Circuit City Bid Sounds Alarm To Hedge Fund ArRival –

The proposed acquisition of Circuit City does not involve a private equity firm, but most industry observers will probably be watching this deal to see how it unfolds. Hedge fund Highfields Capital Management made a $3.24 billion offer to take the company public, valuing the stock at a rich $17 a share. If the private equity world had not previously seen the hedge funds crowd into their space, this deal could serve as a harbinger of things to come.

The convergence of private equity and hedge funds has been making waves throughout both industries, as some LBO shops have begun tackling distressed debt while the hedge funds are increasingly showing up at auctions. CalPERS CIO Mark Anson reportedly told a conference in Geneva that the increased hedge fund influence, coupled with rising interest rates and an already high LBO capital overhang could conspire to pop what he termed as a “bubble” in private equity.

And as the two sides increasingly mingle, it does not necessarily make for friendly bedfellows. At the recent SRI Private Equity Round Up in Scottsdale, Ariz., one private equity pro called the hedge fund intrusion “troubling,” noting that “you end up with some money in dumb hands.”

In the case of Highfields, it’s unlikely anyone would characterize this firm, in particular, as dumb money. Richard Grubman, a managing director at the Boston-based hedge fund, gained notoriety that morphed into repute when he grilled Former Enron CEO Jeffrey Skilling on the absence of a balance sheet in a 2001 earnings call. Skilling famously referred to Grubman as a seven-letter profanity that refers to a person’s posterior.

But while they don’t qualify as dumb money, the firm has certainly gained a reputation as among the more contentious investors in the hedge fund world. Highfields has spoken out against potential mergers involving the companies in which it invests, and has in the past tried to block unions between Coors and Molson and Mony and AXA Financial. Also, the firm swung its weight around with positions in Adelphia, Readers Digest and Stilwell Financial.

Nothing has been made public about prior control investments by Highfields and the firm did not return calls to Buyouts by press time. But the firm has made some private equity-like investments in the past, and Highfields was part the group that launched CapitalSource, joining an assembly that included Madison Dearborn Partners and Wachovia Capital Partners. The hedge fund also backed the German LBO firm NannO Beteiligungsholding GmbH in its acquisition of Agfa-Gevaert NV’s film business.

However, those deals did not have the profile of the proposed Circuit City acquisition, and some private equity onlookers envisage that the proposed deal will not end in a good way for Highfields. One pro, with a strong track record in the public-to-private realm, predicts, “I don’t think it will close. If I’m a shareholder, I’d be happy to see it close, but I suspect that [Highfields] will get cold feet once they get into the due diligence and realize what kind of capital it’ll take to actually complete the deal.”

Highfields, as of press time, owned roughly 6.8% of Circuit City’s total shares outstanding, and, according to a Bear Stearns & Co. analyst note, paid an average price of approximately $11.25 a share for that stake. Even if the deal does not go through, Highfields clearly has something to gain by putting the company in play. The stock jumped on the news of the offer climbing from $14.23 a share a day prior to announcement to around $16 a share as of press time.

But if this is just a ploy to goose the stock price and the Highfields ends up owning Circuit City, the firm could find itself in over its head. The buyouts pro adds, “I really don’t think those guys have any idea of what they’re getting into. It’s not rocket science, but [taking a company private] is very different from buying public stocks… [Highfields] is a large shareholder, so they may have other motives, but at the multiples they’re bidding and the competitiveness of that industry it seems like a full price to me.”

In a letter to Circuit City, Highfields states, “Though some steps have been taken to address the Company’s operating performance and sub-optimal capital structure, we are nevertheless disappointed that management has been unable to move more aggressively.” Highfields adds that removing Circuit City from the public market would allow the retailer to pursue its strategy without having to worry about quarterly performance numbers. Further, Highfields notes that the company’s significant cash balance “severely limits the potential upside to equity holders.”

For a hedge fund looking to make a splash in the buyouts space, Highfields has chosen a difficult part of the pool to dive into. The consumer electronics space has not been kind in recent years. And as private equity found through investing in the toy industry, whenever Wal-Mart’s presence looms large, disappointment can soon follow.

Whether this investment serves as an opening salvo to a hedge fund rush into large-scale private equity buyouts remains to be seen, but anecdotally hedge funds have started to pop up more frequently.

“We’re seeing the hedge funds on the equity side in about two of every 10 auctions… It’s hard to tell at this point how deep this convergence will go and how long it will really last, but from a seller’s perspective they’re generally viewed very positively. They’re considered very smart and have flexibility and the ability to move quickly on deals,” says Hiter Harris, a managing director with Harris Williams & Co.

Michael Littenberg, a corporate partner with Schulte Roth & Zabel adds, “Hedge funds have become very formidable competitors to the private equity funds. They have a much broader mandate, and unlike a typical private equity firm, hedge funds are usually in multiple levels of the capital structure. That model provides an advantage in that there is new money constantly going into funds and they can reinvest the proceeds.”

One has to look no further than Highfields to see an example of this. The firm -ostensibly in connection with the Circuit City bid- submitted a Form D filing with the Securities and Exchange Commission to bolster its first and second funds with new commitments. The filings were dated February 7, a little more than one week prior to the proposal.

Meanwhile, private equity has done its part to enter into the hedge fund universe as well. AEA Investors recently merged with real estate and hedge funds manager Aetos Capital, while, Texas Pacific Group just recently unveiled TPG-Axon Capital, its entrant into the asset class. Both HIG Capital and Sun Capital Partners have unveiled distressed debt vehicles that focus on the smaller end of the market, and late last week CarlyleGroup Co-founder David Rubenstein told an industry conference in Frankfurt, Germany that his firm intends to raisetwo separate hedge funds: a securities hedge fund and a separate hedge fund of funds.

Whether this expansion of boundaries proves fruitful remains to be seen, but if it does not, it can be expected that both sides will cut their losses and move on. “Hedge funds are very opportunistic,” Littenberg says. “They have a history of jumping in and out of private equity… In the late 90s we were seeing a lot of hedge funds doing venture. I was getting five to 10 calls a week from hedge funds looking for those deals, but very few of those guys would even look at a venture deal now.”

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