Hedge funds: A new source of dealflow

In the pre-Lehman world of liquid debt markets, many hedge fund managers found themselves operating as mini-banks, taking on collateralized 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.

"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 type of assets; consequently, active management of companies lies outside the core area of expertise for those hedge fund managers."

The result of this strategic difference, credit 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 off-loading these assets," he says, highlighting the opportunity for private equity funds to acquire assets at competitive valuations while also providing much-needed liquidity for the hedge fund owners.

When asked about financials, Keefe and De Sigy are keen to point out that the companies are enjoying stable and positive cashflow. It is believed that, at the moment, some hedge funds tap 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 majority stakes and controlling positions available as well. The companies cover a wide spectrum of sectors, but are often American, reflecting the traditional investment scope of hedge funds.

He argues that a private equity fund's abilities to take a long-term view and work actively with companies, provides a better environment to nurture growth. Moreover, 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 towards each other. "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 that increasing awareness of the opportunities available between private equity fund managers and hedge fund managers, will mean more funds will be able to reach mutually beneficial solutions. Hedge funds can off-load their illiquid assets, while private equity managers can source the primary dealflow they need.

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