Two become one: all signs point to continued trend of private equity and hedge fund convergence.

• Author: Reid, Dan
• Position: HEDGEFUNDS

Nearly a year has passed since Grant Thornton and the Association for Corporate Growth first discussed the growing trend and potential impact of private equity and hedge funds converging in their whitepaper, Blurring of the Line: Private Equity and Hedge Funds are Converging. And while the trend toward convergence strongly continues, several new trends have developed.

THE NEED FOR A ROBUST DUE DILIGENCE PROCESS

Generally, private equity investments tend to be relatively illiquid. As a result, private equity investors must take a longer-term view of their portfolio companies. This view may be only five to seven years down the road, but one may run into a down cycle in the company's industry or the economy in general during this period.

Private equity investors historically prepare to ride out these bumps through extensive due diligence prior to closing the transaction, understanding that this process helps uncover any issues that might impact the purchase price or valuation of the company and identifies potential issues that might arise during the holding period.

Due diligence has always been an important concept, however, hedge funds are new to the private equity type investing game and and sometimes shortcut the process.

Now that hedge fund investors have adopted a private equity strategy, they are more often employing a traditional due diligence process. We are seeing fewer private equity-like hedge funds omit this very important step in the transaction process.

Hedge fund investors understand the need for due diligence to better understand the target company and incorporate their findings into the terms of the transactions. Once a transaction closes, the buyer controls the company and generally has an illiquid investment. Any shortfalls in expectations, such as uncollectible accounts receivable, obsolete inventories and poor customer relations will impact future earnings and value.

If the buyer has not built into the purchase agreement mechanisms to adjust the purchase price or recover damages under indemnity provisions, then these shortfalls impact the ultimate return the buyer will realize on this investment. More and more, they understand that post-closing, they will pay a steep price for not having obtained insight into various issues and potential problems during the due diligence phase.

Additionally, hedge fund investors are realizing the benefit of developing a comprehensive transition plan and forward-looking plan based on their...