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In a 2004 speech in New York, Henry Kravis warned hedge funds against trying to eat private equity’s lunch by competing to acquire big companies. Three years later, if anything, they are helping to prepare meals for the buy-out kings such as KKR.
In spite of a few painful clashes, the relationship between private equity and hedge funds is increasingly symbiotic. On one level, activist hedge funds are stalking public companies, trying to force radical change. That can drive them into the waiting arms of private equity, as it did with Ceridian this week. Thomas H. Lee agreed to buy the payments company for $5.3bn.
Even if the link is not always so clear, the overall threat of activist scrutiny no doubt makes the idea of accepting a clean buy-out at a healthy premium pretty attractive. Meanwhile, at the slightest sniff of a deal, merger arbitrage hedge funds flood a target company’s share register, helping to oil the wheels for an eventual transaction – even if they sometimes push up the price.
More profoundly, hedge fund investors are adding fuel to the buy-out fire as enthusiastic buyers of high-yield debt – helping to keep it cheap and plentiful. So far this year, hedge funds and similar investors have bought more than 20 per cent ofleveraged loans, according to Standard and Poor’s. The impact in the high-yield bond market has also been significant. As Martin Fridson of Leverage World points out, the risk premium on high-yield bonds is narrower today than in previous cycles when default rates and other indicators were at similar levels. He attributes that partly to the aggressive entry of hedge funds into the market since 2000 and their influence on pricing.
On top of keeping debt cheap and plentiful, heavy demand has forced the steady erosion of financial covenants. A sort of virtuous cycle has emerged. Private equity funds can pursue ever-bigger, more expensive, more highly leveraged deals, in turn creating more high-yield debt for hedge funds and others to gorge on.
The debt markets have also allowed private equity funds to move beyond targeting stable, high cashflow industries into the riskier reaches of the economy – including the notoriously cyclical airline and semiconductor businesses. That suggests that private equity groups have spread beyond specific company and sector risks towards taking a broader bet on the overall economy.
One interpretation is that buy-out groups and those hedge funds heavily into high-yield debt are betting on a fundamentally benign macroeconomic outlook. They might believe that the cycle has been tamed by a new generation of wise central bankers, technology advances and the emergence of China and India.
The desire for both sets of investors to embrace maximum leverage – which juices returns in the good times – certainly suggests that they think the world of low inflation, low interest rates, reasonable economic growth, minimal defaults and low economic volatility can continue.
The other interpretation is that private equity/hedge funds are simply acting in a rational fashion because they are so heavily motivated to take big risks with the huge pots of money they have raised. If the good times continue, they get 20 per cent of the profits from their deals. So it is worth rolling the dice rather than being too cautious. Whatever their motivation, their behaviour continues to allow them to feed off each other.
The question is what happens if, and when, the good times finally come to an end. At some point a number of sizeable buy-outs are likely to hit trouble. The symbiotic relationship between hedge funds and private equity could unwind quickly as risk premia expand, covenants come back into vogue and the leverage available for deals contracts.
For individual deals that run into problems, it is likely to turn into outright confrontation. Hedge funds are not set up to act in the clubby style that banks once used to – of trying to work through a challenging financial situation. Instead, they are likely to fight hard for everything they can get. Private equity and hedge funds can rub along nicely when everybody is feasting on the opportunities thrown up by exuberant markets. The clash Mr Kravis warned of is likely to come in a time of famine when both sides start fighting over the scraps left on the table.