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November 28, 2007

Countering hedge fund invasion

In an article appearing in AltAssets, James Kelly of US-based law firm Nixon Peabody LLP, talks about the increasing "hybrid" strategies adopted by hedge funds and how PE firms need to counter this. While the article is written based on the US context, parts of it are relevant for other rapidly maturing markets like India - where hedge funds like Galleon, DE Shaw, Passport, Quantum, etc. are becoming increasingly active in traditional PE turf - as well.
In our view, hybrid funds will likely begin to play a bigger role in the middle market. As money continues to pour into private equity funds and hedge funds alike, these funds find themselves in bidding wars as competition for deals rapidly increases. Further, as the markets have become more efficient and the role of transactional intermediaries has increased, proprietary deals are becoming rarer and auctions commonplace. Aside from the obvious intangible currencies of operating focus and expertise, timing, and track record, the hybrid flexibility of a particular firm may add additional currency to the mix, allowing bidders to get creative to win bids, since valuation is not the only driver.

As we have seen, large hedge funds are already using side pockets to engage in middle-market buy-out activity. These hedge funds (as hybrid funds in this capacity) are attractive to targets as they provide financing without usually demanding control of the target, in contrast to venture capitalists and private equity firms, which more often require significant minority holder protections or complete control. A hybrid fund can justify lower returns in an investment it views as conservative to diversify its main return-generating activities such as traditional hedge fund investments in public securities. This may make hybrid funds more competitive in auctions where they are bidding against traditional mid-market private equity firms that typically seek higher returns.

Arun Natarajan is the Founder & CEO of Venture Intelligence, the leading provider of information and networking services to the private equity and venture capital ecosystem in India. View free samples of Venture Intelligence newsletters and reports.