Beyond Convergence: Flexibility is the name of the game as the hedge fund and private equity worlds collide

Flexibility has become the driving force uniting the hedge fund and private equity asset classes. As the debt markets adjust to a new reality, this elasticity could give some a distinct advantage. In August, Mergers & Acquisitions met up with some top names working on the fault lines of this tectonic shift in the market. Mergers & Acquisitions: Convergence obviously isn’t a new trend. I would argue that it’s been ongoing for the past five years or so. But, considering all the different shapes it can take, I think there’s still a lot of confusion about it. How have you guys seen it develop over the past couple years? Fries: I see convergence actually being two or three different things. We see investment firms across the board playing in more parts of the capital structure. Hedge funds, specifically, are doing more interesting deals: Sometimes they are passive money and sometimes they are actually triggering new deals, but many are moving away from pure activism to be a player in a lot of different types of transactions. That’s one element of convergence. I’ve also seen private equity firms that are diversifying their business, in part by setting up a hedge fund arm to deal with other issues. But I would almost say that we are beyond convergence at this point, as businesses are playing in a more diverse and sophisticated investment pool. Bonoff: To me, convergence is being driven by the different motivations of each asset class. From the hedge fund side, many groups are taking advantage of the flexibility that they have in their charters and chasing the most attractive returns that they can. From the private equity side, many of the bigger names are using their brand equity to become more of an asset manager. Chang: I think the media has portrayed convergence as private equity funds getting into the hedge fund business, or alternatively, hedge funds getting into the private equity business. Of course, that’s part of it, but to me when you talk about convergence, you have to think about things like fund structures. A lot of opportunity funds now have longer lock-ups, whereas private equity funds have more flexibility in the types of deals they can pursue. Mergers & Acquisitions: Convergence, by all appearances, has flourished in what have been ideal market conditions. But considering the dislocation of the credit market during the past couple months, I imagine the idea of holding onto an illiquid investment such as private equity, may not be as agreeable for some hedge funds these days, especially considering the redemptions some groups are experiencing. How do you see convergence being impacted by these new market dynamics? Zenni: It is an issue for some hedge funds that don’t have the right kind of capital to pursue private equity. But some are very large and they have carved out a certain percentage of their assets to pursue these deals. With that said, there are still a number of hedge funds that don’t have a lockup that’s needed to really pursue, extract and create value in private equity. I think that’s an issue, although I also think that it’s less of an issue today than it used to be. Fries: The disruption is going to allow the firms that do have the flexibility to be more successful. Zenni: No question. Fries: I think there will be more convergence as a result, and people are going to see the benefits of having that diversification within their portfolio. Thorn: It is really about risk management and asset liability management. And if you have long-term assets and short-term liabilities and those are out of whack, then you are going to have problems. But I think the funds that have either set up side pockets or received long-term funding – or even those who’ve thought about asset liability management in the same way a bank might – those types of funds will have a lot of opportunities in the next three to six months. Mergers & Acquisitions: Let’s talk about the flexibility. That seems to be at the core of the convergence trend. Can you discuss some of the ways a hybrid fund might bring something different into play that a standard private equity shop or hedge fund wouldn’t be able to do? Thorn: I would say flexibility is one of the most important components that convergence brings to the table. At Marathon we have about $10 billion of capital that we manage and we are involved in credit, real estate, private equity, emerging markets and public equity. When it comes to private equity, we are not wedded to control buyouts. Every person on our team has a private equity and buyout background, but at the same time we can also invest in minority transactions; we can invest in debt with a view toward helping the company restructure; if a deal is difficult to finance, we can invest in the entire capital structure of a company; and we can launch new companies backing experienced managers. Having more arrows in your quiver is a pretty significant advantage in today’s market. A lot of the large-cap funds probably have the ability to do the same kinds of things, but in the middle market, I don’t think there are many firms that can really bring that kind of flexibility to private equity investing. Chang: Absolutely. At the end of the day, investing is about understanding the fundamentals of a company and an industry. And how you structure your entry a lot of times depends on your understanding of those fundamentals. We have the ability to invest in equity or debt to either take control or minority positions. And having that flexibility is a huge boon for us. A lot of times you may understand the fundamentals of an industry or company, but if your charter is limited, then you can be precluded from investing there. Thorn: Just to give one example, we bought an automotive supplier earlier this year called Contech from SPX Corp. We were not actually the highest bidder, but the seller didn’t want any financing risk or any uncertainty over whether or not the deal would close. So we provided 100% of the debt and the equity for the transaction, which I think really helped us stand out from the other bidders. Mergers & Acquisitions: What about the investors that may be less “hybrid” firms, but rather more traditional private equity investors within a larger hedge fund? For example, Dan, at Angelo Gordon do you have the same kind of flexibility that Wray and Steve are talking about? Bonoff: We do have a tremendous amount of flexibility. We are able to do everything from investing in pools of assets to literal startups of financial service companies. Prior to joining Angelo Gordon, I came from a world where those sorts of things were just completely outside of the charter and would not fly with the LPs. [Bonoff joined Angelo Gordon from Apax Partners]. That being said, being able to provide one-stop financing, similar to what Wray mentioned, is not something that we would do. We do have the ability to invest on the credit side of the equation, although it is generally along the lines of something Sun might do, where we’d be looking for a potential ownership position down the road. Bernzweig: At Sun, we will go in and take what we believe is the fulcrum security in the debt structure and try to gain control. If we are unsuccessful, the outcome typically is that the debt security trades to par, which is not the worst outcome in the world but sometimes not necessarily what we were seeking to do. Zenni: Convergence is largely a result of platform extensions from both ends of the spectrum. The smart guys figure out where the value is, but they may not have the right structure to pursue it. So what do they do? They figure out a way to extend the platform. I have done it. Sounds like these other folks have done it as well. That’s the key. And that’s why you have seen so much of this melding of strategies. Bernzweig: It is interesting to contrast our story to that. I mean, the mandate of Sun Capital up through its first four private equity funds was strictly controlled private equity. And we were being presented with a vast number of opportunities to take positions up and down the capital structure but we didn’t have a vehicle to capitalize on it. Zenni: It is frustrating. Bernzweig: So we began a test vehicle raising the first tranche of our securities fund, which was $300 million, and the deal flow and returns were exceptional. So we went out and raised another billion dollars and with that we’ve pursued public equities, public debt and we will provide financing into LBO opportunities. Mergers & Acquisition: Let me ask about deal flow. It seems as if some sellers might be drawn to the flexibility you guys can provide, but at the same time, I would also think there might be some confusion too about what you guys do? Chang: The challenge of convergence is that with the flexibility you have to find focus. When we look at investing, we think about two resources: Capital and people. In terms of sourcing investments, we strike a balance between maintaining relationships on the deal side of the world (such as investment bankers, traditional private equity firms and other industry contacts), as well as on the capital markets side (talking to people on the trading desks and other hedge funds). And it is complicated, but at the heart of this is how you manage your time. Bernzweig: When Sun Capital went out and actually began to a hire dedicated team for its securities fund, one of the strategies that we put forth was to hire people with public markets experience. I am an equity analyst by trade. A couple of my partners are equity and debt analysts. Considering our backgrounds, the way we generate deal flow differs significantly from the way traditional private equity deal flow is generated. They’ll operate through relationships. Being in the public markets, we tend to take a more offensive approach. We run screens and really study up on industries, so we can be proactive in putting capital to work and not wait for opportunities to present themselves. Thorn: I would just echo that. I joined Marathon about two years ago [from Fox Paine & Co.] to help build their private equity business, and sourcing is one of areas that’s really different. I’ve been amazed at how robust the opportunity set has been. We have about 170 people and we have offices in five different geographies around the world. The deal flow that emanates out of those relationships is phenomenal. At a traditional buyout firm, we wouldn’t even know these opportunities existed. So we spend a lot of time proactively looking for opportunities, and at the same time we are reacting to a lot of the ideas that come through the various relationships that the firm has. I would say that around 70% of our deal flow actually comes from the firm-wide relationships. And to Steve’s point from earlier, we have to spend a lot of time prioritizing what to actually work on, because with the flexibility, we have to concentrate on what we can actually get done. Bonoff: I also came from a world that was strictly buyout focused. And when you are introduced into a world where the tentacles of your firm reach far and wide, there is a constant source of deal flow – more than enough to fill you plate. Mergers & Acquisitions: Let me ask, though, I imagine there has to be a delicate balance regarding how closely the private equity side can work in concert with the hedge fund side. A lot has been written about the conflicts that exist when you have a private equity business with access to non-public information, and there’s interaction with traders who are dealing with public securities. Fries: I think most situations that we are involved with, where there is both a private equity arm and a hedge fund, there is usually a desire to have some sharing of information, and the question is: How do you do that effectively? You may have the analysts who are used to looking at public markets and, from an industry basis, are useful to the private equity investors, or alternatively, the private equity team may have looked at a company a year ago and maybe there is some information that would still be useful. We spend a lot of time working with folks to try and figure out not only how to establish the walls from a regulatory standpoint, but how to establish a process so you don’t lose the benefits of having the various groups work together as part of the same organization. Zenni: In our case we are virtually always on the private side of the information wall so it is less of an issue. But I will tell you that this will be a much larger issue going forward. It is a real issue today. Chang: I agree. I think you have to decide at the end of the day what kind of firm you are, and what your investment philosophy is. You cannot really play both sides of the wall equally. If you are in the deal business and you are part of a hedge fund that leans toward the public side of the business, the investment bankers may hesitate to call you or won’t be as free in sharing information. They need to be confident in the relationship. Thorn: It is a key question, and I think it is fraught with a number of potential issues. If we are going to look at or be involved in an opportunity with a company that has public securities, we’ll restrict the firm on those securities. We also have separate floors, with all the private equity activity taking place on one floor and all of the public-market activity occurring on another. And that’s not to say we can’t share ideas and information, because that’s the real benefit of having analysts that follow different industries and can provide that kind of perspective. But we just don’t take any risks in these areas, because it’s not worth it. Bernzweig: I wouldn’t call it an issue. I would call it something that you just have to deal with and take very seriously. We have a lot of procedures and conflict checks that we put in place. Well in advance of initiating any public position, we have to be cleared by legal to make sure that we don’t have any material nonpublic information. And if there is any question, then we just do not engage in that investment. Fries: How this will be handled on the debt and equity side will be interesting as well. We are focused at the moment on the wall between public and private information, but once you have people who are getting information as a lender, you have to ask how that will play on the equity side. Thorn: I think that’s a really interesting question: Is bank debt a security? I don’t know if that’s been resolved, yet. Fries: Not really. Chang: At Clearlake we manage things a little differently. We operate as one large group and everyone works on everything, be it public, private, debt or equity. So the philosophy really goes back to fundamentals, and understanding the fundamentals of the industry to develop a clear idea of what we want to do. And we stay completely clean on this because we absolutely have a handle on our entire business and there is no coordination required. We’ll dip our toes in the capital markets if we know the industry really well and have some insights or ideas, but typically we are not trading at all. Bernzweig: I think another important aspect, which Steve mentioned earlier, is that you have to decide what type of firm you want to be. Often, we would prefer to own the whole company when we are looking at an investment in the public markets. However, either due to structural reasons or the fact that the company is just not for sale, we would still like to capitalize on the opportunity and initiate a public equity position. But if it comes down to the two avenues and there is a choice in the matter, as a firm we will pursue a going-private transaction as opposed to public equity position. Mergers & Acquisitions: We touched on this earlier, but I imagine there could still be some confusion on the part of sellers when it comes to a firm’s motivations. Especially considering Steve’s point about how bankers may be remiss to shop deals if there are any questions about conflicts. Thorn: I think generally speaking in today’s environment there are so many sources of capital that you have to work hard. You can’t sit around and wait for the phone to ring. You have to really work hard at generating interesting ideas and opportunities. And once we sit in front of a management team or in front of a seller and we talk about our backgrounds and the things that we have done, then they get a better idea of what we do. Maybe two years ago people had questions about that, but not nearly as many do today. Bonoff: I would just say I do encounter it. At conferences, I’ll often hear, “We didn’t think that you guys had a separate private equity fund,” or “We thought of you as a hedge fund or distressed shop,” and each time it’s a challenge for me to do a better job of branding us and making sure that I’m spreading the word about what we do. We do encounter it, but I think it is less so with every passing day. And I don’t view it as an obstacle at all, but rather as more of an opportunity for us. Bernzweig: We are actually the exact reverse. I think it is very clear to the market that Sun is a private equity firm and that our public market activities are an ancillary business. That said, we try to take our investment strategy, which focuses on turnarounds and special situations, and apply it to the public markets. And we are very operations oriented. We try to make all the resources that are available to our private portfolio companies available to our public holdings as well to help effectuate the outcome that we would like to see. Thorn: Have you ever thought about taking a more activist approach toward some of your public securities investments? Bernzweig: We do not consider ourselves activists. We do consider ourselves active. Therefore, when we pursue an investment, we are never going to write some sort of scathing 13-D letter berating management, although we reserve that right. What we try to do is be constructive with the management teams. We enter a company in a very friendly way and we try to explain the resources that we can bring to the table and work with them. Frequently, in the situations we are in, if a turnaround doesn’t come to fruition, it’s often the case that activists do become involved. Chang: For us it comes back to the focus question. We can’t be all things to all people, so we don’t compete with buyout firms in LBOs or hedge funds in trading securities. Our investment strategy really is based on convergence. We get involved in situations where capital is scarce, where you have to maybe look, feel, act, and analyze like a private equity firm, but we have the ability to move quickly in a structure like a hedge fund. So we’re really pursuing opportunities that take advantage of the cracks between these two large markets. Mergers & Acquisitions: Going back to Jason’s point, where do you think activists fit in this whole convergence conversation? Bernzweig: I think a lot of the activists out there often make good points about what could be done at these companies to create value. But, that said, they are financial-markets oriented and have typically never operated a company, so don’t have the ability to really push and carry out their agenda. Since we do actually have those resources, we consider it a differentiating factor at our Sun Capital Securities Fund. Chang: The activists certainly played a role in convergence over the last few years. You have even seen some of these activist funds roll their positions into buyouts, so there is an example of convergence right there. They’ve had a lot of success, in large part because of the private equity boom over the last few years, although it remains to be seen how successful going forward that play will be. Mergers & Acquisitions: That’s a good segue way into another topic that I wanted to discuss, which we’ve already touched on. Basically, everyone here has had a front row seat as this credit mess has unfolded. How did this happen, and how bad do you think it really is? Zenni: From my perspective we – fortunately or unfortunately – have had a front row seat. What you have seen over the last few months is a result of the excesses on the credit side that were created with all this liquidity, primarily from the CLOs and CDOs. Multiples could be very high, financial balance sheet structures could be very loose, and all of that couldn’t continue forever. So it snapped back quickly because the liquidity dried up on the CLO side, which has dried up financing for the financial sponsors. It will correct itself over the next few months and I think the result will be an environment where risk premium is more appropriately priced. But deals will still get done. Thorn: I agree with Jim. We are basically seeing two asset bubbles burst – one related to housing and the other related to credit, which had gotten very, very cheap and very loosely structured. An interesting question is: Will this carry over to the broader economy? Does the fact that housing values are lower impact how much someone spends at Wal-Mart? And I think if that is the case, then we are in for a bumpy ride. At the same time, we haven’t seen any impact yet in any of the companies we are involved with. Earnings continue to be strong and the business environment continues to be pretty robust. Zenni: I would argue that for folks like ourselves, this leads to a lot of opportunity. Multiples will come down and it will also bring to light some deficiencies in the business models or management teams. It also means that many of the companies that have been rescued over the last few years probably would have defaulted. Bonoff: Unfortunately, some of those loose credit structures will potentially extend out the time horizon before some of these companies can’t bear the burden of the debt they took on. With these covenant lite models, they are going to be protected I think a little bit longer than they should be. Thorn: We need to come up with a new measure for defaults, because a lot of the loans that were issued last year are default proof. With covenant lites, PIK toggles and equity cure rights, companies have to simply run out of money in order for those loans to default. Mergers & Acquisitions: The covenant lite loans and PIK toggles are largely a phenomenon of the bigger deal market. How will the current shakeout impact mid-market companies in particular? Thorn: In terms of financing today, it’s the deals that aren’t as big that are the easier deals to get done. And I think the larger lenders that weren’t so focused on the middle market in the past will now start to spend more time in this area. But having said that, there has definitely been an impact on all financing, and the cost of debt has climbed across all areas of the market. Chang: This is where you are going to see an example of convergence funds becoming more active, as they can go out and buy up some of the debt in the capital markets and they’ll also be active making private loans to middle-market companies. The middle market has a more diversified base of lenders, and obviously requires less capital, so you’ll see deals in this area continue to get done. Mergers & Acquisitions: During the last downturn, back in 2001 and 2002, the middle market was probably the most impacted by the liquidity dry up. What makes it different this time around? Bonoff: During the last boom, the former middle market lenders either consolidated or migrated to the larger market. But since then, a new crop of lenders and alternative lenders have moved in to fill that void. And we’ve even seen some of the larger banks address the middle market, too. There will likely be a pullback in the middle market as well, but considering all the lending options that cater to this market, it shouldn’t create another void. Mergers & Acquisitions: Everyone here seems to have some experience in distress. Is there a link between distressed investing and convergence, or is it just another instance of flexibility? Chang: My partners and I have a lot of experience in dealing with distressed situations. We have all served on creditor committees and we have been involved in operational turnarounds. But we don’t think of ourselves as distressed investors at all. It’s really just another tool in our toolbelt, which includes complicated buyouts, carveouts, capital market accumulations and restructurings. That being said, I do feel that distressed investing has its own philosophy and rules that you need to really understand to be active. Zenni: Distressed investing: I don’t even know what it means anymore to be honest. I mean, if you look at the history of transactions we have been involved with, there has always been some event that alters the company for some reason or another. It could be cyclical; it could be economic; it could be external; or it could be geopolitical. It is always something that alters the terrain of the business, which then alters the enterprise value. And what we try to do is find companies that have had some event where we can come in, work with the existing management in most cases and effectuate a change. If that’s distressed, then I guess that’s what we do. Bernzweig: In the case of Sun, when we think about distressed, we think about it very similarly to you. We don’t think about distressed securities. We are not financial architects. But we’ll deal with operational situations, whether they are company specific or cyclical, that have caused a company to underperform. Mergers & Acquisitions: Moving back to the current market, what’s everyone’s take on how the credit dislocation will impact overall universe of hedge funds and PE firms? If you guys believe Jim Cramer, he predicted that the number of hedge funds will be sliced in half. And then on the PE side, Tony James, Blackstone’s president, alluded to a shakeout in the industry that is wiping out some of the peripheral players. Do you guys see the universe of competitors getting smaller and what will be the impact? Zenni: We have seen it before. What’s happening is just part of a natural cycle. We saw it ten years ago, when there were some private equity shops and hedge funds that went away, although I’m not necessarily sure whether it ultimately helps us or hurts our business. Chang: Part of it really goes back to your earlier question about your capital base. Is it long-term capital or short-term capital? Clearly private equity firms have more stability because of the long-term capital base. Hedge funds, in turn, have less stability. For the hedge funds whose strategies were based on leverage, you are seeing some pain in the market as investors begin unwinding those positions. Thorn: It is really hard for private equity funds to shake out. You have six years in most cases to invest the capital and six years to harvest it. So you may see a firm struggle through a period. But this is by design, because the idea is to build long-term shareholder value behind the structure of the private equity fund. I think you may see some firms have some trouble raising a next fund, because maybe they made some bad investments. It does happen, but not nearly as often as you might think. Bonoff: I think it’s more of a question among the hedge funds, where some with exposure to subprime or even the public equity markets could be licking their wounds a bit. Mergers & Acquisitions: Let’s talk about returns for a second. As hybrid investors or even guys that may be more inclined to invest along the full spectrum of the capital structure, what kind of returns are you aiming for? Thorn: It depends on the asset class. If you are buying bank debt, it is going to be a different number and it is probably going to be levered on your balance sheet. If you are buying private equity, it is certainly going to be a higher number and it is going to be unlevered on your balance sheet. At least that’s how we think about it. What some firms struggle with is thinking about IRRs versus ROIs, because ROIs tend to be more important from a private equity standpoint, whereas on the hedge fund side, you are looking more at annual returns, which can be a little bit more IRR driven. It is a constant balance to figure out how to bridge those two approaches. Chang: The other part of the return analysis for investors is how you return capital. For instance, most people in this room are pretty familiar with the J curve. One of the attractions of hedge funds is that the return can be calculated fairly quickly. So we try to strike a balance between these two areas. Bernzweig: We tend to think of it as relative performance, and one of Sun’s mandates in our marketing materials is that we try to be in the top decile of private equity returns. On the securities fund side, where it becomes a little more difficult, we do have the significant public equity positions and private positions, so it is a hybrid-type of return. There, we try to seek the appropriate risk-adjusted return for each investment, whether it is debt, public equities or private equity deals, and each of those have their own return parameters. One of the things we have struggled with internally is thinking about the returns in the public equity portfolio, because we deploy a very similar investment strategy as we do in the private equity side and we consider ourselves as long-term money. We don’t look at interim fluctuations in value while we are trying to effectuate a turnaround. We just try to keep to our conviction that that the turnaround will occur and when it does, we will eventually achieve the value we want. And rather than being mark to market every month like a hedge fund, we try to keep the long-term mentality. Mergers & Acquisitions: Do you guys have any projections about what we’ll see in the next six months to a year. It doesn’t even have to be about private equity or the hedge fund market. Any projections will do. Thorn: I think there are going to be great opportunities over the next six months for value-oriented investors in all parts of the capital structure. So I think having the flexibility to invest in different areas is really going to allow you to take advantage of those opportunities. That’s a near-term projection. Zenni: I think it is a given that defaults will rise. They have to, and it can’t go on much longer. Do we go back to the 2001 timeframe? I think high-yield defaults peaked at 14%, bank loans peaked at seven or eight percent. Do we go back to those levels? I don’t know. We could. But I personally think that defaults will rise. Mergers & Acquisitions: Will this be true among private equity-owned companies, or will they try to keep those businesses afloat with equity infusions? Zenni: I have seen it all over the board. You look at some of the private equity deals that were done in the late nineties, early 2000 timeframe, and in some of the transactions they infused new equity and that was a smart thing to do. Others, I saw them walk away from their investments. And then there were those who put more equity in and that probably wasn’t the smartest thing to do. It just really depends on the situation. Thorn: It is interesting because in the late nineties, a lot the companies private equity firms had invested in simply did not have good business models. And today, at least among the mega deals, most of the companies are good, solid businesses – they’re industry leaders. They might be capitalized wrong or the buyers may have priced their deals to perfection, so to speak, so it will be interesting to see if the investors will put more equity into them. But the belief is that long term, these are good businesses. Zenni: The problem, though, is just that they paid a very high multiple and as a result there is a very high multiple of total senior debt. So for them to put new equity in probably doesn’t make much sense. But it could make sense – assuming there is a downturn – for them to be buying up the junior debt, or even the senior debt. I could see that happening. But Wray is right. These are far better companies today than [PE-backed businesses from] ten years ago. Bernzweig: The circumstance we find ourselves in today, at least so far, is a re-pricing of risk. We are not necessarily in a significant fundamental downturn. A lot of the companies in our portfolio are no different than they were three or even six months ago. To the extent we remain in a positive economy, there is no reason to believe that our investment is any different than what we entered into. Chang: I think the question still remains, though, will the tail wag the dog. Will the downturn in real estate and the downturn in the leveraged finance markets end up impacting the economy at some point. With that said, we’re not trying to predict the economic cycle, so we have actually been taking advantage of the repricing of risk by deploying capital very selectively into defensive noncyclical industries, such as healthcare. Bonoff: For value oriented investors, which it seems like we all are, I think this is going to be a great stretch and it will be exciting. And on that note, it’s time to get back to work. Participants Daniel Bonoff Angelo Gordon & Co. Elizabeth Shea Fries Goodwin Procter James Zenni, Jr. Z Capital Partners Jason Bernzweig Sun Capital Partners Steven Chang Clearlake Capital Group Wray Thorn Marathon Asset Management Ken MacFadyen Mergers & Acquisitions