0.14.1.m: Sources of Capital: Hedge Funds

HEDGE FUNDS

The investment universe tends to be divided into three broad categories: stocks, bonds, and alternative investments. Alternative investments include real estate, commodities, private equity, and hedge funds. The SEC describes hedge funds as private unregistered investment pools that traditionally have been limited to sophisticated, wealthy investors; they are not mutual funds.^[49]

These funds employ various investment strategies and techniques seeking higher-than-market returns, and in some cases investing in emerging growth and middle-market companies. The line of distinction between the hedge funds and private equity funds has blurred as hedge fund managers seek to boost returns, diversify risk, and attract more capitalS0 by making^[50] investments in areas traditionally targeted by private equity.

As a source of financing, hedge funds make debt and equity investments using some traditional financing structures (i.e., participating in preferred stock rounds with venture investors) and some recently popular ones. One of the more recent investment approaches adopted by hedge funds to invest in middle-market companies has been tranche B or second lien financing. This junior debt sits below the senior lender in claim priority against some or all of the assets of a company. Table 5.15 illustrates how second lien financing compares to private equity mezzanine financing. Distressed debt funds, specialized high-yield funds, a few commercial banks, and some commercial finance companies also accelerated junior debt lending as credit in the early part of the decade became plentiful. During the five years leading up to the 2008 credit crisis, second lien deals drove the effective cost for high-yield debt down and forced many mezzanine lenders to sit on the sidelines. As the credit markets began to freeze in 2008, second lien financing declined significantly and the pendulum swung in favor of mezzanine deals as borrowers sought more stable (and available) debt financing.

Hedge funds have also been active with investments into publicly traded companies seeking private placements using PIPES (see Glossary). This type of investment has allure for both hedge funds (because they have at least the potential for liquidity and ease of valuation of assets) and private equity funds (frequently used with smaller public companies of the type often appealing to private equity funds-i.e., the ability to invest in illiquid and potentially undervalued companies).^[51]

Given the market meltdown at the end of 2008, we are unsure of the future of hedge funds in early stage or middle-market deals. In addition, it is not clear how the tradingshort-term temperament typical of hedge funds will play out in private equity over the long term, as patience and some operating experience are likely required in times of turbulence, change, and growth of privately held companies.

^[49] Securities and Exchange Commission, "Invest Wisely: An Introduction to Mutual Funds."

^[50] Harris Smith, "Crossing the line: The growing convergence of private equity and hedge funds," Grant Thornton white paper, 2006.

^[51] Ibid.

The above material is excerpted from:

The Handbook of Financing Growth: Strategies and Capital Structure by Kenneth H. Marks, Larry E. Robbins, Gonzalo Fernandez, John P. Funkhouser and D. L. "Sonny" Williams.

To order the Entire Second Edition of, The Handbook of Financing Growth: Strategies, Capital Structure, and M&A Transactions, 2nd Edition

This material is used by permission of John Wiley & Sons, Inc.