Some concerned about managers so eager to jump into new waters

Consultants and hedge fund-of-funds managers fear the convergence of private equity and hedge funds will result in neither class of managers succeeding at wringing alpha consistently from an unfamiliar asset class.

"It kind of scares me that hedge fund managers are so ready to make private equity investments without a lot of experience," said Susan McDermott, a consultant at Stratford Advisory Group Inc., Chicago.

"Private equity is tough enough for people with experience. Hedge funds are more trading-oriented than deal-oriented. True private equity managers love to do deals. That's what they're good at. The mindsets aren't mutually exclusive, but there really are few hedge fund managers that are deal-oriented."

Convergence also concerns Alan Dorsey, director of non-traditional investments at consultant CRA RogersCasey, Darien, Conn. "We don't like it because we look at hedge funds within a client's portfolio as marketable alternatives. We consider private equity unmarketable securities. You lose the liquidity of hedge funds if they are locked up in private equity securities and lose the longer lockup for private equity managers who need to hold securities … for more than three years in order to get the real value of the security. Investments that fall between the two asset classes usually don't offer the best of either world."

Michael Zimmerman, a partner at hedge fund-of funds manager Tower Capital Inc., New York, agreed. Investors "don't want to pay their hedge fund managers for investment in illiquid securities. It's a completely different kind of risk," Mr. Zimmerman said. "And they don't want to pay their private equity managers so much to invest in public securities." Tower Capital manages about $425 million for institutional investors.

Philip Maisano, chairman and chief executive officer of EACM Advisors LLC, Norwalk, Conn., said analysts there are skeptical of hedge fund managers who say they can manage private equity.

"It's really more of a gap filler they use when they have a lot of capital to put to work. They say they can hedge these bets, but I'm not convinced. Running a hedge fund and investing in private equity are very different functions," Mr. Maisano said. EACM manages $4.5 billion in hedge funds of funds for institutional investors.

Mr. Maisano noted that most hedge fund managers who turn to private equity run macrofunds not restricted to a specific investment style. He said such managers often have "a high-profile name and a master-of-the-universe attitude. We avoid the wonder kids who say they can (manage private equity). If you have private equity, we're not putting you to work here. We wait a year or two before investing and see if it really works out."

One of the larger, more sophisticated hedge fund investors, who asked not to be named, said officials at his pension fund discourage hedge fund and private equity managers from entering each other's territory. The problem, he said, is that hedge fund managers overpay for portfolio companies, thereby bringing down returns.

Christopher Wagner, senior investment manager of the $26 billion Los Angeles County Employees' Retirement Association, Pasadena, Calif., said he thinks deal competition between hedge funds and private equity managers could drive up purchase prices for private equity deals, but he isn't terribly concerned. "I don't believe that hedge funds are that big of an investment that they are moving the needle an extreme amount."

So far, the LACERA board has not invested in hedge funds but does invest in private equity. Officials have not seriously considered hiring crossover funds.

Private equity and hedge funds are likely to converge within the next five years, bringing the investment management industry full circle back to a style of portfolio management that was popular in the 1920s, predicted Leo de Bever, executive vice president, Manulife Financial, Toronto. In those days, investment firms would create a risk/return strategy on an entire portfolio, he said.

The problem with the blurring of asset class lines within alternative strategies is measurement, Mr. de Bever said. "You could put on the wrong benchmark," he said. "In some sense, the industry is edging back to the portfolio approach of management, rather than segmenting things into 50 buckets."