Illiquid hedge fund assets may be source of deal flow for private equity funds

Hedge funds holding unwanted and illiquid equity stakes could prove to be a new source of deal flow for private equity buyers and give hedge funds liquidity.

Hedge fund managers holding private equity-type assets may find a way to offload them if private equity funds are able to access their holdings.

“The problem is two-fold,” says Benjamin Keefe, director at specialist corporate finance adviser Gamma Finance. “First of all, credit hedge funds are not structured to hold these types of assets and, consequently, active management of companies lies outside the core area of expertise for those hedge fund managers.”

In the pre-Lehman world of liquid debt markets, many hedge fund managers found themselves taking on collateralised debt from private businesses. As the credit crisis progressed, businesses started defaulting on their loans and the hedge funds saw fixed income assets turning into equity, an unexpected and undesirable outcome for the funds involved.

As a result of the strategic difference, hedge funds currently sell equity stakes at a discount, explains Gamma Finance managing partner Florian de Sigy. “Hedge funds will pay a premium for the additional liquidity attained by offloading these assets,” he adds, highlighting the opportunity for private equity funds to acquire assets cheaply while also providing much-needed liquidity for the hedge fund.

Keefe and de Sigy say financial companies are enjoying stable and positive cashflows. At the moment some hedge funds are believed to be tapping into the cashflow of these companies to generate sufficient returns to honour redemptions.

Keefe describes the equity stakes held by hedge funds as varied. Some are minority positions but there are also majority stakes and controlling positions. The companies cover a wide spectrum of sectors and are often based in the US.

The ability of private equity funds to take a long-term view and work actively with the companies provides a better environment to nurture growth, according to Keefe. Management teams would be third-party beneficiaries, owing to the value-creating nature of private equity ownership.

The problem with these opportunities is that private equity and hedge funds have little professional overlap and little visibility of what each other are doing. “Private equity professionals are not necessarily aware of the opportunities out there and hedge fund managers do not always readily disclose their holdings,” says de Sigy.

Gamma Finance believes increasing awareness of the opportunities available would help both private equity and hedge fund managers find mutually beneficial solutions. Hedge funds could offload illiquid assets while private equity managers could source the primary deal flow they need.

This article first appeared in Unquote

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