Hedge funds forced to sell private-equity holdings

Hedge funds — facing forced margin calls and investment redemptions — are selling off wide swaths of their private-equity-type investments in search of cold hard cash. And private-equity firms have been only too happy to scoop them up. While there was some talk of the selloff last year and a few transactions, the number of transactions involving both single companies and pools of portfolio companies didn't take off until early this year. Hedge funds' private-equity portfolios are the result of a convergence of private equity and hedge funds that began about three years ago. At that time, hedge funds started participating in private-equity deals in a big way. They invested in the debt layers of private-equity deals syndicated by banks and also invested directly in companies in private-equity deals. They can no longer afford to own these investments, which have much longer holding periods — three to six years — than typical hedge fund investments, and they're selling them off. Several hedge funds are selling interests in individual companies to co-investors and other syndicate members to pare down their positions. The more troubled firms are offloading private-equity positions in bulk, industry insiders say. Nobody knows for sure how much of the nearly $2 trillion hedge funds have under management is invested in private equity and what percentage of that will eventually be put up for sale. Still, a growing number of deals have been coming to market recently. So far, most of the deals have been on individual portfolio companies, said David Fann, president and chief executive at PCG Asset Management LLC, a La Jolla, Calif., private-equity consulting and investment management firm. "When hedge funds try to exit [their private-equity investments] in bulk, it signifies a more significant shift in strategy at the hedge fund itself," Mr. Fann said. If the capital markets continue to decline, a large number of hedge funds could run into trouble, resulting in more bulk sales, he said. "As hedge funds melt down, we would expect a more bulk [sale] mentality," Mr. Fann said.

SIGNIFICANT GROWTH

In the last two months, Edward Hortick, managing director of private-equity firm VCFA Group of New York said his firm has seen a significant growth in the number of venture capital bulk sales. Mr. Hortick's small firm usually sees only about two or three such deals per year but has already seen more than that in the first two months of this year. Some hedge funds made private-equity-type investments in portfolio companies on a deal-by-deal basis, but others recruited experienced teams of private-equity executives. Now the portfolios built by these private-equity teams are being put on the block. "There's been a lot of margin calls, and they need the liquidity to try to fund the margin calls," Mr. Hortick said. This is creating an opportunity for VCFA and other venture capital and private-equity firms to buy hedge funds' direct private-equity investments. "We started to get wind of this type of activity at the end of last year, but didn't see deals until the beginning of this year," Mr. Hortick said. VCFA's strategy is to back the spinoffs of private-equity groups currently within hedge funds. Rather than buy a slice of a new firm, VCFA plans to become a limited partner in its first fund, which includes their existing pool of investments, Mr. Hortick said. "In the current environment, I think a lot of hedge funds are trying to create liquidity" and private-equity firms, mainly those that specialize in the direct secondary market, are in a position to buy, he said. These private-equity sales are part of a broader sale of hedge fund portfolios, PCG's Mr. Fann said. The private-equity and venture capital firm buyers are buying these interests in portfolio companies at significant discounts, he said. For the single company deals, hedge fund executives are approaching the firms that know the portfolio companies the best. Private-equity and venture capital firm co-investors generally have the right of first refusal or a first look at these deals, under their contracts. Buyers of bulk private equity have been mainly secondary private-equity firms that specialize in buying portfolios of private-equity-backed companies. "There has been sufficient activity to make it of interest to us," said Elly Livingstone, a partner at private-equity firm Pantheon Ventures Ltd. of London, which has a secondary private-equity business. "We've looked at a number of deals in this space." Traditionally, banks, corporations and private-equity firms have been sellers of private-equity-backed companies in bulk. Occasionally, general partners sell portfolio companies owned by older funds that have run their course, Mr. Livingstone said. Banks and corporations are also selling now to get these long-term investments off their balance sheets, and these transactions are also increasing, he said. But direct secondary deals from hedge funds are growing rapidly as hedge funds search for liquidity to fund their margin calls. "And this is creating opportunity for us," VCFA's Mr. Hortick said.