Hedge Funds Jump Into Private Equity

Eager to boost performance, they're entering the market at a risky moment

Hedge fund magnate Steven A. Cohen is running with a new crowd on Wall Street. After hiring a seasoned private equity dealmaker in December, Cohen's $12 billion SAC Capital Partners teamed up with buyout king Kohlberg Kravis Roberts & Co. on a $3.1 billion deal for the higher learning outfit Laureate Education Inc. (LAUR ) in late January.

Cohen isn't the only hedge fund guy expanding his repertoire. Hedge funds accounted for at least 50 private equity deals in 2006, according to Dealogic. Most recently, Farallon Capital Management joined with real estate investment trust Simon Property Group (SPG ) on a pending deal to buy mall operator Mills (MLS ) for $1.56 billion. ValueAct Capital jumped into the $3 billion deal in December for used-car auctioneer ADESA Inc. (KAR ).

The lures of private equity are twofold. First, hedge funds want to tap the gusher of money flowing into private equity from institutional investors. Second, and more worrisome, hedge funds as a group need a way to boost their performance. The average fund returned 13.9% in 2006, according to the Credit Suisse/Tremont Hedge Fund Index--not much better than the 13.6% return of the Standard & Poor's 500-stock index. The typical buyout fund soared 25%, according to Mercer Investment Consulting Inc.

True to their nature, hedge funds are exploiting opportunities overlooked by their bigger private equity brethren. While brand-name firms are arranging mammoth buyouts--Blackstone Group's record $39 billion acquisition of Equity Office Properties Trust (EOP ), for instance--hedge funds are setting their sights on smaller prey. DE Shaw & Co., one of the more active hedge funds in the private-equity space, sank $500 million into Kentucky's ERORA Group, a private developer of coal gasification plants. It's a typical size deal for the group.

In many ways, hedge funds' move into private equity is a natural progression, especially for the larger funds. Many are getting into the lending business, providing capital to startups and even financing more exotic ventures such as Hollywood movies. "[Private equity] is a perfect extension of what we do," ValueAct Capital founder Jeffrey Ubben says.

The lines between hedge funds and private equity funds will only get more blurred as more hedge fund types look to emulate $30 billion Fortress Investment Group (FIG ). Fortress, which saw its stock soar 68% in its first day of trading on Feb. 9, will deploy its capital any way it can to make money.

But the move into private equity is fraught with risk. Hedge funds are famous for their short-term investment horizon, usually a year or less. By contrast, buyout firms often take 3, 5, or even 10 years to extract themselves fully from private equity deals. The longer time line can make it more difficult for a hedge fund manager to price an investment.

INHERENT DANGERS

What's more, private equity deals are illiquid transactions, meaning a manager can't quickly turn them into cold cash. If too many investors seek to redeem their money, the fund could develop a cash crunch. That's one reason some hedge funds are putting limits on how quickly investors can reclaim their money. Most hedge funds require investors to keep their money locked up for a year. But funds moving into private equity are upping that period to three years.

Another danger: timing. Some on Wall Street are fretting about a private equity bubble. In particular, they worry about the debt that firms are heaping on companies they take private. Entering the market now could be highly dangerous, especially since these deals require real expertise. The question is whether hedge funds will have the skills to pay the bills when the burning-hot buyout market cools.

Then again, hedge funds are supposed to be skilled at hedging risk. If private equity blows up, and the distressed debt market tanks as a result, it'll just be another buying opportunity.

By Matthew Goldstein

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