Hard underwriting of new share issues is as dated in the City of London as red braces and mobile telephones the size of briefcases. So Lehman Brothers’ decision last month to take a 4.99% stake in BlueBay Asset Management ahead of its £571 million flotation was both an echo of the past and a manifestation of a current trend. Investment banks are in love with hedge funds.
Lehman is following a trail blazed by Morgan Stanley. On October 30 it acquired 20% of Avenue Capital, a New York-based distressed debt specialist. The following day it bought outright FrontPoint Partners, founded by former Tiger Management head trader Gil Caffray, in a deal reportedly worth $400 million. It rounded out a frenetic week by buying a 19% stake in London based long/short equity specialists Lansdowne Partners for $300 million.
The prices look eye-popping but then hedge funds can make mind-boggling sums. Lansdowne’s flagship $3 billion in assets UK equity strategy (incorporating Lansdowne UK Equity Fund Ltd. and Lansdowne UK Equity Fund LP), was up 27% net in 2005. Applying a typical hedge fund impost of 2% of assets and 20% of performance above benchmark, a conservative estimate of its revenues in 2005 is $150 million. A 70% cost-income ratio (again modest) would have meant that Lansdowne’s UK Equity strategy generated an income of $45 million (pre-tax).
To put that in perspective, Morgan Stanley’s entire mainstream asset management business made only 22 times that amount ($1 billion in pre-tax income) from 143 times the assets of this one Lansdowne fund in 2005. Such is the magic of hedge funds. The net present value of a dollar invested in a mainstream fund pales beside the value it has invested in a hedge fund, especially a top-performing one.
The clincher for both sides of these deals is distribution. Hedge funds have relied on ultra-high-net-worth clients and funds of funds for their asset growth. However, these are notoriously hot hands. Institutional clients are more desirable but hedge funds are not natural asset gatherers. Their partners tend to be money managers not marketers or relationship managers.
Institutions want to buy hedge funds. A recent study by US-based consultancy Casey, Quirk & Associates estimated that global institutional demand for hedge funds would treble from $360 billion now to $1 trillion by 2010. By buying into the biggest and best multi-strategy firms, investment banks are betting that their superior distribution platforms will enable them to disintermediate the funds of hedge funds.
The banks are also gaining valuable expertise. Morgan Stanley’s takeover of FrontPoint is a lift-out of talent. Gil Caffray will become vice-chairman of Morgan Stanley Investment Management (MSIM). Michael Kelly, partner and FrontPoint’s head of manager selection, will become chief investment officer and head of MSIM’s absolute returns strategy group. Arthur Lev, FrontPoint’s general counsel, and Joanne Pace, FrontPoint’s chief operating officer, take the same roles at MSIM. Daniel Waters, partner and head of FrontPoint’s client advisory group, will become head of US institutional distribution at MSIM.
There are numerous fringe benefits as well. At the margin hedge funds might be more likely to direct prime brokerage and other commissions to their partner investment banks. And being able to look through to the trading positions of funds could enable the banks to create structured products and derivatives to sell on to private clients.
The biggest question hanging over these deals is timing. The performance of hedge funds has been poor of late. The Credit Suisse/Tremont Hedge Fund Index is up 7.64% year to date, and was up 7.6% in 2005 and 9.6% in 2004. The MSCI World Index has risen 9.6% so far this year, was up 13.7% in 2005 and 9.6% in 2004. Beta is consistently trumping alpha.
Hedge funds are facing ever greater fee scrutiny. Talk of convergence between the traditional asset management realm and hedge funds is fashionable. The threat of greater regulation is always in the background. Still, the good times are far from over. Multi-strategy businesses, the targets of the investment banks, will likely have some funds performing well even if some are struggling. However, if hedge funds want to get the benefit of cooler money the inevitable consequence over time will be the cost of lower fees.
Of course, it is always better to build. Goldman Sachs Asset Management (GSAM) and Barclays Global Investors (BGI) rank first and sixth, respectively, in Alpha magazine’s Hedge Fund 100. Robert Litterman and Mark Carhart at GSAM, and Richard Grinold and Ronald Kahn at BGI are not names well known outside the rarefied world of quantitative finance. But by applying investment theory they have created successful hedge fund businesses that have already made the cross-over into the mainstream institutional investment world.
Morgan Stanley and Lehman Brothers are playing catch-up. For that the investment bankers of Goldman Sachs and Barclays should be grateful to their asset management quants.
Andrew Capon is editor-in-chief at State Street Global Markets, the research and trading business of State Street Corp. He was formerly senior editor at Institutional Investor and has won numerous awards for journalism on fund management and investment issues. The views expressed are the author’s own