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Hedge Funds: A threat to Private Equity?

Due to various common characteristics, private equity and hedge funds are often mentioned in the same breath. Some investors have even come to view the two asset classes as being in direct competition with one another. Dr. Isabelle Borello and Dr. Hanspeter Bader of Unigestion argue that the comparison is often over simplified and that rather than representing a substitute for private equity, hedge funds can provide a rewarding complimentary investment strategy.

During the long downwards-trend in the equity markets between 2000 and 2002, hedge funds were generally considered to be a very attractive investment proposition. They promised de-correlation to public equity, positive returns between five per cent and ten per cent and reasonable liquidity. During this same period private equity was in a less comfortable position, characterised by negative returns, higher than expected correlation to public equity and nearly no liquidity. As a consequence, the hedge fund industry experienced a high capital inflow at a time when private equity was struggling to attract any major interest. Many investors therefore started to see hedge funds in competition with private equity.

But in this article we argue that it is an oversimplification to classify hedge funds as a single asset class. Rather, we differentiate between two universes of hedge fund strategies, which we define as the equity hedge fund universe and the defensive hedge fund universe. Defensive hedge funds have certain bond-like risk characteristics, and are therefore clearly not in competition with private equity. Equity hedge funds have certain risk characteristics that are close to private equity and could therefore be considered a threat to private equity.

However, rather than considering equity hedge funds as a potential substitute to private equity, at Unigestion we exploit the similarities to deal with two key problems of private equity investing; the downside risk of private equity and the efficient use of committed, but un-invested capital. By combining equity hedge strategies with private equity we can substantially increase the performance of a private equity commitment while reducing the downside participation to public markets by over 70%.

Hedge Funds: Two Distinct Universes

“Hedge funds” is a generic name given to a set of investment strategies, which have risk and performance patterns that differ from traditional markets. The following graph illustrates the trade-off between return and volatility for the main strategies within the overall hedge fund universe. For illustration purposes we also plotted the risk/return position of private equity into the chart.

Taking this a step further, and in order to understand the sensitivity of the different strategies to traditional markets, Unigestion analysed their respective correlations to both bonds and equities. Two distinct universes emerge:

• The “defensive” universe consists of strategies such as Global Macro, Forex, System Traders as well as certain arbitrage strategies. Because the volatility of these strategies combined is close to that of bonds, institutional investors will typically take the allocation for defensive hedge funds from their bond allocation and not from equity. Investing in defensive hedge funds reduces risk through diversification across different strategies while generating performance which is uncorrelated to both equity and bond markets. Therefore the defensive hedge fund universe is clearly not in competition with private equity.
• 
  The “equity” universe includes such strategies as Long Short Equity, Merger Arbitrage and Event Driven, which have an implied correlation to equity markets but substantially lower volatility. Because of the positive correlation investors should typically take the allocation for equity hedge funds from their “traditional” equity allocation. The equity universe seeks to provide asymmetric performance, i.e. maximum upside participation in rising markets with only limited participation on the downside. With these attractive features, equity hedge could theoretically be considered an alternative to private equity, especially in markets with little direction and substantial down-side risks.

Compared to hedge fund strategies, private equity shows relatively high volatility but also high long-term returns. The correlation characteristics of private equity are, however, quite similar to some of the equity hedge strategies, especially to “Event Driven” and “Long Bias”. This is also intuitively understandable: What is private equity, if not “Extremely Long Bias” due to its illiquidity and long holding period and “Extremely Event Driven” due to the value-adding strategies of the private equity managers?

The similarities in correlation of equity hedge funds and private equity, their asymmetric performance pattern (i.e. maximum upside participation but only limited downside participation) and their liquidity make equity hedge funds an attractive “tool” to manage the committed, but un-invested private equity capital.

Efficient use of un-invested private equity capital

Making a commitment to a private equity fund of E10m does not mean that E10m will ever be invested in private equity. Typically, capital is called from investors over time and repaid again when the underlying investments are realised (see below graph). As a result, at any given time a commitment of E10m is only partially “at work” in private equity.

When measuring performance, the private equity industry uses the “internal rate of return” or IRR. The IRR measures only the performance of the money that is “at work” in private equity. An IRR of 15 per cent for example doesn’t mean that the investor earned 15 per cent on the E10m but 15 per cent on the money “at work” in private equity. If the un-invested capital is therefore left idle or invested inefficiently, private equity can easily become a sub-optimal asset class.

Equity hedge funds are an attractive alternative for un-invested private equity capital for the following reasons:

(1) Equity hedge funds are similar to private equity in their correlation characteristics with bonds and equity. They have therefore a similar diversification effect as private equity.

(2) The asymmetric performance pattern allows the upside potential of the non-invested capital, while reducing the downside risk.

(3) The relatively good liquidity of most equity hedge funds allows investors to regularly “feed” the private equity portfolio when the capital is required for investments.

To demonstrate the impact of investing un-invested private equity capital in equity hedge funds, we use Unigestion’s proprietary Private Equity Index [1] . We have calculated the performance, volatility and correlation of three different portfolios: (1) the S&P 500 index, (2) Unigestion’s Private Equity Index with un-invested capital [2] in cash and (3) the Private Equity Index with un-invested capital in equity hedge funds. The graph below shows the evolution of the indices.

The following conclusions can be drawn:

(1) Private equity with equity hedge funds clearly outperforms the S&P 500 as well as private equity with cash.

(2) The volatility [3] of private equity with equity hedge funds (9.73%) is significantly lower than the volatility of the S&P 500 (15.81%) and similar to private equity with cash (9.49%). Private equity with hedge funds is therefore especially attractive on a risk-adjusted level.

(3) The following graph shows that private equity generally has a low participation rate to public equity in bear markets while maintaining a large part of the upside potential in bull markets. The addition of equity hedge funds slightly increases this participation rate due to a higher sensitivity to equity markets.

Bear and Bull Market Participation
Quarterly Average Return – From 31.12.93 to 31.12.03

Conclusion

Due to certain similar correlation characteristics to traditional assets, we believe that equity hedge funds can be considered complementary to private equity. Both can be combined as effective diversifiers in an equity portfolio. Equity hedge funds and private equity are particularly complementary in terms of risk-adjusted returns as well as different in terms of underlying assets. Therefore they are effective diversifiers for a traditional equity portfolio.

Additionally, investing un-invested private equity commitments in equity hedge funds generates a combined exposure with higher risk-adjusted returns than private equity or public equity alone. Public equity participation rates during bear market conditions are low, while maintaining a large part of the upside potential during bull markets.

[1] Unigestion’s proprietary Private Equity Benchmark was constructed due to the lack of a reliable publicly available private equity benchmark. It is based on public market indices (e.g. S&P 600 or MSCI Small Cap for buyout investments and Nasdaq or MSCI Information Technology for venture capital), adjusted for the cash flow pattern of private equity funds (capital call period, distribution period), the lack of valuation during the first years, vintage year considerations and a risk premium of 5% over public equity. The graph is based on the following assumptions: 75% Buyout and 25% Venture Capital. Indices are based in USD.

[2] Un-invested capital : Undrawn commitments in private equity funds and distributions received from private equity funds.

[3] Volatility is defined as the annual standard deviation of monthly returns from 12/93 – 12/03.