March 27, 2006
Private Equity and Hedge Fund Convergence
Posted by Bobby Bartlett

I was recently informed of a large VC investment made last week in a start-up called Salick Cardiovascular Centers, Inc. The company develops medical centers that provide diagnostic and treatment services for cardiovascular disease on an outpatient basis. Last week Salick announced that it had raised $75 million in a first round financing. What I found especially interesting about the financing was that it was led not by a traditional venture capital firm, but by Warburg Pincus—a private equity firm known primarily as an LBO/buy-out shop (for instance, they were part of the LBO consortium that bought Neiman Marcus last year for $5.1 billion). The conventional wisdom about private equity is that it consists of “venture capital funds” and “buy-out funds,” but deals such as Salick signify how this categorization can often be quite misleading. In fact, Warburg Pincus is not the only buy-out firm that dabbles in start-ups. For instance, KKR—arguably the quintessential “buyout” shop—has done several, including a whopping $250 million financing of a start-up called Jazz Pharmaceuticals in 2004. Traditional venture capitalists, for their part, have also tried the occasional leveraged buyout (the most recent one that comes to mind is New Enterprise Associates’ failed buyout of m-Qube earlier this month).

The blurring of lines that occurs among buy-out firms and venture capital firms is also occurring more generally between private equity and hedge funds. In theory, hedge funds are supposed to engage in sophisticated trading strategies that allow them to exploit inefficiencies in the public markets and realize value in short periods of time. In recent years, however, a number of hedge funds have begun to invest in private equity transactions. The reasons for this trend have been discussed elsewhere, so I won’t go into detail here. But the general theory is that as the number and size of hedge funds have increased, the market has become intensively competitive, causing some hedge funds to look to private equity as a means of achieving superior investment returns. Cerberus Capital has been especially active, nearly defeating KKR in the $5 billion auction of Toys-R-Us last year, and just this month, it came close to out-bidding KKR again in GM’s $8.8 billion auction of its GMAC financing arm. In response to this new competition, some of the most prominent buy-out firms have recently established hedge funds (e.g., KKR, the Carlyle Group, Bain (via Sankaty Advisors) and Blackstone). I suppose one could call it a turf war of sorts.

From a legal perspective, the hedge fund/private equity convergence suggests yet another problem with the SEC’s new rules requiring the registration of hedge fund advisors. In proposing the rules, the SEC rightly noted that traditional private equity firms do not pose the same types of concerns that have been voiced about hedge funds—in particular, the “retailization” of traditional private equity funds has not occurred as it has with hedge funds. Consequently, it sought to remove private equity funds from the scope of the registration requirement by exempting any private investment fund that allows its investors to redeem their securities within two years of purchase. Traditionally, this would have excluded venture capital and buy-out funds that require investors to be locked into the investment funds for several years (usually 10-12 years) to permit sufficient time to realize value on their illiquid investment portfolios. Hedge funds, in contrast, have historically permitted investors to enter and exit funds at any time, which posed little problem for funds that are invested in liquid, publicly-traded securities.

The convergence of buy-out and hedge funds indicates that the SEC’s attempt to distinguish between hedge funds and private equity funds may ultimately be unworkable from both an economic and a legal perspective. Economically, is Cerberus more properly classified today as a “hedge fund” or a “private equity” fund? Likewise, the economic convergence of private equity and hedge funds undermines the SEC’s legal standard for distinguishing between the two. The free redemption model of traditional hedge funds only works so long as a fund is invested primarily in liquid securities. Not surprisingly, as hedge funds have moved into private equity investing, they have required investors to agree to “side pocket” provisions with lengthy lock-ups that prevent investors from freely redeeming the non-liquid portion of their capital accounts. Consequently, many hedge funds have bona fide business reasons for requiring lock-ups that exempt them from the SEC’s new rules. (This is to say nothing of the ease by which even a more scheming hedge fund advisor can avoid the registration requirement by simply imposing a two-year lock-up provision—an incentive that only accentuates the agency risks of investing in a hedge fund.)

Fundamentally, the problem with the SEC regulation stems from the fact that the SEC chose a legal standard that has nothing to do with the reasons for exempting traditional private equity funds in the first place. If the SEC was worried about the retailization of hedge funds, it seems a more direct approach would have been advisable. In fact, why even turn to the Advisor’s Act? Why not instead tighten the investor suitability requirements under Reg D/4(2) as they apply to the private placement of investment funds?

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