Hedge Funds and Private Equity Capital Raising in the Current Environment in the EU - Essay Example

? Hedge Funds and Private Equity Capital Raising in the Current Environment in the EU Introduction Hedge Funds According to Brigham &Ehrhardt (2005) a hedge fund is an organization that manages money. This money can be invested in essentially any type of assets in just about anywhere in the world. Originally they bought undervalued securities and sold what they believe to be undervalued securities short. Currently, hedge funds take positions in hedge funds as well as other complex derivatives. Madura (2006) indicates that hedge funds sell shares to the wealthy individuals and financial institutions and use the proceeds to invest in securities. Most hedge funds establish and organize themselves as limited partnerships because of the flexibility that it allows them. In order to withdraw funds investors have to give notice of 30 days or more. There are approximately 7,000 hedge funds with market values of US$1 trillion. According to McCaherty and Vermeulen (n.d.) hedge funds take a variety of forms and are characteristic of the pursuit of high returns and the use of leverage to enhance the return on their investment. In recent times hedge funds and private equity have come to represent a significant part of financial activities in the financial markets in Europe, USA and Asia. The sizes of these investments are large as they continue to grow. Fund managers use a number of strategies, traditional techniques and a number of instruments such as equity, debt, options, futures and foreign currencies. In recent times hedge fund managers have engaged in high risk investment strategies including currency trading, credit derivatives and restructurings in order to obtain above normal returns on their investments Private Equity Private equity fund managers invest mainly in unregistered securities. However, in recent times they have been engaged in taking private a number of publicly listed companies. They use a number of different investment strategies with varying levels of liquidity. Private Equity Firms are not only involved in providing funds for new and developing companies but they are also engaged in the provision of funds for corporate restructuring, management buy-out and leveraged buy-outs. One Writer attributes the emergence of the buyout fund as the dominant style of investment to favorable credit market conditions, a large supply of loan funds and low interest rates, changes in the preferences of investors, a large number of publicly listed private equity vehicles and the increase in the demand for alternative assets by institutional investors such as pension funds. Brigham and Ehrhardt (2005, p. 664) indicates that “in a going private transaction the entire equity of a publicly held firm is purchased by a small group of investors that usually includes the firms current senior management.” There are usually two ways in which this transaction is carried out. In one instance the managers acquire all the equity of the company and in the other it does so with a small group of investors who set the previous managers to manage. These are referred to as management buy-out (MBO) and management buy-in (MBI) respectively. This process normally involves substantial borrowings and is therefore described as Leveraged buyouts (LBO). Another term which is normally used is “taken private” which relates to a buyout of a public company and in the process removing it from the stock exchange listing, and therefore transforming it into a private firm (Fraser-Sampson, 2007). Public companies are normally taken private because they have the potential of providing substantial cash flows to investors as the shares are currently undervalued on the stock market. The managers see the potential of “significantly boosting the firm’s value under private ownership” (Brigham and Ehrhardt 2005, p. 664). This means that companies taken private have the potential of enriching not only the managers who take part in the buyout but the public shareholders who are often offered prices higher than the going market price to sell their shares. Sometimes these shareholders resist but in the end they have to sell their shares because the buyers have enough of the company’s shares to sufficiently influence the takeover of the public company. A large number of public companies have been taken private over the years. Arguments for and against public to private transactions A number of arguments have been leveled against public to private transactions. However, there have also been several arguments in its favor. According to Becky (2002, Private vs. Public …) “… in the 1980s a lot of public companies were taken private through a process called a leveraged buyout. That trend may have benefited the entire economy by making the companies a good deal more efficient.” Arguments against public to private transactions Opponents to public companies being taken over by private equity have leveled a number of criticisms against these types of transactions. They believe that some of these private equity managers actually buy public companies, reduce employees, strip the companies of assets and then sell them in secondary buy-out deals. Some also indicate that they are allowed to set off interest payments against income and in the process paying less tax. According to Wiley (2007, p.79) “some countries are pursuing tougher and tighter ‘thin equity’ tax rules under which it can be difficult to make loan interest fully deductible.” Adding value by increasing earnings multiple Some of the opponents of these types of transactions have indicated that there are many ways the managers of public companies could add value to the company instead of allowing them to go private. These include taking out loans instead of issuing more shares which would be favorable to shareholders as they would see their earnings per share increase. These companies would also pay less tax because the interest on these loans is tax deductible. Increasing the cash flow of the Company Cash flow can be improved through proper management of public companies. There is normally unpredictability in the levels of cash flow in public companies that have been taken private and which therefore need to make regular interest payments. Debt added to private company These purchases normally take place with the use of large amounts of debt, referred to as leveraged buy-out (LBO). High levels of debts in the private equity system could pose potential dangers for these companies (Acharya et al, 2008). Because of the high levels of debt and the consequent regular payment of interest some companies go bust soon after because the anticipated cash flows do not take place to make the relevant interest payments. Public Companies have superior access to capital and liquidity Public companies are not usually highly leveraged and so they have the capacity to borrow and remain viable. This is as opposed to a LBO which does not have the immediate capacity to take any more loans after the buyout. The stock market provides public companies with better access to funds. They can issue new shares to current shareholders by way of a rights issue and they could also convert debt into equity if that option was laid down in debt covenants. Balancing of stakeholders interests Private equity firms are concerned with a limited number of stakeholders. They are not expected to have their annual report ready within any specified time period as is the case with a public company. Issues of governance such as audit compliance, risk management and remuneration are serious issues in public companies (Acharya et al 2008, The voice of experience …). Management therefore has to balance the varying interest of their stakeholders- the community in which they operate, the shareholders, employees, advisors acting on behalf of potential investors, the government and their customers. Arguments in favor of public to private transactions According to Brigham and Ehrhardt (2005, p. 664-665) “the primary advantages to going private are administrative cost savings, increased managerial incentives, increased managerial flexibility, increased shareholder participation, and increased use of financial leverage, which of course reduces taxes.” Other arguments in favor of public to private equity includes the ability of private equity firms to add value to the business, thus increasing earnings multiple. Additional arguments include the avoidance of regulatory requirements, long term strategic planning, the alignment of the interest of management and owners, stakeholder management and superior performance management. Administrative cost savings The requirements for public companies are stringent and involve the preparation of quarterly as well as annual reports in addition to securities registration. This along with the investor meetings that are normally held in publicly listed companies to brief shareholders and investors and to vote on resolutions are normally time consuming. In addition to eliminating certain non-value added costs going private releases management from administrative matters that do not add value to the company. Consequently, they therefore have the opportunity of spending time on value added activities which benefits the company and are generally in the best interest of stakeholders. Increased managerial incentives There are increased benefits to be gained from high levels of managerial performance. According to Brigham and Ehrhardt (2005, p.665) “Their increased ownership means that the firm’s managers benefit more directly from their own efforts, hence managerial efficiency tends to increase after going private.” There is an incentive for them to work hard to ensure that the firm does well as they could see themselves benefiting tremendously from increases in the net worth of the company. The possibilities of huge returns are tremendous but if the firm does not do well they stand to lose their investments. The fact that they have a stake in the firm therefore provides them with the impetus to carry out their functions well. Increased Managerial Flexibility The short term focus on returns to shareholders’ equity in public companies no longer exists. They are more focused on the long term and building a firm foundation. They now have the opportunity to take the necessary risks which has possibilities for huge returns. They are no longer constrained with satisfying a broad group of stakeholders and so they do not have to worry about a fall in the share price as it is with a publicly traded company. The pressures that they normally come under, no longer exists like ‘heavy weights’ on their shoulders. It’s like ‘freedom at last’ and so if they want to sell an asset it does not have to be approved or “justified by a large number of shareholders with potentially diverse interest” (Brigham and Ehrhardt 2005, p. 665). Increased shareholder participation According to Brigham and Ehrhardt (2005, p. 665) “going private typically results in replacing a dispersed, largely passive group of pubic shareholders with a small group of investors who take a much more active role in managing the firm.” These new investors have a key position in the business and are therefore in a position to monitor the management of the firm and ensure that they are adequately monitored and provided with the necessary incentives which will encourage and motivate them to aim for high levels of performance than they would normally have in a publicly listed company. Increased financial leverage This has the advantage of reducing the amount of tax the firm pays and forces managers to hold costs down in order to ensure that interest payments are made. Brigham and Ehrhardt (2005, p. 665). This has merits in that the shareholders make greater returns on their investments. Going private add value to public companies Value creation is the main factor or argument of the proponents of public companies taken private. Private equity firms add value to pubic companies in ways that publicly managed companies cannot imagine. Normally after an average of three years the earnings multiple of the business is increased significantly. In addition to the undervalued stocks of publicly listed companies, private equity firm managers usually identify labor productivity as a key aspect of the ingredient to increasing returns and added value. They create value by eliminating none value added activities over a period of time through value engineering. In this process of creating value excess labour is generally the first ‘excess fat’ that is trimmed. By doing so the productivity of labour is increased. According to Wiley (2007, p. 87) “the ability to grow the earnings of a company is the most prized of buyout firm abilities”. Private equity firms are not as risk averse as public company managers who are constrained by the wishes of their shareholders and so do not have a free hand in making the choices that they may want to make which can determine their fate in the company. Bernstein (qtd. in Shaw, 2003) states that: “Risk is a choice rather than a fate. The actions we dare to take, which depend on how free we are to make choices, are what the story of risk is all about. And that story helps define what it means to be a human being.” Avoidance of regulatory requirements Public companies call for strict regulatory requirements. These requirements mean that public companies sometimes have to shift resources from value added activities to get their financial statements out on time. Non-presentation of financial statements can result in fines and delisting from the stock exchange. This is not so in private equity firms and so managers are free to spend time on value added activities and ensuring that the long term objectives of firms are achieved. Long term strategic planning Private equity firms are focused on the long term for a number of reasons. Managers will not be able to earn bonuses for themselves if the company does not do well. After the takeover of a public company some time would pass before private equity managers start to see some returns on their investments. Because the company is normally highly leveraged, the focus has to be on ensuring that the cash flow is there to make loan repayments and to provide the managers who are the owners with a fair return. The focus is on growth and value creation over the long term. Aligning the interest of ownership and management In private companies the owner and manager is the same and therefore the interests of both groups are aligned. This is different from public companies where the managers are not the owners. Some may own a few shares but not enough to have any major influence on decisions. Managers in private companies are generally focused on ensuring that the company does well. Unnecessary or unproductive employees are terminated and employees are monitored to ensure that they carry their end of the bargain. Stakeholder management Management of stakeholders and their needs is very important to the success of any company. While public companies have a wider range of stakeholders, the private equity firms have only the fund investors who are in it for the long haul. According to Acharya et al (2008, The voice of experience …) the effective stakeholders in the private equity funds are essentially locked in for the duration of the fund. The private equity fund managers who invest on their behalf are in effect a single bloc and so act in alignment. Further, these representatives are more engaged than the board members of public companies. They are much better informed about the realities of the business than investors in public companies. Additionally, the burden of the task of managing investors is not as onerous as in public companies and the quality of dialogue between the stakeholders is much better (Acharya et al, 2008). Performance management The management of private equity firms focuses on key performance indicators to determine whether their goals are achieved. The key performance indicators are closely monitored to determine when corrective actions are necessary. Managers are focused on value creation and so paying keen attention to performance indicators such as return on equity, return on assets and other profitability metrics are very important. Managers make projections and meet when necessary to determine their current position in relation to the goal(s). Anything that is preventing the targets from being met is dealt with appropriately. Managers are not averse to taking risk as they seek to create value for investors. Employees are not left to do as they please. Whatever they do has to be related to the goals and objectives of the business. If they are not making the required contribution then they are replaced with employees who have the skills and aptitude to assist the company in attaining its goals. Supporting information based on research A number of surveys have been done to determine the merits of public to private equity transactions. In an article written by Acharya et al (2008, The voice of experience: Public versus private equity) which is based on an interview of twenty (20) directors who have worked on both private and public boards of reputable companies. They indicated that the superior performance of the private equity company stems from “financial engineering” and “stronger operational performance” of which the behavior of the board is a key element. Fifteen (15) of the twenty (20) directors indicated that the private equity boards added more value. None of the twenty (20) directors indicated that their public counterparts were better. On a five point scale they rated private equity boards as being more effective than public boards. Private equity boards averaged 4.6 while public boards averaged 3.5 on the five point scale. The diagram below shows the details of these ratings based on interviews with 20 UK based directors who have served over five years on the boards of both private and public companies (FTSE 100 or FTSE 250 businesses and private equity owned) most with an enterprise value greater than ?500 million. These interviews were carried out by reputable individuals. Chart created from data in McKinsey’s Quarterly Report In the chart above private equity boards and therefore the companies were rated higher in terms of overall effectiveness, strategic leadership, performance management and stakeholder management than public companies. The public limited companies were however rated higher on the basis of their development/succession management and on governance issues such as risk management and audit compliance. Even though these are very important issues the private equity companies tend to place less emphasis on these areas. Shareholders of the public companies have to be provided with timely and accurate information on a regular basis and so corporate governance and risk management is more central to their business model. A lot of managements’ time is therefore taken up with this effort in publicly listed companies. The diagram below shows what the 20 respondents described above believed to be the top priorities on the boards of the publicly listed companies and private equity firms on which they served. Chart created from data in McKinsey’s Quarterly Report The chart above shows that the top priorities for private equity companies are value creation followed by exit strategy were seen as top priority by 18 and 11 respondents respectively. Strategy initiation (including M&A), External relations and 100 day plan were seen as priority by only five respondents. The chart also shows that the top priorities of the publicly listed companies are strategy initiation, organization design and succession followed by governance (compliance and risk) along with value creation and external relations with 9, 7, 5, 5 and 4 respondents respectively seeing these as top priorities. The importance of value creation in public companies taken private Value creation is important to private equity firms because they are managing investors’ funds. Even though the investors are able to sell in a secondary market it is not a simple process as on a stock market. It therefore means investors are locked into a deal for at least a three year period. It is therefore very important that managers of private equity funds take private publicly listed companies that are normally mature and established rather than newly started enterprises. The deal normally involves bank loans and so even though cash flows are unpredictable as mentioned earlier they have to be highly probable. It therefore means that the profit level of companies taken private should be such that they provide good returns on investment. These investors focus on how possible it is to turnaround the company by eliminating non-value added activities. Technology considerations are normally irrelevant and these firms consider control of these companies to be of utmost priority. According to Fraser-Sampson (2007) these transactions generally result in reductions in employment “through restructuring and rationalization and certainly of reducing tax yield since financial restructuring will use loan interest to reduce taxable earnings.” The Difference between Private Equity and Hedge Funds They are both seen as alternative investments. Hedge Funds, however, cater to the very rich. According to Brigham and Ehrhardt (2005) hedge funds are opened to wealthy individuals and institutions whose net worth is at least US$1mn and whose income is at least US$300,000. They are basically focused on short term returns while private equity looks more to the long term. This can be seen in their main focus on MBO’s where they invest, spend some time to turn around the business and then sell it at a profit. This indicates that hedge funds are more liquid and their lock in investors for shorter time periods. However, notice has to be given; in some cases 30 days before withdrawals are allowed. In spite of these differences there appears to be some convergence between private equity and hedge funds with hedge funds moving towards non-listed companies. In an article dated October 2006, and entitled: “Hedge Funds gives private equity a run for its money”, Joyce Pellino quoted James T Barrett, a partner in Boston-based Edward Angell Palmer & Dodge LLP as saying that hedge funds have an enormous amount of capital and they have to find new ways to deploy it. They have done so in the private sector, competing with venture capitalist funds and private equity. Private Equity and the Current Environment In his article entitled “Buyout Funds Lead Private Equity Performance Gains” Stephen Taub (2011, March) indicates that a new article from Preqin (the London-based specialist in alternative investment data) is making it easier for private equity firms to raise money as all four sub-categories of private equity made money for the period July 2009 to June 2010, the most recent data available from Preqin. The return was 17.6% for the twelve month period. However, the three year period came in at a loss of 1.9% while the five year annualized return was 15.7%. This Taub indicates compares favorable with returns on Standard & Poor’s (S&P) 500 at 14.44%, MSCI Europe’s 5.7% and MSCI Emerging Markets at 23.2%. All of which lost money over the three year period which coincides with the Great recession. Over the five year period, however, they faired much better with MSCI Emerging Markets leading the pack with a 12.7% return. According to Taub, Preqin also indicated that the larger private equity funds in the form of buyouts achieved the largest one year return of 23.6% while the small and mid-market buyouts netted returns of approximately 19% and 17.9% respectively. However , the three year mega buyout funds yielded negative returns of minus 4% while mid-market and small buyouts generated, small yet positive returns of 4.7 and 4.9% respectively. The average return for the buyout funds over the five year period was 20%. According to AltAssets (2010, Long-term …) information compiled by Thomson Reuters in association with EVCA while short-term horizons for European private equity performance has registered a small improvement, the long-term returns remain robust. The short term which is represented by 1 year showed a 3.1 per cent increase and this does not reflect the rally in the stock market in 2009. The internal rates of return for the five year period fell from 8.5% to 6.1% in 2009. This decline was driven by buyouts which declined from 11.1% to 7.9% in 2009. The net internal rate of return for the European equity industry remained “strongly positive” at 8.8% for all private equity since its inception to December 2009. This indicates that though the recession which has not yet abated in some countries in the European Union like Greece and Ireland the impact on the private equity industry was not major. AltAssets (2010, Long Term …) further stated that: the long-term performance of private equity was ahead of the HSBC small Company Index at 6.8% and Morgan Stanley Euro Equity Index at 0.7%. The performance in the last quarter of 2009 was 21.4% for all European private equity funds. The foregoing indicates that the situation in Europe in the private equity market is improving. This market however, is less risky than hedge funds. Furthermore, even though the private equity firms are located in Europe they are investing in other countries. A prime example is the investment made by the European private equity firm, Truffle Capital which bought Brazil’s leading online performance marketing firm Media Factory, through its subsidiary LeadMedia (investinbrazil.biz, 2011). According to investinbrazil.biz (2011) LeadMedia’s Chairman Stephane Darracq indicated that the firm’s presence in Brazil since 2009 has allowed them to confirm the strength of the sector with its triple digit annual growth rate and therefore Media Factory has provided a solid foundation on which LeadMedia can build its business. Following this merger they intend to achieve turnover of US$25mn in 2011. LeadMedia provides its business clients with a number of internet marketing solutions, including qualified traffic generation, lead and traffic retargeting, online customer relationship management (CRM), lead generation and the sale of tailor-made technology solutions for behavioral and semantic targeting. Truffle Capital invests in and builds technology leaders in the IT, life science and energy sectors. With €400 million under management, Truffle Capital is managed by a team of four partners. The firm seeks to achieve superior financial returns by leveraging its industry knowledge, extensive network and focus on spin-offs to identify business ventures that match latent market needs. Media Factory is the digital performance company of BrANDS, a digital communication holding company from Ideiasnet. It was founded in 2002 under the brand name Ivoxcorp – one of the pioneers in offering solutions to generate efficient e-mail marketing actions in Brazil. In 2008, the company expanded its range of services on offer, with a focus on digital performance. This acquisition confirms Steve Johnson’s (2011) article in the Financial Times Financial Market Quarterly Review which he indicated that European investors were staying in safe waters as very little of some €66bn invested found its way in domestic markets. This is because of the uncertainties that still exist in the European Union with a common currency and divergent economies, some of which are still in recession. Hedge Funds and the Current Environment According to Agnew and Pfeuti (2010, Nov) a record number of hedge fund management companies were being formed in 2010. This is the fastest rate at which they have been formed since the financial crisis. More hedge fund management companies were launched in the third quarter ending 30 September 2010, than at any other time since Lehman Brothers collapsed in September 2008. Imas Corporate Advisors (qtd. in Agnew and Pfeuti 2010) indicated that the Financial Services Authority (FSA) in the UK registered 25 new hedge fund firms in the three month period ending 30 September 2010. This brought the total to 62 for the nine month period. This surpassed the 60 hedge fund firms that registered for the whole year ended 31 December 2009. Dominic Freemantle, Head of European capital introductions at Morgan Stanley (qtd. in Agnew and Pfeuti 2010) also indicated that there was a backlog of persons that were unable to launch during the financial crisis and so the two years of demand that was built up was just coming out since a level of stability currently exists. Freemantle also indicated that there would be “a hand full of large ones and a tail of small ones”, the typical size of between $25mn and $75mn, with fewer in the $100mn range than before the financial crisis. Stephen Burke who is the group director at IMS Consulting, which assists firms in obtaining FSA authorization (qtd. in Agnew and Pfeuti 2010), suggests that all the businesses that registered in would have planned their activities in 2009 and began fundraising in early 2010. This Burke indicated was as a result of combinations of strong markets, improving fundraising opportunities and increasing levels of investor demand. This increase follows two consecutive years of net outflows. According to data provided by Hedge Fund Researcher (HFR) net inflows resumed in 2010. According to HFR (qtd. in Agnew and Pfeuti 2010) in the third quarter of 2010 an allocation of net $19bn was made to hedge funds. This is the largest quarterly capital inflow since the fourth quarter of 2007. The performance of hedge funds fell 19% in 2008 and gained 20% in 2009. The average for the nine months ended 30 September 2010 was an increase of 7%. Sixteen (16) of the twenty five (25) new firms that registered with the FAS in the third quarter of 2010 were set up by persons who were trained at a larger hedge fund firm and who had established a track record for themselves. They have obviously seen some opportunities in the industry that they want to exploit and so they have decided not to sit and wait for the opportunities to come to them, but to go out and fend for them by doing what they were used to doing for someone else. Agnew and Pfeuti (2010) further indicated that the number of hedge fund firms coming to the market is likely to increase further as the Volker rule takes effect. This rule will result in banks scaling back some aspects of their operation which is not in keeping with their objectives and push them towards setting up their own hedge funds. Agnew and Pfeuti (2010) have quoted Patric de Gentile-Williams of FRM Capital Advisors, a firm that provides capital for hedge funds that: “the wave of prop traders has become something of a tsunami, which he expects to go on for a while. Demand for Funds According to Sharma (2011) Standard and Poor’s (S&P) estimates that public and private sector borrowers worldwide will require about $70,000bn of bonds between now and the end of 2015 in new funds or in order to refinance previous loans. This means that there are opportunities that both hedge fund and private equity firms can tap into. This also implies that the current environment looks promising as possibilities abound globally in Europe, USA and in Emerging Markets. Sharma (2011) further states that in developed countries much of this $70,000bn will be accounted for by sovereign issuers. However, a large portion will be demanded by firms looking forward to finance growth and replace low cost bonds, loans and structured securities which were issued before the financial crisis at a low cost and are now close to maturity. This Sharma (2011) indicated compounds the task as a record amount of this refinancing will those that are very risky in nature. For example, over $1,000bn of US non financial corporate bonds and loans which become due in this period are below investment grade. Demand will also great in the emerging economies of Asia as they continue their convergence towards the developed countries. References Acharya, V., Kehoe, C & Reyner, M. (2008). The voice of experience: Public versus public equity. Available: https://www.mckinseyquarterly.com/The_voice_of_experience_Public_versus_private_equity_2245. Last accessed 30th Jan 2011 Agnew, H. & Pfeuti, E. (2010). A record number of hedge fund firms come to market. 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