Hedge Funds, Private Equity and Side Pockets

In my last post (Searching for Alpha), I commented on how applying hedge fund metrics to private equity fund performance creates unique complications. Recently another phenomenon in the convergence of alternative assets has emerged as a hot topic—hedge funds making investments in illiquid private companies. In a large buyout deal announced earlier this year, KKR teamed with a consortium that included hedge fund S.A.C. Capital to acquire Laureate Education Inc. for $3.8 billion. On the venture side, Sequoia Capital teamed with San Francisco-based hedge fund Artis Capital Management to invest $11.5 million in YouTube. While Google’s $1.65 billion acquisition of YouTube made it one of the most successful venture investments of 2006, not every investment has a fairy-tale ending and the relationship between fund managers and their investors can change dramatically when the investment takes a turn for the worse.

Private equity funds are generally structured as ten-year partnerships to match their long-term investment horizon. The only path to liquidity for limited partners is typically through a secondary sale to a replacement LP, often a specialty firm such as my employer VCFA Group. In contrast, hedge funds tend to have limited lock-up periods and investors can withdraw their capital during pre-determined redemption periods. The ability for investors to withdraw their capital at relatively short notice can create a spiraling death cycle if a hedge fund is not invested in highly liquid assets. Many hedge funds that also invest in private equity try to mitigate the withdrawal risk in their illiquid investments by creating “side-pocket” funds. The side-pocket funds have an economic structure that will more closely resemble a private equity fund.

There are two important considerations for hedge funds relying on side-pocket vehicles: First, depending on the investment opportunities that arise, a side pocket could easily outpace the growth of the primary hedge fund. While this might not be an issue for many funds, it could potentially be an unwelcome surprise for investors expecting access to liquidity. Second, hedge funds should consider how they will react to an investor who requests liquidity in a side-pocket vehicle. In the private equity market, General Partner groups have learned to use the secondary market for their own portfolio management process. Hedge funds utilizing side pockets should proactively consider how they will handle liquidity when the requests inevitably arise. Since most private equity secondary transactions are not performance related, it is highly likely that even the best performing side-pocket vehicles will encounter requests for liquidity.

Private equity firms that co-invest with hedge funds should also consider how the hedge fund will handle liquidity requests. We have heard stories of hedge funds that needed to quickly sell illiquid positions creating an undesirable situation for their portfolio companies by destabilizing their investor base. Historically, private equity firms and their portfolio companies desire stable, long-term investors. Whether true or not, many hedge funds have developed reputations as short-term momentum investors. Side-pocket vehicles will help to mitigate the liquidity risk for private equity co-investors and portfolio companies, though the liquidity considerations remain important.

If you are interested in hearing a lively discussion of the private equity secondary market, hedge funds and liquidity issues, I will be chairing a panel on the topic on June 27 at the New York Society of Securities Analysts headquarters in Midtown Manhattan. The panelists will include Dayton Carr, the founder of VCFA Group and a pioneer in the private equity secondary market. Dayton created the private equity secondary industry almost 25 years ago and will discuss emerging liquidity issues in relation to hedge funds. You can register for the event until Friday, June 22, at the link below or via the PEHub.com calendar.

Event Registration