The New Private Market for Funds: An Alternative to Going Public

Sam Roseme, O'Melveny & Myers LLP

There is now an alternative to the public markets for private equity funds and hedge funds wishing to issue shares. The alternative is a newly-created private market that just may end up being the market of choice for funds if it proves to be viable. Goldman Sachs, as was reported in the Wall Street Journal[1], has developed a private market on which shares of funds will trade. The market is called "GS Tradable Unregistered Equity OTC Market" or GSTrUE. Oaktree Capital Management LLC, a Los Angeles-based investment firm with close to $42 billion in assets, was the first to sell its shares on GSTrUE. Oaktree raised $880 million in the private offering in May.

This development comes at a time when funds are increasingly looking to issue shares. But, until now, the funds only had the option of listing on public markets, such as the New York Stock Exchange and Euronext. For example, Fortress Investment Group LLC, the private equity fund and manager of hedge funds, has already listed its shares on the NYSE, Carlyle Group LP is planning an IPO on Euronext, Blackstone Group LP has filed for an IPO on NYSE, and others are reportedly considering following suit.

There are several advantages for funds to list their shares on a private market rather than selling shares to the public. First, the minimal regulatory oversight that a private market offers--compared to the public markets--is the most obvious advantage. As the Wall Street Journal put it, the private market will allow "Oaktree to avoid most regulatory requirements of a traditional share offering, [and] the deal is structured so shareholders will have practically no say in how Oaktree is run."[2] For funds that value their privacy this is the best of both worlds. They can raise significant amounts of capital--and give their founders and key employees a major payday at the same time--while not being forced to reveal their secrets to the public.

In addition to allowing funds to retain their privacy, the minimal regulation also is significantly cheaper for the funds due to the high cost of compliance that comes from being a public company. While the shares will likely trade at a discount compared to what they would trade for on a public market--because of the diminished liquidity due to the limited number of investors who can access the market--the lower price will be offset by the cost savings of being less regulated.

Another possible advantage stems from how these funds may be valued differently by the private market than they would be by the public markets. It has not yet been proven that the public markets function in such a way as to correctly value these funds. The public markets are good at placing a value on traditional public companies; the markets understand how to value the assets, cash flow and other factors of public companies. In addition, the public markets place great emphasis on the quarterly earnings of companies and the predictability of those earnings. But funds do not earn money the way most public companies do, and this can cause trouble for both the publicly listed funds and their investors. Funds' earnings are for the most part unpredictable and they often result from a one-time liquidation of certain assets that can cause net income to swing wildly from one quarter to the next. This can cause problems for funds listed on the public markets. Fortress recently found this out when it reported its quarterly earnings--becoming the first American private equity firm to ever do so. Fortress's stock price fell almost 4.5% after it reported that its quarterly net income was significantly lower than that of the year before. As stated in an article in The Deal, "the disclosures highlighted the difficulties the public markets have dealing with businesses whose income streams are volatile and difficult to predict."[3] The article went on to describe why funds may have trouble with the expectations of public markets: "net income is not the only way, or even perhaps the best way, to evaluate the firm's performance since much of a private equity firm's income derives from profits on the sale of investments and from one-off dividends from its portfolio companies." In addition, "[b]ecause Fortress cashes in on its investments sporadically, its earnings are extremely volatile."[4] And volatility is not a characteristic highly prized by the public markets.

Despite the advantages that the private market may offer, it is still not clear if this market will be able to get off the ground. The success of this new market--and any market like it--depends almost entirely on whether or not it can achieve sufficient liquidity. That will likely depend on Goldman's ability to sell this market to investors by convincing them that it will be both a safe and profitable way to invest in these funds. Liquidity is the primary benefit that such a market can offer to investors that the traditional method of investing in these funds does not. The traditional method of investing in a fund is to become a limited partner of the fund. By doing so, however, the investor is often forced to agree to a "lock-up period" during which the investor is prohibited from moving its investment out of the fund. These lock-up periods can vary in length depending on the fund. And even after the lock-up period expires, at least for most hedge funds, the investor then is only allowed to liquidate its investment once a quarter. With a market like GSTrUE, however, investors can buy and sell their investments as they please--but only if the market can provide liquidity. If Goldman cannot provide liquidity, there will be no investors. But if Goldman succeeds and achieves the necessary liquidity, expect to see more funds opting to list on GSTrUE--or copy-cat markets that are likely to develop if GSTrUE is successful--rather than turning to the public markets.

Of course, not everyone will be able to buy shares in this new market, which is why liquidity is such an uncertainty at this point. In fact, even fewer investors will be allowed to participate than the already limited number who can invest directly in hedge funds and private equity funds. GSTrUE will likely be a market based on what are called Rule 144A offerings. Rule 144A of the '33 Act works as an exemption to registration. To qualify for the exemption under Rule 144A the securities must be "offered or sold only to a qualified institutional buyer.." The term "Qualified Institutional Buyer" is defined in the rule as any of a variety of entities listed in the rule "that in the aggregate owns and invests on a discretionary basis at least $100 million in securities of issuers that are not affiliated with the entity." In other words, institutional investors such as large pension funds. Luckily for GSTrUE and Oaktree, such institutional investors are the primary investors in--and reason for the significant growth of--hedge funds and private equity funds.

Samuel Roseme,, is an associate in O'Melveny & Myers LLP's San Francisco office and a member of the Mergers & Acquisitions/Private Equity Practice.

[1] Henny Sender, Oaktree to Try a New Twist for Share Sale, The Wall Street Journal, May 10, 2007, at C1.

[2] Id.

[3] Lisa Gewirtz-Ward, Fortress Reports, Stock Falls, The Deal, May 16, 2007

[4] Id.