The Hedge Fund Report: Locking up the Money

Hedge funds continue to push into private-equity investing.
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Every day, the boundaries blur between private equity and hedge funds. Hedge funds are imposing more illiquid terms on investors and seeking returns in the nonpublic universe. And traditional private equity behemoths like Kohlberg Kravis Roberts & Co. and Blackstone are rolling up hedge funds.

D.E. Shaw is in the process of dedicating a small, segregated portion of its multi-strategy hedge fund to private equity or illiquid investments, according to a person familiar with the matter. The firm, to be fair, is not new to private equity investing. Its partners have been engaged in a variety of private deals for a decade. They injected capital in Juno Online Services prior to its becoming public in 1999, for instance. But now the plan is to allocate a portion of hedge fund capital to private equity investments, which is slightly different.

A spokesman at D.E. Shaw declined to comment.

Imposing longer lock-up terms to investors in order to invest in illiquid assets reflects the same trend. But only the elite hedge funds can do that. A recent example is the newly created hedge fund by Nelson Peltz, which has a three-year lock-up, according to a

Wall Street Journal

report.

When hedge funds want to lock up money, better to do it at the launch. If changes in the management agreement are adopted later on, investors sometimes react with unease.

This is what happened with Ritchie Capital Management, a hedge fund that created an illiquid side pocket and more stringent withdrawal provisions last year, drawing the ire of some of its investors. Bank Leu, a Swiss-based fund of funds, ended up pulling a portion of its money out of Ritchie in January.

"You put pockets of private equity and pockets of hedge funds commingled. To me, it's a problem," says a hedge fund investor.

Another issue is that hedge funds that want to put more money in private equity may be doing it as a way to artificially lower the volatility of the fund. "As an investor, you must be aware of that. Those funds have a very low volatility because they have a lot of private equity deals and don't get marked to market very often," says a fund of funds manager.

Hedge fund managers also have a compensation-related edge when they explore private equity. The hedge fund formula offers managers the advantage of getting paid every year, while private equity managers get their performance fee only when the value of the investment is realized -- and it could be years before that happens.

Short Interest

Jim Chanos, head of Kynikos Associates, a well-known short-seller, is launching a group that will promote various hedge-fund causes with lawmakers in Washington. Is it a short-seller lobbyist organization? Not officially, since the existing 12 members vary in shapes and styles.

Part of the mission, though, may be to help bears speak more freely. Andrew Lowenthal of Porterfield & Lowenthal, a government-relations firm that helps Chanos with his project, describes the so-called Coalition of Private Investment Companies in these terms: "To allow the press freedom to do its job; shareholders to express their opinion without fear of intimidation by the issuers; and analysts to be independent."

Driving South

Latin America is hot and hedge funds are starting to emerge there, even though the field is still in its infancy.

Just last week, Swiss bank Banque Safdie launched a fund of funds that will only invest in Latin American hedge funds. There are only 222 hedge funds in Latin America, representing $18 billion, but the number of managers is growing fast, says Ricardo Simone Pereira, a Brazil-based director at the bank. With emerging markets a top category of hedge fund performance, traders are beginning to understand the opportunities in Brazil, Mexico and Argentina. "Latin America attracts a lot of capital, due to its commodity boom and the liquidity of its equity market," he says.

Real Returns

Equity hedge funds make money by stock-picking, not short-selling, according to Barclays Capital's latest Equity Gilt Study. That would explain why some successful managers like Caxton Associates or Maverick Capital have rolled out long-only funds in the recent past. The study shows a strong correlation between long/short hedge fund indices and the

Nasdaq Composite

, suggesting that returns are not so much the fruit of a manager's skill but rather simply of market conditions. The study also points to return differentials between large-caps and small-caps. It suggests that a hedge fund investment can be replicated by a long Nasdaq position combined with a short big-cap/long small-cap position.

In a recent conference, Aleksander Weiler, investment strategist at Tremont, underlined some of the newest and most exotic niches where hedge funds can make money. The list is interesting and bizarre: catastrophe reinsurance that has conventionally been the province of offshore reinsurers; activist investing, a space traditionally undertaken by private equity firms; credit default swaps; derivative instruments tied to the housing markets; and trading carbon-emission rights. Strangely enough, asset lending and PIPEs were not part of the list. Have those styles acquired mainstream status?