Hedge Funds Joining the Private Equity Game

Wednesday’s announcement that Highfields Capital Management, the Boston-based hedge fund, plans to bid for ownership of Circuit City, marks the latest development in the unwanted intrusion of big hedge funds into the world of private equity deals and leveraged buyouts.

Last September, Henry Kohlberg assailed hedge funds that dare encroach on his territory. During his keynote speech at the Private Equity Analyst Conference, he argued that fund managers essentially have no experience improving the management of the companies they invest in, something essential for success in the private equity game, and only fair to the employees and other investors of the target company. In contrast, private equity investors take an ownership stake, if not outright ownership, in companies whose operations and financial management they intend to enhance.

Others in the investment community, however, are not surprised or outraged by hedge funds’ interest in private equity. "I see it as a natural progression of what some hedge fund managers already do – working with less liquid assets," said Justin Dew, senior hedge fund analyst at Standard and Poor’s. "What it boils down to is that when these guys get sufficiently large, they’re going to want to diversify into other businesses and keep them in-house."

The more pressing question, according to Justin, is how best to integrate these businesses. Justin said that some hedge funds are "side-pocketing" private equity deals, which essentially means keeping them separate from their hedge funds. Hedge fund assets – options, futures, and complex derivatives – are far easier to sell off than an ownership stake in a firm. "If they’re mixed, you could have a liquidity mismatch." In the worst case scenario, fund managers would not be able to redeem the shares of investors looking to cash out of their fund. “For this reason, it probably makes to set up a separate operating unit,” said Justin.

Kohlberg and likeminded private equity investors can take comfort in the fact that Circuit City has plenty of means with which to defend itself a Highfield’s hostile takeover. Unfortunately, the company could not be reached for comment because a corporate plane crash recently took the lives of eight Circuit City employees.

In the end, Kohlberg and others may actually benefit from the participation of hedge funds in bidding for companies; when one investor announces a takeover interest in a high-profile target like Circuit City, it opens the gates for others to bid, and Wall Street banks may start lining up behind Kohlberg, fueling his business.