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Trends in Private Equity: Hedge Funds Seek Permanent Capital

Trends in Private Equity: Hedge Funds Seek Permanent Capital

Addressing the Problem of Redemption Rights

Unlike private equity funds, hedge funds and hedge fund managers must worry about redemption rights — the right of an investor to have his or her capital investment returned. In times of economic downturn when investors may be nervous about a fund’s ability to perform, it is common for large groups of investors to simultaneously exercise redemption rights. Consequently, funds whose investments have dropped in value due to the market downturn may be forced to sell assets for a fraction of their value.

Funds have responded to this problem in various ways. Some have exercised contractual provisions limiting redemption rights in times of economic recession. Others have simply chosen to keep additional cash on hand.  The latter approach may come with significant opportunity costs in that a fund manager may be forced to pass on very promising investments in order to maintain cash reserves.

Another solution to this problem—and an emerging trend—is for hedge funds to seek the use of permanent capital instead of traditional investor capital with redemption rights. Permanent capital refers to income streams a hedge fund will never have to pay back to investors. Some permanent capital vehicles are structured as insurance companies where the constant stream of premiums can be invested and used, while others are structured as publicly traded corporations where shareholders buy stock in the fund. The fund receives this permanent capital without having to worry about investor redemption rights. If a shareholder wants out of the fund, he or she can simply sell his or her stock.

Innovation and Legal Changes Driving the Permanent Capital Trend

Like many other trends in the private equity-verse, is this really something new, or is the industry just trying out a new term? While Warren Buffett and Berkshire Hathaway’s use of insurance premiums as a source of permanent capital for the fund is highly innovative, the use of publicly listed funds is also being driven by changes in the law.

Innovation and Legal Changes Driving the Permanent Capital Trend

Hedge funds and hedge fund managers historically had few registration and disclosure requirements under federal securities laws. However, under the Dodd–Frank Wall Street Reform and Consumer Protection Act (2010), hedge funds are now required to register with the Securities and Exchange Commission. Additionally, many major institutional investors in hedge funds are pension funds, which already have significant disclosure requirements under ERISA.  With registration and disclosure requirements for hedge funds already on the rise, the disclosures and registration requirements associated with public listings are not as onerous as they once seemed.

Fortress and KKR as Case Studies

While it is unclear how investors will respond to this new model, some major firms, including Fortress Investment Group, Apollo Global Management and Blackstone, are experimenting with permanent capital strategies. In its October 30, 2014 Private Equity and Permanent Capital Overview presentation for investors, Fortress presented investments spread between traditional private equity, permanent capital and “NextGen” private equity. The company acts as the external manager to six publicly-traded companies in different industries—transportation and infrastructure, healthcare, print and digital media and housing. Fortress describes the characteristics of its permanent capital business as targeting (1) large, addressable markets, (2) mispriced or misunderstood assets and (3) long duration assets.

Although promising, not all permanent capital experiments have ended well. According to Financial Times in its recent article “Permanent Capital: Perpetual Cash Machines,” KKR listed on the Euronext exchange a permanent capital vehicle, which traded at a discount and was eventually absorbed into KKR’s New York-listed stock.

The choice of where to invest is always a tricky one, but your attorney and financial advisor can guide you through the multitude of options, including new and emerging options like permanent capital vehicles. Be sure to check back as we cover additional emerging trends in private equity.

Allen & Gooch is providing this legal update for informational purposes only. This article should not be construed as legal advice or a legal opinion as to any specific facts or circumstances. You should consult your own attorney concerning your particular situation and any specific legal questions you may have.