market returns as margins in the traditional hedge fund sandbox erode.

Hedge Fund, Meet PE Group
As hungry hedge funds range over the financial landscape, they’ve stumbled into PE territory. They're poking around somewhat tentatively now, trying to figure out how the longer-term investment orientation of PE deals works in the traditional hedge fund short-term environment, and they’re not welcome. After all, PE groups are themselves feeling similar, though perhaps less urgent, heat to generate returns amid apparently diminishing opportunities. For both, the amount of capital available is growing faster than places to put it.

But in the rising competition, we think hedge funds may enjoy an advantage: they have proportionally less to lose. For one thing, many of them now have an awful lot of money. For another, they’ve arrived on the doorstep of PE territory opportunistically and they can leave it just as quickly if things don’t work out. Said differently, we think rising numbers of hedge funds believe it’s easier for them to grasp what it takes to make a PE deal work than it is for a PE group to master the intricacies of a successful proprietary trading technology. That's an open question, but if true, it leaves PE groups fewer places to go if they’re priced out of the MBO market.

Combine all this with the hedge fund’s natural inclination to gamble, and you’ve got a situation in which more risk-averse PE players can get knocked out of deals by a continuing parade of newbie hedge fund competitors.

What’s Next?
For these reasons, we expect one result will be higher sale prices for large company MBO’s, one more boost for a seller’s market already booming due to the strong economy and cheap debt. Another result will be unprecedented pressure on what is often called the “clubby” world of traditional PE investing. We’ll likely see faster decision-making, less attention to detail, less contact with management, less collaberation with fellow investor groups, and an overall breezier, maybe cut-throat style. While the seeds of debt disasters may lurk in this larky attitude, we’re not sure hedge funds won’t meet with some notable successes as they crash the PE party.

Perhaps that's why we’re seeing large PE groups buying into hedge funds for insurance, and we may next see hedge funds investing in PE groups to spread the risk and learn more about the other’s guy business.

Of course what would bring the party to a halt for all players is a slowing economy and/or Alan Greenspan’s likely continued tightening of interest-rate screws. Without cheap debt, seller prices will drop along with transaction volume and the search for the next place to put all that surplus capital will become even more frantic.

Ryan Kuhn

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