Convergence of Hedge Funds and Private Equity Funds - Rethinking the Vote Buying-

In U.S., despite similar regulation under federal securities laws, traditional hedge funds and traditional private equity funds are very different. * This article is based on a part of my J.S.D. dissertation: "Hedge Fund Regulation in Global Financial Markets: Implications for Financial Market in Korea." ** Washington University in St. Louis, School of Law, Visiting Scholar See Jonathan Belvilacqua, Comment: Convergence and Divergence: Blurring the Lines Between Hedge Funds and Private Equity Funds, 54 Buff. L. Rev. 251, 251. As stated above, hedge funds identify value inherent in market inefficiencies and take profits through short-term trading strategies such as convertible arbitrage, merger arbitrage or long-short public equity portfolios. See Matthew Judd, Hedge funds and private equity converge, International financial Law Review (Supplement- The 2006 Guide to Private Equity and Venture Capital), available at http://www.iflr.com/Article/1984647/Search/Hedge-funds-and-private-equity-converge.html?OrderType=1&Keywords=Matthew+Judd (last visited Aug. 2011) On the other hand, private equity funds generally permit only relatively specific and focused investments in unquoted companies based on strategies to create volume in those companies over the medium to long-term through improvements in the management and operations such as corporate restructuring. See Id. Once totally separate asset classes, these two styles of funds may be converging. Belvilacqua, supra note 1, at 251. The hedge fund industry has experienced an enormous growth in assets. MARHedge reports that 8,800 hedge funds are now managing some $1.2 trillion in assets worldwide, with approximately 60 percent in the United States. Harris Smith, Crossing the line: The growing convergence of private equity and hedge funds, The ACG/ Grant Thornton Survey (2006), at 2. The huge inflow of capital into hedge funds and creation of new hedge funds have increased competition in the traditional hedge fund market. Belvilacqua, supra note 1, at 252. Some hedge funds managers are moving away from traditional investment strategies and expanding their universe of investment opportunities in order to satisfy their clients' strong demand. Id. A couple of hedge funds have recently been established in conjunction with well-known private equity funds, such as 'The Blackstone Group' and 'Texas Pacific Group,' in attempts to acquire private equity 'know-how' to invest in longer term positions in companies. Danforth Townley, The Convergence of Hedge Funds and Private Equity Funds, in Hedge Funds 2006: The Changing Regulatory Landscape, 1563 PLI/Corp 217, 220 (Sep. 2006). Some of the largest private equity firms have established hedge funds, such as 'The Carlyle Group' and 'Bain Capital,' in order to take advantage of having multiple private fund investment services under one company. Id. at 221. In short, these hybrid strategies and structures have blurred the line between private equity funds and hedge funds, and enabled hedge fund advisers to become meaningful players in the private markets. The ACG/Grant Thornton Survey also revealed some significant divergence in thinking about which fund category is driving this convergence. “83 percent of private equity fund respondents believe that hedge funds are more likely to become involved in private equity, while only 52 percent of hedge fund respondents share this opinion. In addition, only 17 percent of private equity respondents believe that both hedge funds and private equity funds are moving equally into each other's space, while 45 percent of hedge fund respondents believe this to be the case.” This survey suggests that hedge funds are far more willing and likely to expand their horizons than are private equity funds. Many private equity firms and hedge funds also revealed that despite the convergence trend, they prefer to stay within their traditional investment comfort zones. Smith, supra note 5, at10. Some activist hedge funds want to build up considerable equity stakes to influence shareholder-led changes in corporate management or corporate governance, i.e. “Shareholder Activism.” See Judd, supra note 2. To arrange their considerable amounts of capital, hedge funds have also been active providers of subordinated debt in the leveraged buy-out market traditionally occupied only by private equity advisers. See Id. Along with the surge in hedge fund investment, hedge fund “shareholder activism” has also increased. Professor Kahan and Rock argue that hedge fund activism differs from activism by traditional institutions in several ways: it is directed at significant changes in individual companies (rather than small, systemic changes), it entails higher costs, and it is strategic and ex ante (rather than intermittent and ex post). The reasons for these differences may lie in the incentive structures of hedge fund managers as well as in the fact that traditional institutions face regulatory barriers, political constraints, or conflicts of interest that make activism less profitable than it is for hedge funds. But the differences may also be due to the fact that traditional institutions pursue a diversification strategy that is difficult to combine with strategic activism. See Kahan, Marcel and Rock, Edward B., "Hedge Funds in Corporate Governance and Corporate Control", U of Penn, Inst for Law & Econ Research Paper No. 06-16 (July 2006) at 41, available at SSRN: http://ssrn.com/abstract=919881 While many of hedge funds focus on passive investing, it is increasingly common for larger hedge funds to hold meaningful stakes in public companies. Stephanie Breslow and Paul S Gutman, Schulte Roth & Zabel LLP, Hedge fund investment in private equity, in the Practical Law Company Cross-border Private Equity Handbook 2005/6. available at http://www.srz.com/files/ ARTICLE-PrivateEquity2005-06--HedgeFundInvestmentIn PrivateEquity.pdf [hereinafter Handbook 2005/6] at 13. Unlike private equity funds, hedge funds typically do not have size caps, and all capital is available for reinvestment. Id. This flexibility enables hedge fund activists to deploy capital towards large, concentrated investment opportunities when needed. Id. This paper proceeds as follows. In Part II, this article will outline the key features of hedge funds when operating in the private equity market. This article will examine the structure of the SEC's Vacated Rule, its legislative history and purpose. This article will also discuss the deficiencies of the Vacated Rule. This article will examine how the convergence may evolve in the future. In Part III, this article will analyze the vote buying case, King-Mylan merger case. This article will also discuss other problems that arise from the stress that hedge funds put on the governance system. In Part IV will conclude.