Private Equity The Brave New World Of Private Equity And Hedge Funds

Wednesday, February 1, 2006 - 01:00

Editor: Please tell our readers about your practice.

Tabak: We have a global private equity practice at Weil Gotshal with over 200 lawyers in many of our 20 offices around the world. Our business strategy continues to be representing sponsors when they form funds and, then subsequently doing the execution work for the funds. My concentration for the last number of years has been in the fund formation area. I have had the opportunity to work with our existing funds that are forming successor funds as well as with new start-up funds that we form and watch mature into successful business enterprises.

Editor: You represent private investment funds. Does this include corporate pension funds directly or as investors in private equity funds?

Tabak: In addition to representing sponsors and general partners of the funds, we also represent institutional investors. We have long-standing relationships with many institutional investors. This provides us a broad view into the marketplace at any given time. Because of the types of institutional investors that we represent, including some non-U.S. investors as well as U.S. pension plans, we see a large majority of the private equity funds that are being raised all across the world which helps us on the sponsor side as well.

My theory of representing clients has always been that each party to a negotiation has a valid point of view for its position. If all I did was to represent general partners, I might not fully appreciate and understand what limited partners want. By representing limited partners, I am better able to service my general partner clients by acknowledging and resolving the issues that limited partners have in a manner satisfactory to both sides.

Editor: Do you also represent occasional sellers of properties to funds?

Tabak: Yes, though there are two categories of sellers. One is on the execution side. We represent a number of large corporate clients who have merged with or been acquired by a private equity firm.

But, I am also thinking about the secondary market because there are a number of private equity investors who are looking to sell some of their interests in various private equity funds. The secondary market continues to be strong. We represent a number of secondary funds and other clients that are looking to purchase those interests.

Editor: Do you also represent clients in Club Deals (consortiums of private equity funds)?

Tabak: Club Deals are a developing area of the private equity fund practice. We have represented a number of clients in these types of transactions. It's a very interesting dynamic to see these large private equity funds that for many years were doing deals by themselves now negotiating the acquisition as a group. The relationships among the private equity funds that are participating in the Club add an interesting dimension to the practice.

Editor: What are the pros and cons of being a member of a Club, especially when things go sour?

Tabak: One element is that deals are getting larger and larger. Being part of a Club allows the private equity firm to diversify some of its risks and to allocate capital among more deals. It will be interesting to watch the exit strategies play out in these investments. Who is going to control those types of decisions? Is there one lead investor in the Club? Is this decision shared? Does someone have a veto right? What happens when, as is inevitable, some deals do not go well? How will that play out?

A consequence of these Club Deals is that an institutional investor may find itself with more exposure to a transaction by virtue of its interest in a number of funds that are participating. Thus far, we have not heard many objections from investors about that.

By the way, that is also happening when a private equity fund sells an investment to another private equity fund. An investor in the selling fund may receive proceeds from that fund yet be contributing capital to acquire back the same interest as a result of being an investor in the buying fund.

Editor: Do you also represent hedge funds? If so, how does this representation differ in terms of what hedge funds seek as their objectives from those of private equity funds? Do you see a convergence between hedge funds and private equity funds?

Tabak: We do represent hedge funds. The hedge fund world for many years was very different from the private equity fund world in that hedge funds catered primarily to high net worth individuals. Hedge funds had a variety of different strategies but they all participated primarily in liquid transactions. As a result, their managers were not looking to do illiquid or longer term transactions such as LBOs. Lately we are seeing more of a convergence of private equity and hedge funds. I am moderating a panel next month in London at the American Bar Association/International Bar Association's International Conference on Private Investment Funds dealing with this very topic, the convergence of private equity funds and hedge funds.

For me, it has come full circle. One of the first clients I worked with as a first-year associate at Weil Gotshal was a newly formed fund called Odyssey Partners. Odyssey was a true hybrid fund, investing a portion of its capital in liquid securities like a hedge fund while at the same time using a portion of its capital to do leveraged buy-outs. They had a longer lock-up period than most hedge funds do today. If investors wished to withdraw their money, they withdrew capital from the liquid investments made by the fund, but their capital in the illiquid investments remained until those investments were sold. Today there are hedge funds taking advantage of the opportunity to do "side pocket" investing in illiquid investments. I represent a number of hedge funds that only invest in liquid positions, but I now represent a number of hedge funds that are crossing over and doing private equity-type investing as well.

Editor: How do you protect your clients from fraud?

Tabak: One thing is certain - you can't protect them 100 percent. If you are representing an institutional investor, you can help by doing background research on the manager. If the manager is registered with the SEC, you can review disclosure forms that are filed with the SEC. You can negotiate into the documents as much transparency as possible, asking for reports to be delivered on a regular basis or whatever information the client thinks that it needs.

A new SEC rule goes into effect on February 1, 2006, which will require hedge fund managers to register with the SEC if they manage a fund that has a lock-up period that is less than two full years and have more than 14 clients. So more managers will have to file documents with the SEC, although those documents won't tell you what is happening on a day-to-day basis.

People need to be very careful before they invest anywhere, not just in the private investment fund area. The same is true with respect to any business. You need to make a judgment about the people with whom you're investing. You develop relationships with them and there is a fair amount of trust that is a part of that relationship. And, you hope for the best because if someone is going to commit fraud, it doesn't matter much what the document says.

Editor: You also concentrate in the area of basic business formation, such as limited and general partnerships and LLCs. Do you assist clients not only in determining the best structure in protecting them from future liabilities but also those that are most tax advantageous?

Tabak: Yes. A large part of the private fund formation area is tax driven. We work very closely with our tax colleagues whenever we are structuring a private fund. Not only on the domestic side, but also on the international side, it is critical to determine the best place to organize a particular fund, depending on who the investors are and where the investments will be made. We also coordinate closely with our ERISA colleagues. As I mentioned before, a large number of the institutional investors in these types of funds are public or private pension plans that have ERISA issues to consider.

With respect to domestic funds for U.S. taxable investors, those are generally set up as Delaware limited partnerships. The general partner and the investment management companies are often separate entities set up as limited liability companies.

Limited liability companies have proven useful because they provide the tax flow through advantages of a partnership with the limited liability protection of a corporation.

In the case of an offshore fund for non-U.S. investors and U.S. tax-exempt investors, we might set up a limited partnership, limited duration company or exempted company in a foreign jurisdiction.

Editor: Why do you think so much money has been poured into equity-type funds?

Tabak: . When you look at the numbers of private and public pension plans, endowments, foundations and, in the case of hedge funds, the number of high net worth individuals in the world, there is a lot of money in the marketplace to invest. Investors look for opportunities to diversify their portfolios and maximize their returns. The private equity and hedge fund area has proven to be a very profitable alternative strategy for a number of investors. Certainly, if you look at the historic returns that private equity funds have generated for their investors, it's no surprise that more and more investors seek out this asset class.

What is happening to hedge funds these days is a perfect example. For many years, hedge funds were the province of high net worth individuals. Institutions did not invest in hedge funds. Hedge funds started to generate higher returns, prompting institutional investors to look at them more closely. As a result, hedge funds have grown exponentially in numbers and in volume. Now we're seeing more convergence between hedge funds and private equity funds. But there are cycles. As hedge funds invest more and more in illiquid investments, you will see more and more money chasing similar types of investments, and I think you might see somewhat of a squeeze on returns.

Editor: Has corporate America benefited from the growth and power of investment funds?

Tabak: Reasonable people can differ, but, in my view, corporate America has benefited from their growth.

Funds have provided exit opportunities for owners. The expertise that a private equity fund brings to a particular business helps them grow and develop. Certainly venture funds have provided smaller businesses an opportunity to develop new and exciting products, which has led to tremendous technological advances in the world.

Please e-mail the interviewee at www.jeffrey.tabak@weil.com with questions about this interview.