There's an old saying: "Keep your friends close and your enemies closer."

But what happens when you're not sure which is which? That's the situation companies may find themselves in when dealing with hedge funds. When a hedge fund presents itself as a potential investor to company executives, it is a good idea to try to understand the fund's investment profile and orientation to determine whether it could be a good fit for both parties and whether you're dealing with a potential ally or someone who seeks to benefit at your expense.

In recent years, assets under management by hedge funds have grown tremendously and so have concerns about the funds themselves. Hedge fund investors have traditionally been wealthy individuals or private institutions. Hedge funds are frequently described as secretive, destabilizing and overleveraged, whose investments lead potentially to short selling or unnecessary market volatility.

On the positive side, hedge funds have been called vehicles for compensating for mispricing of securities. They also can invest in companies that other funds find too small or too risky and thereby provide opportunities and liquidity to growth to companies short of cash and investors.

Since 1999, assets under hedge fund management have tripled from $324 billion to more than $1 trillion. During that same period, the number of funds has doubled to approximately 8,050. The assets under hedge fund management constitute only 4% of the market of all domestically listed stocks last year. Nonetheless, they can have a big impact on price movement. Many have the freedom to put substantial amounts of money into a single stock and cause tremendous impact on the price and volatility. Given their ability to leverage the funds they manage, they should definitely be considered powerful players in the marketplace that cannot be ignored.

Handled properly, companies may find additional sources of capital and a fund willing to invest for the long term. Or companies may find a short seller looking to pounce on any bad news. In the past, hedge funds were not considered part of the established investor community. They have been called opportunistic and are perceived as only looking for momentum and arbitrage situations, especially in cases of short selling. While this is true of some hedge funds, many are looking for long-term gain and are content to wait months and possibly years for their returns.

It is instructive to briefly consider different types of hedge funds. Those with a short-term focus look at the bottom line each month and exit from nonperforming stocks without regard for long-term prospects.

Other funds pride themselves on in-depth research, giving them an edge when finding opportunity. These funds consider the value or event that could drive up the stock. They can often be very aggressive in their fact-finding attempts and will often ask for one-on-one meetings with senior management and frequent updates.

Activist hedge funds seek to influence management in order to create value. They can either be hostile or friendly depending on their short- or long-term perspective.

Short sellers are hedge funds that sell stocks aggressively as part of their strategy. With large established institutions you can assume their orientation but with hedge funds, there needs to be caution in order to gauge their approach.

By being consistent with your communications to all investors (regardless how persistently and aggressively the questions are asked), companies can control the process. This means that your press releases, presentations, collateral materials, and conversations should convey information that is accurate and reflective of the company's values. Selective disclosure is illegal and a company should never feel compelled to reveal more information to one investor than it does to any other investor regardless of size or influence.

Doing research prior to meeting or speaking with a hedge fund can be vital. There are paper trails on the Internet, and you can make a judgment based on the kinds of investments they make, who runs the funds, etc. By doing research about the firm, you can gauge how closely you want to involve yourself and whether or not to set up a meeting. Sometimes the best thing is to be polite but keep your distance. A key criterion is whether they are long or short investors. In many cases hedge funds are both long and short and therefore are willing to be patient investors.

Forty to fifty percent of hedge funds voluntarily report with the SEC, and any fund that manages more than $100 million of investments must file a 13F. By February 2006, hedge funds will have to report with the SEC if they have at least 15 clients and $30 million under management. That said, there are still many cases of fraud and stock pumping among hedge funds, so it is important to do one's homework.

In conclusion, hedge funds have gained much more acceptance in recent years as investment vehicles, and the flexibility that they can exercise can present an opportunity. However, the old adage still applies: Know the difference between your friends and foes. By understanding as much as possible about what a hedge fund is and what its investment strategy and objectives are, companies will be in a much better position to control the relationship.