Where does value come from in PE vs. HF?
As a PE guy looking to transition to HF, I've been asking myself this question lately.
Common knowledge is:
- PE: value comes from 3 levers, i.e. (1) increase in EBITDA (or other aggregate to which multiples are applied), (2) deleveraging and (3) increase in multiples.
- HF : value comes from any positive information not yet priced in by the market
Funny how these points of view are different:
(1) Increase in EBITDA (or in results altogether) is more restrictive for HF as only the part that's not priced in by the market is taken into account
(2) HFs don't see leverage as a lever of value creation on a deal-by-deal basis. The HF is leveraged in itself, but at much lower levels than individual PE deals.
(3) Increase in multiples applies to both, but in reality PE funds always assume iso-multiples in their valuation models because "they cannot predict what the market will be in 4-5 years". On the other hand, it is the key assumption for HFs: the multiple of the company is going to grow.
Any thoughts?
1 - good point that may be missed by some. I think the broad generalization is that MFs are looking for absolute EBITDA/EPS growth while HFs are looking for what the market is missing.
3 - I don't know if I'd say "the key assumption", but it is also extremely difficult to find an opportunity where the market estimate for EBITDA or EPS is off by 25%.
You can make money where there's fundamental upside You can make a lot of money where there's fundamental upside and that leads to investors re-thinking how they want to value the stock (higher multiple) I am struggling to think of many situations where EBITDA/EPS came inline, but for some reason the multiple went up. I suppose you could get that to some degree in a highly levered situation where fundamentals played out, the company was able to de-lever, and then you are left with a more attractive equity.
Well, correct me if I'm wrong, but HFs often invest because they think the multiple of the target company will grow (e.g. because it trades at a discount vs. its peers and it doesn't deserve it).
In Private Equity, I have yet to see an lbo model that assumes the multiple will grow! Usually, we just plug the entry/exit multiple that's just enough to reach our target IRR. If that multiple is deemed acceptable (i.e. in line with comparables), then we buy the company.
If a HF had to build an IRR model, I think the exit multiple wouldn't be equal to the entry multiple. It would be higher.
It is not so formulaic. First of all "hedge fund" is a very broad term referring to a structure, not an investment philosophy. Assuming you're referring to a fundamentals-oriented long/short fund, the basic idea is to buy securities for less than intrinsic value and sell them for more than intrinsic value. Investors assess "value" in many ways and it's not just a function of multiples and earnings, though they are common shorthand for a more nuanced understanding of a business' growth prospects, return on capital, cash generation, capital allocation, management, strategy, industry dynamics, etc. as well as what might or might not already be expected by other market participants. The fund may or may not be leveraged and it may or may not expect any individual investment's capital structure to contribute to returns. It depends. Many hedge funds value businesses the exact same way private equity investors do.
So, in my opinion the only real broad generalization you can make is that any differences in investment returns come from having a control position vs. having a more liquid passive position. PE gets to extract juicy management agreement fees from portfolio companies and maybe achieve some operational improvements, while in principle a HF can generate returns in a down market and reinvest when valuations are most attractive.
I'm assuming you haven't followed the stock market for the last 3 years or there is no way you would believe this. I don't think I could begin to count the number of activist funds that have been agitating for companies to take on cheap leverage and return capital to shareholders. Not every case is successful but in the last few years many of them have been. Yes a hedge fund can't directly lever a balance sheet like PE but the idea of creating value via a more efficient (I won't say better) capital structure is not something that PE funds have a monopoly on.
Also there are lots of cases where you look at an investment assuming the multiple will contract. It isn't a one way street; or if you only assume multiples will expand I don't think you'll be in business very long. Overall I think you are taking an incredibly simplistic view of how you think things work.
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