Eric Mindich, formerly managing director at Goldman Sachs, recently formed hedge fund firm Eton Park Capital Management, New York. Sources familiar with his plans said Mr. Mindich plans to offer a $3 billion hedge fund that invests 30% of its assets in private equity.
"That a hedge fund will put 30% in private equity is unheard of," said one foundation executive, who requested anonymity. "That is startling."
The presence of that much illiquid private equity within a hedge fund could wreak havoc on those who invest in hedge funds, including funds of funds, said Barry Colvin, president and chief investment officer at Tremont Capital Management, Rye, N.Y. Tremont manages about $7.5 billion in hedge funds of funds.
"That much (private equity in a hedge fund) will cause a problem for us. You end up having a real mismatch between assets and liabilities in that most hedge fund portfolios are valued quarterly and monthly. Most illiquid securities are valued much less frequently," Mr. Colvin said.
Mr. Colvin said investment of even 5% or 10% of a hedge fund portfolio in illiquid securities will cause "an accounting and logistical nightmare" for the fund-of-funds manager and the investor in the event of a market downturn or large distributions without sufficient lead time.
Because there is no distribution in kind from private equity, there is no way for the hedge fund manager to come up with enough cash for large distributions. The realized losses from selling securities to make the distributions "is going to have to be carried on the books for years," Mr. Colvin said.
"The key will be coming up with creative, innovative vehicles that leverage the expertise of private equity managers" while shielding the investor from impacts of the long lockup periods, Mr. Colvin said.
Consultant Carrie McCabe, president and chief executive officer of McCabe Advisors LLC, New York, also looks askance at hedge funds with high percentages in private equity. Ms. McCabe advises large institutional investors on direct investments in hedge funds.
"If a hedge fund ends up with a large proportion of unmarketable securities with a lockup longer than a year, that is a real cause for concern. If it's more than 10%, I have to take a really hard look at it. You just can't run a hedge fund like you can a private equity fund. It takes a very different skill set," Ms. McCabe said.
Sources broadly agreed with Ms. McCabe that most hedge fund managers, whose strategies hinge on rapid trading to exploit market inefficiencies, tend to be less skilled in managing buy-and-hold investments than private equity managers.
Hedge funds "are more short term and used to moving too quickly," said John Friedman, founder and managing partner of venture capital fund manager Easton Capital Investment Group, New York. "They generally don't do the sort of due diligence that better venture capital and private equity funds are doing. They are used to pulling the trigger quickly."
The result is deals are either overpriced or structured incorrectly, Mr. Friedman said. And furthermore, the better entrepreneurs are wary of hedge fund manager investments, he said. They want better terms when the company goes public, he said.
As for private equity managers, Cadogan's Mr. Isaac said: "We see some PE firms deciding to use their industry research to find ideas for associated hedge funds which trade in public securities. The idea is they sometimes uncover bad business models (possible shorts) and good companies which won't become PE deals (possible longs). Funds of this type have existed for at least three to four years, but we are seeing more starting up."
The effect of hedge fund competition for private equity deals is compressed returns, Baird's Mr. Carbone said. For example, private equity managers are now seeing internal rates of returns in the mid-20% range; returns had been in the mid-30% range a few years ago. Mezzanine fund managers were used to returns in the low 20% range, but now they are down to the midteens, he said.