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Hedge funds know how to pick stocks and make lots of money, particularly with stock which they can “trade at will”, unburdened by inside information or other constraints. But, that is not the same thing as creating value through ownership of an asset over the long-term in a hands-on way.

Henry Kravis, Kohlberg Kravis Roberts

Private equity and hedge funds are the latest buzz-words in the Indian financial community. While hedge funds are purely financial investors who live for the moment, private equity investors tend to have a longer term outlook of typically five to seven years. Strategic investors, on the other hand, have an even longer term outlook. But at heart, all three are fundamentally managers of capital, tasked by their investors with generating best returns on their capital. In this context, it is interesting to compare the investment styles of strategic investors with the other two.

In fact, strategic investors can benefit to an extent by adopting some of the investment disciplines of private equity inves-tors. For example, strategic investors tend to be more focused on improvements in their business’s cash flows over time. This can sometimes result in a “too close to the coal face” mentality. In reality, cash flows can vary for reasons which could be market-based or business-related. Strategic investors strive to create value by generating higher cash flows which, on a present value basis, tends to lead to a higher business value. In other words, they are discounted cash flow (DCF) investors, where models are constructed to horizons stretching out to 20 years with some assumptions for terminal values after that. I would, therefore, also call them fundamental investors.

However, in reality, a business’s value also changes over time and this could be on account of factors such as market sentiments, liquidity, future outlook, changes in long-term discount rates, etc. In other words, the same cash flow stream can have different values at different points of time. This difference in value can also be arbitraged—either over time or over geographies—to create value. While it is impractical for strategic investors to sell and buy back their entire business, it is practical and sensible to be alive to such value arbitrages, using the same sector knowledge required to improve operational cash flows. Such changes can be tracked by detailed sector knowledge of factors that impact this arbitrage and could be exploited. For example, by buying and selling a company’s own shares or by buying and selling non-core assets.

Leading on from there, it is also true that a portfolio’s returns are more significantly driven by asset allocation decisions rather than by specific stock picking expertise. Clearly, a strategic investor cannot sell his entire business and reallocate his portfolio into other sectors, because that is not the mandate. However, strategic investors can focus more on asset allocation decisions within the context of their business. For example, how much to invest in up-stream, mid-stream or down-stream and, importantly, when; whether to be cash heavy or asset heavy, when to acquire parts of the business and when to divest.

• Strategic investors should be aware of value arbitrages
• They need to focus more on asset allocation decisions within their business
• Such decisions need better appreciation of asset allocation within a business

These sorts of decisions need a better appreciation of both asset allocation within a given business, as well as the value of the business over time. If strategic investors only focus on operating value improvements, then it is akin to only focusing on stock selection to improve performance while ignoring the major value impactor, i.e. asset allocation. This operational focus unfortunately tends to miss what could be the real drivers of value creation within the business.

Clearly, investors can do asset allocation themselves. However, managers of strategic businesses need to be more aware of the elements that can lead to true value creation in their businesses. The same sector knowledge which leads to operational improvements in the business can also be coupled with elements of financial value creation and, hence, be further exploited. Buy-out funds, which marry the traditional private equity investing practice with a stronger focus on strategic management of businesses, attempt to do just that. There is no reason for strategic investors not to do the same. In time, as buy-out funds become more dominant in the international financial market place, the line between such active investors and strategic investors will become blurred.

Source: The Financial Express