A critical juncture

Steven Alecia is a senior vice president at BISYS Private Equity Services. Bob Donahoe is a managing director at BISYS Hedge Fund Services. BISYS Alternative Investment Services is a leading provider of fund administration, accounting and tax services for alternative investment products.

Today, the press is full of articles about the convergence of hedge funds and private equity and it is absolutely true that these two asset classes are converging in terms of how they deploy capital, with a particular move by hedge funds, with their liquid mark to market mentality into more illiquid private equity type or highly leveraged situations.

The sticky wicket is that these two economic models need very different supporting infrastructures, in terms of both people and processes. The challenge is to build administrative and operations systems that recognize the similarities but successfully manage the differences.

Off to the side
Private equity investment by hedge funds can take several forms. Typically, these investments have taken the form of side pockets, where a portion of the hedge fund is segregated from the rest of the assets for illiquid investments.

In other cases, if the investment represents a minor fraction of the portfolio, it can be held within the portfolio. At BISYS, we also see numerous multi-product managers separately offering buyout and hedge vehicles as completely different funds or products but increasingly, managers are turning to hybrid funds. Side pockets are still the prevalent method, but the usage of other architectures among our clients has recently grown from a single fund to a handful.

A booster shot
A hybrid fund of the type we are describing is a generally liquid investment vehicle, at its core basically a hedge fund, with an illiquid component that can be deployed in unique situations (LBOs, debt financing, etc.) to boost returns. The illiquid portions of these funds generally target middle market investments and invest no more than $500 million across the entire illiquid portfolio. Many are focused on a particular industry, hoping to leverage a core competency to transition from short-term trading in public securities to long-term investing in private equity or similar situations.

Typically, these illiquid portfolios are contained within existing and well known hedge funds or are part of new funds started by individuals with a hedge fund background. This is likely the result of a far greater pool of capital to deploy combined with an intense search for higher returns than can be obtained in the increasingly competitive ? and therefore lower returning ? world of ?traditional? hedge fund investment strategies (trading, risk arbitrage, etc.).

Hedge funds are looking at leveraged transactions and other deals that were once solely within the purview of private equity funds for the same reason that they are pursuing ?activist? strategies: An intense need to deliver returns in an increasingly competitive environment. Today, hedge funds number approximately 6,000 with $1.3 trillion under management while private equity funds total about 1,000 with $200 billion in assets.

A ?natural? extension
Hybrid funds can make a lot of sense for alternative asset managers looking to extend their brand by offering more products. From a marketing standpoint, they can leverage the reputation and past performance of a fund manager. They can take advantage of an increasingly overlapping investor base. They can achieve certain economies of scale by leveraging industry knowledge and due diligence to source and close deals. And they both attract entrepreneurial individuals with deep analytical and financial engineering skills.

While both hedge funds and private equity attract the best and the brightest, the personalities and backgrounds of the people tend to differ. Hedge funds, due to their historical focus, tend to attract people who thrive in a trading environment such as quant types interested in creating sophisticated models to uncover pricing inefficiencies in the public markets.

Private equity generally attracts people focused on research and analysis, interested in building a thorough understanding of specific industry segments and in uncovering operational inefficiencies in targeted companies. Historically, private equity focuses primarily on long-term growth in private companies, while hedge funds focus mainly on short-term opportunities in the public markets. These differences in types of investments and time horizons affect all areas of fund administration?liquidity, valuation, compensation, tax accounting and governance.

The liquidity solution
When a fund manager tries to simultaneously tackle buyouts and hedge fund investing, it can become very difficult to reconcile a long term investment with the short term liquidity needs of investors. In the past, illiquid investments by hedge funds have made up only a minor portion of their portfolios. Recently, however, fund managers have increased the amount of capital deployed in illiquid investments so hybrid funds must be structured in such a way that they are able to achieve liquidity despite significant illiquid holdings.

We have seen funds address this by requiring 90 to 180 day notice periods for redemptions. But often this is accomplished by establishing a gate ? a percentage limit on the amount of capital that can be withdrawn at one time. For example, if a fund was 70 percent illiquid and had a 30 percent gate, even if all its investors sought to withdraw capital at the same time, it would only have to cover 30 percent immediately, redeeming the rest on a pro-rata basis as illiquid investments are realized.

The value question
Valuation is also a big issue when funds combine both private equity and hedge fund assets. Hedge funds are used to calculating net asset values, which are easily determined on a mark to market basis. Private equity investments are carried at ?fair value? as well; however, there is no readily available market price for the asset until some realization event.

In many cases, fund managers have dealt with this issue by keeping private equity investments in a side pocket, with no redemptions possible until the side pocket asset is realized. This system, however, is facing increased criticism and scrutiny due the ease with which this tool can be abused. The danger is that fund managers will be tempted to put poorly performing investments in the side pocket, where they will not drag down the overall performance of the portfolio.

Valuation also affects compensation. With performance fees based on a valuation that includes illiquid assets, who decides how to value those assets when there is no market benchmark? Is it the fund manager? What about the inherent conflict of interest?

Hybrid funds with two different economic streams also require a way to track and report two different styles of investing. Hedge fund assets are often marked to market on a daily basis and certainly no less frequently than monthly. Hedge funds require daily reconciliations to support their trading activities while private equity funds may not revalue assets frequently ? sometimes even waiting until an IPO, sale or another round of financing assigns a market value or forces a revaluation.

The accounting infrastructure necessary to track and report these two very different asset classes will need to be designed and supported by individuals with a thorough understanding of both. Yet, today, it is very rare for any finance or operations personnel to have experience with both hedge funds and private equity. Coming into a hybrid fund, CFOs, controllers and their staff will need to be aware of what they don't know and fill the knowledge gaps.

Two different economic models also give rise to different tax liabilities coming from both the difference between capital gains and trading income as well as where investors are domiciled and whether investors are taxable or tax exempt. Typically, private equity funds are structured as limited partnerships while hedge funds are structured as open-ended investment companies in a tax haven. Hybrid funds will have to develop a legal structure that accommodates both types of investors and the tax liabilities arising from both types of investments. But after the lawyers are through, those designing the tracking and reporting structure will have to accommodate the different tax reporting requirements, which will be far more complex in a hybrid fund than in a standalone private equity or hedge fund.

Cautionary tale
We hear many war stories from firms that have failed to manage these issues effectively. One firm, which shall remain nameless, had historically made only liquid investments. This firm had identified a one-off opportunity to make a significant illiquid investment and acquired a controlling stake in a private company. Whether due to inexperience with buyouts, incompetence, or some combination of both, the fund did not periodically revalue the investment or highlight the new risks presented by this type of deal to its investors. When the company imploded after a severe industry downturn, forcing a restructuring, the correct (re)valuation was revealed? of course coming as an unpleasant surprise to the fund's investors.

Finally, there is the issue of governance in a hybrid fund. Good governance requires a solid understanding of where things can go wrong and how to prevent such an eventuality. There is a need to separate the public and private investing to avoid any potential for insider trading. Investment banks have long experience with designing Chinese walls to separate personnel who might be tempted to share inside information or make improper trades. The convergence of hedge funds with private equity can potentially create similar situations and hybrid fund managers must build their own walls to prevent them.

Convergence is here to stay but there is no standard yet as to what a truly converged fund will look like. Many managers are flying by the seat of their pants as they try to combine two very different asset classes in the never ending pursuit of higher returns. This combination will require a solid infrastructure?people, processes and policies?to support true convergence and avoid legal, taxation, financial and other issues.