Jonathan Henes
Kirkland & Ellis LLP

“It is not the strongest of the species that survives, nor the most intelligent that survives. It is the one that is the most adaptable to change.” Charles Darwin.

A certain segment of the hedge fund industry is in the midst of evolving. The evolution of these hedge funds is apparent in their shift from focusing on short-term gains to long-term maximization of value. Many of these hedge funds are large distressed funds that hold debt of companies in the process of executing on de-leveraging transactions and are executing control strategies that are more akin to those of private equity firms than the typical quick trade strategy employed by many hedge funds. As these distressed funds continue to pursue these control strategies, they need to adapt, which will require a new way of thinking and an education under fire. But, if done right, these evolved “private equity hedge funds” may realize outstanding returns.

How did this evolution take place?

In attempting to figure out why something has happened or why someone has acted in a certain way, always follow the money. And, this is true with the hedge fund industry. In 1990, there were approximately 300 hedge funds. In 2001, there were approximately 6,000 hedge funds and, by the end of the 2009, there were almost 13,000 hedge funds. The growth was amazing, but not surprising. The hedge fund business model is awesome (typical fees were 2% of money under management and 20% of excess returns) and hedge funds - i.e., private, relatively unregulated investors - can invest in anything their limited partners authorize. Until the Great Recession, hedge funds almost minted money.

One of the first stages of the hedge fund to “private equity hedge fund” evolution was the dot com and telecom bust and its aftermath. As the bust led to a recession and the recession led to a significant increase in large corporate bankruptcies, traditional distressed debt hedge funds did what they did best - bought the debt at a low price, participated and influenced the chapter 11 cases and then either sold the debt at a higher price or received an outsized distribution through a company’s plan of reorganization. As these traditional distressed investors realized strong returns, other hedge funds entered the space hoping to do the same. And, as a result, a new generation of distressed debt hedge funds was born.

A second stage in the evolution was the leveraged loan boom. Specifically, as a significant number of hedge funds (not just distressed hedge funds) became huge buyers of loans, the syndicated leveraged loan market (with the additional help of CLOs) exploded. The buying binge artificially depressed yields (on a risk-adjusted basis) and almost any company could borrow money for any reason, without covenants or even the need to repay interest until the loan matured. Hedge funds were a major part of the syndication process, purchasing a little bit of debt in a lot of companies. Thus, hedge funds were now “lenders” and had a large portfolio of borrowers (borrowers that would soon be in financial distress).

All good things must come to an end and the end came dramatically and loudly. As the Great Recession knocked out the economy and pulled back the curtain, uncovering a huge number of over-levered companies, debt prices plummeted and companies sought the refuge of chapter 11. Many hedge funds went bust from redemptions and losses. Others, however, survived (many by the skin of their teeth). Now, as the Fed and the government, once again (déjà vu all over again), is propping up a failing economy with stimulus spending, the monetization of government securities and the bailout of financial institutions and other industries, certain hedge funds have found their footing. The large hedge funds find themselves holding bank and bond debt in companies that need to restructure and these funds holding the fulcrum security and with cash to spend or loan are in the driver’s seat.

Rather than engaging in tactical, short-term trading of bank debt and bonds, certain large hedge funds are exerting influence on the restructuring process to act like private equity funds and take ownership and control of companies through the exchange of debt for equity. This evolution from hedge fund to private equity hedge fund is almost complete and the survival of these funds will depend on their adaptability to a new world. Private equity hedge funds need to act as owners, not traders, and they need to focus on long-term maximization of value, not short term realization of gains. Specifically, private equity hedge funds need to understand how to best employ strong corporate governance initiatives, negotiate strong and appropriate management arrangements, work with management to develop operational efficiencies, put in place appropriate capital structures (not just for today, but for tomorrow) and be patient to give long-term plans the opportunity to realize results. Those that are able to adapt to their new world will survive, those that don’t will not.

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Jon Henes is a partner in the Restructuring Group of the law firm of Kirkland & Ellis. Jon's practice involves representing debtors (including portfolio, privately-held and public companies), creditors' committees and distressed investors (including hedge funds, private equity funds and companies) in acquisitions, restructurings and bankruptcy cases.