The mating game

By Britt Erica Tunick
Illustration by Graham Roumieu

New York hedge fund firm Claren Road Asset Management has attracted numerous suitors in its relatively short life. The $4.7 billion long/short credit firm reportedly got started with a $250 million seed investment from Citigroup in 2005. Then Goldman Sachs’ Petershill Fund, a private equity vehicle designed to take stakes in hedge funds, bought a minority position in the firm in 2008. The latest firm to take a shine to Claren Road is the Carlyle Group, which acquired 55% of the firm, effectively buying out Citigroup and Goldman, which will cash out their investments.

This is not Carlyle’s first trip down the aisle with a hedge fund, but will the firm do any better with Claren Road than with its previous efforts? After all, the Carlyle-Blue Wave Partners Management hedge fund was liquidated in August 2008, only 16 months after its launch, when the fund lost money on bets that the subprime market was already oversold. Carlyle Capital Corp., a highly leveraged mortgage bond fund listed on the Euronext Amsterdam exchange, liquidated only five months earlier, after that fund defaulted on $16.6 billion in debt.

“Carlyle had Blue Wave and Carlyle Capital, two very embarrassing situations,” observes a former investor in Claren Road. That’s not to mention how other private equity funds have fared. Petershill’s investments have included Level Global Investors and Shumway Capital Partners, two previously high-flying hedge funds, which have recently shut down amid massive redemption requests.

Private equity firms have rarely succeeded in their efforts to add hedge funds to their offerings, but that’s not stopping them from trying once again. In recent months, Kohlberg Kravis Roberts scooped up Goldman Sachs’ proprietary trading unit; Apollo Global Management made a $75 million investment in HFA Holdings, the parent company of fund-of-funds firm Lighthouse Investment Partners; and Petershill took a stake in hedge fund Mount Lucas Management. Such deals have many industry observers predicting that a wave of similar transactions could follow.

There’s a good reason for Carlyle to try again. For cash-rich private equity firms eager to invest capital raised before the credit crisis—cash that may need to be returned if not invested soon—hedge fund firms and the fees they generate are looking like attractive prospects. Adding hedge funds to their stable would broaden private equity firms’ product offerings and beef up returns, two attributes that would make them more palatable to investors if they want to take their businesses public.

Private equity firms have historically achieved higher average returns than hedge funds, which can partially be attributed to higher return requirements from their investors, given the longer lockups and reduced liquidity, says Anthony Maniscalco, head of alternative asset management banking for Barclays Capital. That changed in recent years, especially when private equity firms raised their last round of capital.

“Fundraising in ’06 and ’07 resulted in more challenging vintages, as the capital was used to acquire businesses at or near peak equity market valuations with significant leverage,” Maniscalco says. “Given what happened to valuations, many of those funds on a marked basis are at or around breakeven, whereas most hedge funds were able to reposition their portfolios and get back to or above their high-water marks in ’09 and ’10.”

Another benefit of adding hedge funds is adding variety to product lines. “A lot of larger private equity firms want to go public—as Blackstone, KKR and Fortress have done—so they are diversifying their product service lines with the goal of getting better P/E ratios and valuation metrics,” says Eric Weber, the chief operating officer of independent advisory firm Freeman & Co.

In 2010 deals among alternative asset managers outpaced those among traditional managers for the first time, according to Freeman’s most recent biannual summary of M&A activity. Freeman counted 102 deals involving alternative asset managers in 2010, an 89% increase in volume from the 54 deals that occurred in 2009. But most of last year’s deals were relatively small, and the total dollar value of assets managed by managers in these transactions actually fell significantly.

Total assets managed by the alternative managers involved in M&A deals in 2010 came to $711 billion—far from the collective $4.7 trillion managed by such firms involved in M&A deals in 2009. That number was boosted by a few blockbuster transactions, such as BlackRock’s acquisition of Barclays Global Investors, which alone accounted for assets of $1.5 trillion, and Crédit Agricole and Société Générale’s merger of their asset management groups, a deal with assets totaling $808 billion.

For hedge funds that are either grappling with succession planning or having difficulty raising capital, such equity investments can be equally enticing. Smaller firms are realizing it will be far more costly to run their businesses in the wake of heightened regulatory oversight, while aging founders of larger shops are looking to devise an exit strategy.

“Since you have many hedge funds that have realized they need size, scale, distribution and possibly affiliation with a brand name to provide that distribution, you’re going to see continued activity in the sector,” Weber adds.

Dean Barr, a principal at Foundation Capital Partners, agrees. “A lot of hedge fund founders now see selling minority stakes as a way to attract permanent capital,” says Barr, whose firm was recently established to acquire minority stakes in hedge fund firms. He previously worked as chief executive of Citigroup’s Tribeca Global Management.

“The fact that these transactions are happening more often says that this is not just some niche trend and is probably the start of something larger that actually deals with the maturation of the industry,” says Barr.

New entrants into private equity are also looking for hedge fund investments. Unlike seeding funds that primarily look to back fund launches, Quaestus Capital, a newly formed private equity firm, is planning to take advantage of opportunities among the plethora of existing funds. Quaestus has begun fundraising for a fund targeting institutional money that will inject equity into smaller hedge fund firms, help them boost their assets under management and make them more attractive to institutional investors.

“We’re looking at hedge funds that are already out there that may have great track records but that have been hindered because of the market,” says Lester Hollis, Quaestus Capital’s founder and managing partner, who began his career as an investment banker at Goldman Sachs before moving into the fund-of-funds industry. “If you’re a guy running $100 million and don’t know the institutional marketplace and the players, there’s a gap to be bridged,” says Hollis, who plans to assist firms in boosting their infrastructures and making sure they are sending the right message to potential investors.

Given that staking hedge funds appears to offer advantages for both buyers and sellers, these deals may look like matches made in heaven for both sides. But for private equity firms and other asset managers who have done such deals, reality has proved to be rockier.

Petershill’s investments have underscored the difficulties of getting it right. Just last year the firm took minority stakes in two blue-chip hedge funds, Level Global and Shumway, only to watch as both firms shut down months later.

Late last year, after Shumway founder and former Tiger cub Chris Shumway informed investors of plans to hand his role as chief investment officer to one of the firm’s strongest fund managers, Shumway Capital Partners was hit with redemptions totaling roughly $3 billion. With the firm’s future uncertain, Shumway decided to shut down his firm and return investors’ money.

Level Global was one of three hedge fund firms raided by the Federal Bureau of Investigation in November as part of the government’s insider-trading probe. Though it has not been charged with any wrongdoing and has said it is cooperating with the investigation, in early February the firm’s founder, David Ganek, told investors he was closing up shop because the slew of redemption requests triggered by the insider-trading probe would make it too difficult to continue operating.

For Petershill, Level Global’s closure makes its holdings in the firm essentially worthless. In the case of Shumway, Chris Shumway is reportedly considering buying back Petershill’s stake in his firm.

Carlyle has had a similarly checkered history with hedge funds, given its difficulties with Blue Wave and Carlyle Capital. (Calls to Carlyle were not returned.) Its latest acquisition, Claren Road, has been embroiled in its own controversies. Claren Road upset its investors following the Lehman Brothers bankruptcy, when the hedge fund wrote down its Lehman exposure by only half, allowing it to post a 2008 profit and thereby collect performance fees. The firm has refused to restate its 2008 results, but it did refund some of the performance fees it had charged investors.

Still, it did not voluntarily provide an explanation of how the refunds were calculated, and some investors remain bitter. “I don’t trust them as far as I can throw them,” says a former Claren Road investor who questions Carlyle’s judgment of the hedge fund industry.

In terms of performance, however, Claren Road is coming back: The Claren Road Credit Master Fund was up 4.63% last year and has told investors it expects to profit from the Lehman exposure. The fund has produced annualized returns of approximately 11.9%. Mount Lucas, another recent Petershill investment, manages $1.76 billion and has also produced good performance. The firm’s flagship MLM Macro-Peak Partners fund gained 7.89% in 2010 and is up 3.21% this year through January, leaving it with an annualized return of 15.77%. (Both firms declined to comment.)

Those smaller deals are in sharp contrast to some of the bigger deals that have been done among other types of buyers. Funds of funds, hedge funds and the asset management groups of some of the industry’s largest securities firms have also been shopping for stakes in hedge funds, in some cases setting up funds with the sole purpose of taking equity stakes in these firms. These deals have favored the largest hedge funds, such as Credit Suisse’s recent acquisition of roughly 30% of the $14 billion firm York Capital Management for $425 million and JPMorgan Chase’s acquisition of Highbridge Capital Management, the first deal of its kind. In 2004, JPMorgan Chase acquired a majority stake in Highbridge, which culminated in a complete acquisition in late 2009. Another recent blockbuster deal was Man Group’s acquisition of London hedge fund manager GLG Partners in 2010 for $1.6 billion.

Foundation Capital Partners’ Barr says potential acquirers are primarily interested in firms on the extreme ends of the spectrum—those in the $5 billion and above range whose identities aren’t too closely tied to a single fund manager, or firms just starting out that are in need of seed money and a platform to support them.

Of the hedge funds that have sold stakes in their businesses, the most common benefits cited for doing these deals are the ability to take advantage of the strength of acquirers’ branding and to access their investor networks. Barclays’ Maniscalco says many private equity firms think that if they can get their own longer-term investors into the hedge funds they partner with, hedge funds could finally get some of the stickier money they have long sought. And while some private equity investors may not love the fickle nature of many hedge fund investors, private equity firms are banking on the fact that hedge funds’ abilities to adapt more quickly to changing markets will make up for any hesitation.

Some of these deals have worked out, but many investors are still critical of M&A among hedge funds. “The whole reason we invest in hedge funds is because of the entrepreneurial nature of a hedge fund manager. But when they start getting parents involved, decisions are often made for the wrong reasons,” says the chief investment officer for one major institution that will not invest in hedge funds that have gone public or have sold equity interests in their businesses. “It’s difficult to put your investors first when you have shareholders dictating the price and valuation of your company,” he says, adding that shareholders care only about the bottom line and will almost always push funds to raise more assets to generate greater incentive fees.

The one exception people point to is JPMorgan’s acquisition of Highbridge, though investors note that JPMorgan’s private bank is well known to have heavily marketed it in order to ensure its success. And the CIO is just as quick to note that there have been more failures than success stories, pointing to Morgan Stanley’s 100% acquisition of FrontPoint Partners in 2006 as one such example.

“Morgan Stanley had good intentions about a strategic alliance, but it didn’t really do anything for FrontPoint and never delivered on the distribution promise it made. The deal wasn’t anything more than an investment for Morgan Stanley, which is the same reason they’re now selling the firm back to its founders,” he says. FrontPoint is also among the hedge fund firms that have been caught up in the government’s insider-trading probe. FrontPoint was hit with redemptions of up to $3 billion and was forced to liquidate its health care fund after one of its managers was linked to the scandal, though that manager has not been charged.

Another deal investors point to is Stark Investments’ acquisition of the assets of Deephaven Capital Management’s flagship Global Multi-Strategy Fund in January 2009. Though initially viewed as a good idea, the deal proved difficult to implement when investors in the respective firms voiced concerns about differences in the two firms’ valuation policies, the due diligence having been limited to the firm they had initially invested in, and the possibility that the deal could negatively affect the resulting funds’ liquidity.

Still, these examples haven’t stopped hedge funds from trying to cash out. Another motivation is the difficulty of generating the outsize returns of the industry’s glory days.

“The first and second generation of alpha generators who have proven they can produce risk-adjusted returns are questioning the difficulties involved with running their funds in a more regulated world. Most have accumulated wealth, and some are pursuing more philanthropic causes,” says Jon Yalmokas, head of UBS’s prime brokerage group.

For several of the firms in this group, IPOs were once the end goal, promising a hefty payday and longevity for their businesses. But even before the market turned south, IPOs all but disappeared and have remained an unlikely exit opportunity for hedge funds.

“When Och-Ziff went public, it was clear that there were a number of hedge funds setting themselves up to follow,” says Eric Weinstein, Neuberger Berman’s chief investment officer and head of its fund-of-hedge-funds business. With the IPO route having since disappeared and stocks such as Och-Ziff Capital Management Group having struggled since their initial public offerings, he says, selling equity stakes has become the next best way for firms to cash in on the value of their businesses.

Although Och-Ziff’s initial public offering was priced at $32 per share in February 2007, the stock’s value immediately began declining and was down to the low $20 range only a week after listing. The stock, which has vacillated between $11.74 and $18.50 during the past 52 weeks, closed at $16.61 on February 17.

While the stock prices of publicly traded hedge funds have languished, many hedge funds’ underlying funds have still outperformed the broader market, and private equity firms are counting on hedge funds’ ability to consistently outperform their long-only counterparts over the long term. Weinstein says the current wave of deals is based on the expectation that even modest growth within hedge funds can lead to an attractive rate of return.

Another consideration is the Volcker Rule. Though the rule has yet to be implemented, and many people expect that it could still be watered down, Wall Street has already begun responding to portions of the rule that are not expected to change, such as the stipulation that banks can no longer run proprietary trading desks.

“There’s a big misunderstanding of the Volker Rule and what it does and doesn’t allow, and the big firms are taking different views on it,” says Joseph Vitale, a partner with law firm Schulte Roth & Zabel, which has provided counsel on many major hedge fund M&A transactions – including Credit Suisse’s interest in York Capital and JPMorgan’s purchase of Highbridge.

For banks that can afford minority stakes in hedge funds, however, such deals remain one of their best possibilities for making up for the lost revenues of their proprietary trading groups. “Consolidation in any industry comes when it’s either very cheap or when there’s a necessity,” UBS’s Yalmokas says. “If you’re an asset manager and you don’t have a 2% and 20% revenue stream, you want it.”

1) Subsidiary of Credit Suisse

2) Daughter of Arcelor Mittal chief executive Lakshmi Mittal