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Hedge funds and private equity have one big thing in common. Both charge whopping fees – typically 2 per cent of assets under management (AUM) and 20 per cent of investment profits. Otherwise, the differences are huge.
Private equity is a heavily geared, “long-only” investment in illiquid assets (whole companies), with high levels of control and a multi-year time horizon. Hedge funds, by contrast, typically invest in liquid securities, with no control. They have the flexibility to take both long and short positions and their performance, because it is more transparent, is judged almost constantly by investors.
So which of the two asset classes is more valuable when a management company goes public? The obvious answer is private equity.
First, assets are tied up long-term. Kohlberg Kravis Roberts, which plans an initial public offering, 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 also juice fees with a charge for each deal they do and sometimes a cut for syndicating equity to third-party investors. That can take underlying management fees closer to 3 per cent.
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, private equity firms feel more solid. 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.
Hedge funds are more geared to good performance. If they generate strong returns they enjoy handsome performance fees. The assets on which they can charge future fees also grow by that amount and the good performance attracts further inflows.
In the end, both models live and die by their returns. Private equity groups have longer to prove themselves, have real control over their portfolio companies and can ride out most market storms. Hedge fund investors, meanwhile, can see the real performance each month because most securities are listed. If that is bad, it can spark a rush to the exit and cause real problems for the management company.
Fortress and Blackstone, the main US companies already public, 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 pretty 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.
However, investors also need to take cycles into account. 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.