HEDGE FUND MANAGERS are increasingly looking to the public markets as a source of long-term capital. Citadel Investment Group, a $12 billion Chicago-based hedge fund, sold $500 million of five-year notes in December off its public MTN programme. Alternatives house Fortress Investment Group, which manages $9.4 billion in hedge funds, floated an 8.6% stake in the management company on the New York Stock Exchange in February, raising about $685 million. And hedge fund manager Brevan Howard, which has more than $11 billion in hedge fund assets, raised €770 million when it floated a single-strategy fund on the London Stock Exchange in March.
The three different methods of raising capital via the public markets have drawn comments from all corners of the financial industry. Why should hedge funds turn to the public markets if they can raise money from direct investors such as institutions and high-net-worth clients? How are the banks involved in launching these deals able to value this unique and new type of capital raiser? And why would investors choose to access hedge funds in such a way, opening themselves up to market exposure?
Issuing debt
Both Man Group and Citadel have raised capital in the public debt market. As yet, the two groups are the only hedge fund groups to have accessed the public debt market. However, that is not to say that hedge funds are new to issuing bonds. "I think people forget that managers have been doing private debt placements for some time," says Irenee May, managing director at RBS in London. "Tiger did a $190 million placement back in 1997, for example. Citadel and Tudor each did a transaction in 1999. And funds of hedge funds too, such as Glenwood, Man and Investcorp have accessed the market over the years." One market participant estimates that about a dozen private deals have been done by hedge funds. Leslie Bright, analyst at Fitch Ratings in New York, agrees that there have been many private deals. "Before hedge funds started seeking alternative methods of raising capital, they would take on private money from insurance companies," she says. "To do so, they required a rating, and there was a rash of private ratings in the late 1990s. We have publicly rated just Citadel’s two multi-strategy funds at triple B plus, and we assigned a rating of triple B to Millennium Partners at the end of January." Bright says she doesn’t foresee a surge of hedge funds requesting public ratings to issue bonds. "There are certain limitations. First, there aren’t many hedge funds that are large enough to warrant accessing the public market to raise capital. And secondly, not many funds would meet the qualitative and quantitative standards required to achieve an investment-grade rating."
Kevin Dunleavy, head of global hedge fund strategy and client relations at Merrill Lynch, also thinks only a small number of hedge fund managers will tap the market. "This type of financing is expensive versus prime brokerage but for those clients looking to expand their business or finance long-dated assets this is an option that is only open to a few," he says.
Nonetheless, syndicate sources in London claim to know of six hedge funds considering public debt deals. One source names Cheyne Capital as a potential issuer.
There are obvious pros and cons to issuing public debt. "Like equity IPOs there are significant challenges in doing a debt deal," says RBS’s May. "There is a lot of disclosure about leverage, assets, earnings streams and banking arrangements, and the hedge fund manager must be prepared to deal with that." In the case of a private debt placement, such disclosure can be confined to a small number of investors – normally between five and 10. One source familiar with the Citadel deal says that although the MTN programme off which the $500 million five-year notes were launched is public, it was a private sale and therefore disclosure was kept within a relatively small group. "There were about 35 investors, such as traditional money managers, insurance companies and bank prop desks, with the top five or six getting a larger proportion of bonds than you might see in another deal this size," the source says. "There was a great deal of transparency, although obviously you don’t get a daily NAV on the bond side. Citadel was very intent on having quarterly one-on-ones with its bond investors to provide some comfort as some bond investors can worry they will be at a disadvantage."
Although it might indeed be quite burdensome to obtain a rating, and then comply with disclosure requirements in order to raise capital through a public bond deal, there are clear balance sheet benefits in a hedge fund doing so. "These sorts of institutions are looking for alternatives to traditional means of financing such as repos," says a banker. "It is important to diversify where you raise funds from. Long-term financing also allows them to invest in less-liquid opportunities." May says: "Long-term capital is obviously attractive, and it also provides creditors with a level of comfort that there are sources of stable capital in the organization. A multi-strategy hedge fund, for example, may want to start up a new strategy that is not core. Instead of convincing investors to seed a new idea, they can either fund an internal team or do a lift out of a group from another organization, and provide sizeable long-term seed money. This will allow them to try out the new strategy, develop a track record and build a product extension around the strategy and team."
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"Doing an IPO gives the firm an acquisition currency, and allows the founders to cash out a bit after years of hard work" Craig Coben, Merrill Lynch |
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For the investors, hedge fund bond deals can be highly attractive: given the lack of issuers in the market, bonds tend to price at a premium to similarly rated financials. One source involved in the Citadel deal says: "It wasn’t particularly scientific. There were no good solid comparables, so it made sense to see where the back end of triple B-rated financial institutions were trading and price it somewhere near there, factoring in the investors’ perception of challenges of recovery values." The notes launched at a yield of treasuries plus 190 basis points. Similarly rated financials have a yield of 120bp to 130bp over treasuries.