Hedge funds and Private Equity - PES

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1. Hedge funds
In the following pages we will try to offer an analytical and comprehensive picture of the hedge
funds industry, focusing on its European segment.
Hedge funds are a recent development in Europe. The purpose of hedge funds has been twofold:
1. To create an opportunity to secure the overall development of an investor’s active portfolio.
2. To create a profit by betting on different market developments between different actives/
passives of the same type.
The achievement of the above was attained through varying long/short strategies in different
areas. This could happen through buying and selling of assets, through futures, or through acquisition
or issuance of options. It could also be through a combination of such contracts, including
the conclusions of SWAP-deals 1 .
In recent years the general fall in interest rates has led to a change of the business model of
many hedge funds. Decreasing rates have on the one hand led to a large inflow of capital
because the investors in hedge funds expected a higher return on investment than through traditional
interest-rate-bearing products. On the other hand, the hedge funds have increasingly
placed their investments in stocks instead of market-neutral, interest-rate-bearing assets. Many
hedge funds have thereby become overexposed to investments in stocks, which can be seen
from the fact that indices of share prices of investments in hedge funds have followed the developments
of the international stock indices.
This in turn has made hedge funds look more like the stock-based investment funds where the
investment in stocks is complemented by some financial contracts. Lately the hedge funds have
begun investing in more risk-prone interest-bearing products such as junk bonds, corporate
bonds, and bonds from emerging markets.
Although there is a difference between hedge funds and private equity funds in the sense that traditionally
hedge funds are investing short-term without exercising ownership authority, whereas private
equity funds are more likely to exercise ownership authority, we have in recent years seen a development
where the two types of alternative investment funds have become more closely related.
In a number of cases, hedge funds have been buying up stocks in publicly listed companies that
have subsequently been bought by private equity funds. This is because hedge funds have been
able to trace the specific companies most likely to be bought by private equity funds at a later
stage. The placement of stocks in a hedge fund facilitates the acquisition by private equity funds,
since the hedge funds is focusing on the short-term yield on stocks, and hence is more likely to
sell to gain a quick return.
The relation between the two types of funds also occurs after private equity funds have acquired
a target company. The leveraged buyout funds increase the debt of the company in order to
finance the acquisition, and hedge funds have been buying the corporate bonds, junks bonds
etc. issued by the acquired company. The hedge funds invest in these bonds because they have
a relatively higher interest rate due to the higher risk.
1.1 The anatomy of hedge funds
The financial community and the regulatory bodies do not have a common definition of hedge
funds. Someone defines hedge funds as a specific set of financial products, someone else as a
group of investment strategies. Some commentators prefer to consider hedge funds as a
specific business model, otherwise industry practitioners widely define hedge funds as an asset
class (alternative, of course).
1 A swap is a derivative, where two counterparties exchange one stream of cash flows against another stream. These streams are called the
legs of the swap. The cash flows are calculated over a notional principal amount. Swaps are often used to hedge certain risks, for instance
interest rate risk. Another use is speculation.