Hedge Funds and The Middle Market

From Merger Mogul of March 5, 2007:

The booming market for private capital has led to the breakdown of many traditional walls as investment managers seek new outlets to deploy the huge sums coursing through the public and private markets.

In the United States alone, more than 1,500 private equity firms now have an estimated $811 billion in commitments, creating an active – if not overheated – market for the sale and purchase of companies. An unknown share of that money is targeted at middle-market companies.

And even those large sums are dwarfed by the $1.2 trillion being managed by the estimated 8,000 to 10,000 hedge funds in the United States. That’s led some fund managers to become active in the takeover sector, whether by financing transactions or acting as a principal and taking equity positions.

Some of the biggest names in the hedge fund world, including Eddie Lampert’s ESL Investments, Carlson Capital, Cerberus Capital Management and D.E. Shaw have made private equity-style purchases. At the same time, some of the nation’s largest private equity firms (Bain, Quadrangle, Texas Pacific, Carlyle, Blackstone) have started their own hedge funds. Talk of “convergence” is everywhere.

Over the last several years, Edgeview has expanded its deal marketing to include hedge funds. We’ve seen few true hedge fund purchases of middle market companies in an auction environment, though we expect that dynamic to change over time.

One officer who worked extensively with a large hedge fund on a public-to-private transaction in 2006 recalled that the fund operator struggled to adapt its desire for a significant equity stake to the company’s wish for a full buyout. “Playing the buyout game” was harder for fund managers accustomed to dictating the rules, the officer said.

Another officer held discussions with a hedge fund as part of a sellside assignment, but said the fund’s interest was in a pure value play. That makes a fund a very different middle market buyer than, say, a private equity firm with a history of managing for growth.

One question moving forward is whether hedge funds continue to view private equity-style deals as worthwhile. Last year, so-called Special Situations hedge funds – those known to be executing buyout-style strategies – showed a 12.3 percent return, according to the Greenwich Global Hedge Fund Index. That was barely higher than the index’s overall 12.1 percent return _ and well below the S&P 500’s 15.8 percent return.

Whether or not traditional hedge funds become a truly dominant participant in the middle market, they have become a significant source of creative capital in a short time – and an important consideration in any middle market transaction.