Hedge funds are dramatically changing the landscape for private equity sponsors who, until recently, were the only financial players looking to take public companies private.

Some of that change is positive from a sponsor perspective and some of it is negative. The key benefit is that hedge funds create liquidity for existing shareholders and therefore generally make it easier to complete a public to private (P2P) transaction.

There was a time when institutional shareholders in public companies stood firm (or at least threatened to do so) when they saw a P2P looming. They were afraid of being taken advantage of by management who knew more about the business than they did. They also feared the embarrassment of the private equity sponsor making significant returns by realising its investment rapidly at a large profit. Now they are simply more likely to sell to the hedge funds which are looking to see a deal go through and realise short-term returns.

In other words, the motivation of a hedge fund shareholder is often to support any bidder at the highest price obtainable.

Another helpful development is the recent trend of hedge funds providing mezzanine capital (often with warrants or some equity participation) to assist in bid financing – one example of this is the financing for the Glazer takeover of Manchester United. Although this was not a private equity-led deal, it was highly leveraged and had a structure not unlike a private equity-driven P2P.

The hedge fund challenge

Nevertheless, private equity houses have many reasons to be wary of the increasing influence of hedge funds on bids for publicly-listed assets. For a start, some hedge funds have decided to do P2Ps themselves. The £404m takeover of Peacock Group last year was carried out by a consortium of hedge funds led by Och-Ziff and Perry Capital.

Of course, not every hedge fund has a strategy that lends itself to this kind of transaction. Only those funds that have adopted an event-driven strategy or have a so-called 'private equity side pocket' are likely to be interested.

Equally, length of capital will be important. Trading hedge funds that offer investors short-term or quarterly redemptions will find it difficult to do P2Ps. Hedge funds with long lock-ups (like Perry Capital or Och-Ziff) will find it easier structurally. There are also other alternative asset management groups that have been involved in P2Ps such as Oaktree Capital Management, whose private equity fund recently successfully completed the £182m P2P of Richmond Food Group.

When not actively competing for assets, there have been a number of recent instances of hedge funds buying into announced public-to-privates. Sometimes this has been to a level of stake which ought to enable the private equity sponsor to convince its banks to proceed with the transaction, say 10% to 20%. The intention is not to frustrate the offer but effectively to have a forced co-investment with the private equity house and be long-term shareholders alongside it. This strategy can only be implemented where the deal has been structured as a takeover offer, rather than a scheme of arrangement.

A scheme of arrangement either fails or succeeds and there is no scope for unforeseen minority shareholders. Of course, it is equally possible for hedge funds to build a stake with the intention of frustrating an offer.

For example, hedge funds are understood to be purchasing PagesJaunes' shares on the Paris Exchange to block compulsory acquisition and force enhanced terms for non-accepting minority shareholders. In France, a 5% interest would be sufficient to block compulsory acquisition. There is no doubt that potential private equity buyers would try to find ways of managing this situation if the hedge funds are successful.

On 3i's recent scheme offer for Mayborn, the hedge fund Trafalgar has purchased a stake reportedly with a view of seeking to persuade institutional share-holders to support it in seeking a higher offer. A third challenge for private equity acquirers is the impact of hedge funds as activist shareholders. Some hedge funds attempt to force investee public companies that would otherwise be potential P2P candidates down a break-up or other route that improves value for shareholders. There have been numerous examples of this in the US, such as Cendent. The idea is that by forcing a break-up of conglomerates with diverse businesses, the sum of the parts as separate companies will outstrip the market capitalisation of the combined company.

Alternatively, hedge fund value investors can be satisfied by returns of capital or dividends financed either by disposals or re-leveraging, (that is, giving existing shareholders some of the benefits of a leveraged balance sheet without handing over the upside to the private equity sponsors). Some hedge funds would also be interested in providing the kind of long-term innovative debt that would enable corporates to be more comfortable with taking on the debt that would enable these transactions to take place.

Also, private equity houses have historically often adopted a strategy of building stakes in target companies once the transaction has been announced to improve the chances of success. Today, they may have to compete with hedge funds in mopping up any available shares in the market. In addition, hedge funds have traditionally had greater flexibility than private equity funds in being able to build stakes in public companies in advance of a transaction, although many private equity funds, such as Permira's new fund, now give greater flexibility in this regard.

The private equity response

Of course, private equity sponsors are not taking all this lying down. Many, such as Texas Pacific and Blackstone, have created long/short and special situations funds. Indeed, Blackstone in taking a 5% stake in Deutsche Telekom appears to be acting more like a hedge fund than a private equity house. Kohlberg Kravis Roberts & Co has created a vehicle that can short publicly-quoted shares, although it has resisted calling it a hedge fund.

Many would say that in an environment where there is a great deal of capital-chasing both upper-quartile hedge funds and private equity funds – witness Permira's 11bn (£7.6bn) target on its latest fund – one of the most important battlefields between private equity and hedge funds is not in the P2P arena but the search for talent.

Hedge funds are helped in this regard by performance fees that include credit for unrealised gains and which therefore allow payout to executives more rapidly than a private equity fund. However, hedge funds equally have to reflect unrealised losses in calculating their performance fees and generally do not charge deal fees to the same extent as private equity fund managers.

In the end, however, many industry experts expect the distinction between hedge funds and private equity to blur as both become part of diversified alternative asset management groups. At this point there may be no further battles, but the question is: who will have won the war?

Charles Martin is a partner in Macfarlanes' private equity group.