By Corey Goldman
BlackRock is having a busy year, but that’s not necessarily good news for the hedge fund industry. Never mind that the super-size publicly traded asset management firm has been fleshing out the details of its $13.5 billion acquisition of Barclays Global Investors, announced in June. Behind the scenes, BlackRock has been fielding propositions from a number of troubled hedge funds and funds of funds searching for a lifeline.
BlackRock’s advisory unit, BlackRock Alternative Advisors, has received dozens of calls and a few outright offers from hedge funds wanting to sell themselves to keep their operations, partners, staff and investors afloat. It’s a tall order. BlackRock is happy to eye alternative asset managers on the block, “but generally we are not looking to fuse right now,” says Chuck Clarvit, co-head of BAA. He adds: “Most who are looking to sell right now are unfortunately doing so because they have major issues and/or are losing assets significantly.”
The New York City firm, which will run $3 trillion when its combination with BGI is complete, is far from alone in its look-but-don’t-touch approach. Long gone are the go-go days of big institutions trumping one another to swallow entire hedge fund operations at multiples of four to eight times —think JPMorgan’s 2004 acquisition of Highbridge Capital Management or Lehman Brothers’ purchase of stakes in D.E. Shaw or GLG Partners. Today the landscape for hedge fund mergers and acquisitions is somber, one in which supply far outstrips demand.
The roster of hedge funds that may not survive last year’s losses is growing. Facing seemingly unreachable high-water marks and the challenge of disposing of illiquid side-pocket investments, these funds need to dip into their own capital to keep going, sell their firms or, if they can’t, close down. That’s the fate Tim Barakett ultimately chose in mid-August for his once high-flying flagship vehicle, Atticus Global.
“Survival is the game, not optimization,” says Donald Putnam, founder and chief executive of Boston-based merchant bank Grail Partners. “Think of it this way: The industry used to be like a cruise ship—you wanted the best table and the best cabin, and you could be demanding, pouty and rude. Today, the industry is a lifeboat: If you want a seat, you better be willing to pull the oar and be grateful you are not the seaman that gets eaten to stem starvation.”
As hedge fund managers fight back from their worst year on record—in 2008, long/short equity funds lost an average of 20%, according to the Absolute Return U.S. Equity Index—there is a growing realization that, despite this year’s rebound, it is increasingly unlikely that many funds will get back to prior levels. According to the Absolute Return database, only 27% of hedge funds that lost money last year have climbed above their December 2007 high-water marks, which means the vast majority of funds are still not earning performance fees.
“There are a few large deals, and there are some very small deals where a manager or team with talent is being brought into the fold,” says Eric Vincent, president of Ospraie Management, which sold a 20% interest to Lehman Brothers in 2005 and recently purchased that stake back from Lehman’s bankruptcy trustee. “What you are seeing, in very limited form, are a small number of deals that are both distressed and opportunistic, with very low, if any, multiples,” Vincent says. For the hedge fund stakes, Lehman paid roughly four times pre-tax earnings plus back-end consideration as the businesses grew, while JPMorgan paid seven to eight times earnings, though the payout was structured over five years, according to people familiar with the transactions. Blackstone Group paid about eight times earnings for GSO Capital Partners, the leveraged finance specialist founded by Bennett Goodman, Tripp Smith and Doug Ostrover, all formerly with Credit Suisse.
The deals getting done now, if not as big as BlackRock and BGI, have atypical features—be they valuation or strategy. For example, Stark Investments paid a mere $7.3 million for the assets of the troubled Deephaven Capital Management. Ramius Capital Group turned the tables on investment banks and brokerages by buying one itself—Cowen Group—instead of the reverse.
There is, in fact, no shared rationale in recent hedge fund m&a activity, which has been scant. Some players think an m&a wave will form that will suck in some of the best small and mid-size managers. A former m&a banker focused on financial institutions expects to see transactional activity accelerate among hedge funds, but not for the same reasons as before. “A lot of hedge funds have been burning through their working capital and will soon need to reach into their own pockets to keep day-to-day operations going,” he says. “They are going to need to either bring efficiencies or adopt a parent, with the parent option probably being the better one.”
The other option is to shut down. “Now, it’s about survival of the fittest,” says Robert Picard, senior advisor with Navigant Capital Advisors, which advises financial institutions on restructuring. The smaller, less stable funds that have put themselves up for sale could be disappointed. Says Picard, “I hate to use a sports analogy, but the strongest are the ones who are going to get picked for the team first.”
The first adopters “that are very strategic in their thinking of how all this is going to emerge are the ones that are going to be extremely successful,” Picard adds. Clarvit of BlackRock notes that potential buyers won’t even consider acquiring a hedge fund firm unless it appears to present a remarkable opportunity—and is deemed worth going to the trouble of kicking the tires, taking the test drives, seeing whether it fits in the garage and putting together the maintenance team.
As Atticus Global’s demise underscores, closing down funds is an option that top fund lawyers and prime brokers expect a number of firms to take, given the paucity of buyers and the steep climb many must make to start collecting performance fees. The only properties people want are good ones in good neighborhoods at steep discounts, says BlackRock’s Clarvit. “We have been shown either hedge funds or funds of funds at BlackRock, and the primary criteria we use as a filter in evaluating those is, ‘What does it do for the client versus what does it do for the disruption of our time relative to our fiduciary duties?’” Clarvit says. “There have been a number of funds of funds that have approached us for sale, and the first thing we have looked at is the overlap of the skill set and potential overlap of what we would bring in.” Thus far, BlackRock has not been tempted.
Certainly with BGI, BlackRock can argue the good fit was there. By selling its asset management unit, Barclays boosted its sagging capital base. And by buying the unit, BlackRock brought in a massive institutional-focused alternative investment operation that catapulted it to the top of the ranks in terms of client base, product lines and assets under management, with little overlap.
“Specifically with the BlackRock—BGI deal, you had an undercapitalized parent motivated to sell, and a buyer in a unique position to take on a division that strategically made sense,” says Simon Western, a managing director at Bank of America Merrill Lynch who focuses on m&a. Still, the deal was unusual, he notes, because of how well the Barclays unit fit within BlackRock’s fold. It’s not clear whether the $13.5 billion in cash and stock that BlackRock is paying for BGI is too much, but the question has been asked. Since the 2007 quant crisis, BGI’s hedge fund assets have shrunk dramatically to $15.4 billion in July 2009 from a peak of $27 billion the twelve months prior. BGI has fallen to 14th place on the Absolute Return Billion Dollar Club from sixth place in July 2006 (see Billion Dollar Club, p. 55). BGI runs many billions of dollars more in index and long-only money.
Flailing hedge funds are trying to save themselves in a number of ways beyond mergers or acquisitions, notes Alan Howard, a managing partner with S3 Strategic Advisors in New York City, which focuses on hedge funds and asset managers. “You are seeing a lot of different variations—selling stakes in general partnerships, among other methods, to gain access to sought-after institutional and high-net-worth distribution networks,” he says. “Some deals are driven by an interest in acquiring specific talent.” He adds that there are also revenue-sharing deals in which cash is advanced up front in return for a portion of the revenue stream over a defined period. Platforms are also seeing a resurgence of interest from startups that might have once set up independently and firms that are down on their luck. For example, Bill Young’s Camulos Capital of Stamford, Conn., whose assets peaked at $2.65 billion in January 2008 and is now in the throes of restructuring, has begun transitioning its back office to Mariner Investment Group’s hedge fund operating platform in Harrison, N.Y.
Jefferies Putnam Lovell in New York City, a unit of Jefferies Group, is planning to release a second white paper this month on m&a that forecasts a big jump in fund manager buyouts by private equity firms—essentially “survival-mode transactions,” says Aaron Dorr, a managing director at Jefferies Putnam Lovell.
Survival was the motivation for the sale of Minneapolis’ Deephaven Capital Management to Stark earlier this year. Stark, a $10 billion multistrategy firm in St. Francis, Wis., founded by Brian Stark and Mike Roth, ended up paying less than $7.3 million, an absurdly low sum, to buy most of Deephaven’s assets. Stark wasn’t interested in Deephaven’s holdings, much of which were illiquid. The firm was keen instead to tap into the desirable institutional investor base of its $1.4 billion Deephaven Global Multi-Strategy Fund. The transaction also differed sharply from other m&a deals in that both the buyer and seller performed poorly in 2008. Deephaven Global Multi-Strategy Fund lost 35.92% in 2008, and Stark Investments gave up 23.36%.
Deephaven investors had the choice of cashing out or moving their interests into Stark’s flagship multistrategy vehicle, with full recognition of Deephaven’s prior high-water marks. “From our perspective there were a couple of reasons to do a transaction,” notes Colin Lancaster, a Stark principal. “If we could buy a portfolio that was on the cheap side of fair, it was of benefit to our own investors, but if we could also include large efficiencies within the organization that were a good fit, it would make even more sense.”
Ramius’s reverse merger with the publicly traded Cowen Group, a New York City investment bank and brokerage house, is another unusual animal. Like Stark and Deephaven, Ramius struggled in 2008, declining 19.25% for the year, while Cowen had put itself up for sale following a sharp drop in revenues in its underwriting and advisory businesses. The transaction, announced in June and expected to close in the fourth quarter, gives Ramius a 71% interest in Cowen in exchange for all the hedge fund firm’s assets and liabilities. Ramius also gets a publicly traded currency without having to launch its own initial public offering, an advantage in the event that the firm wants to tap the public equity markets to expand the business. The grander design, according to those familiar with the deal, is for Ramius to move into investment banking. “There’s a void that this calamity has created,” said Ramius founder Peter Cohen. Cohen is no stranger to the power of buyouts. As the former chairman of Shearson Lehman Brothers in 1988, he played a pivotal role in Kohlberg Kravis Roberts’ leveraged takeover of RJR Nabisco.
The deal is a gamble for Ramius, which has lost more than $3 billion in assets under management this past year. Driving some of the losses were positions that got tied up in Lehman Brothers’ bankruptcy, which prompted investors to redeem and Ramius to shutter four funds. As of July, Ramius had about $3.76 billion in assets, down from a peak of $11 billion in 2006. Officials at both Ramius and Cowen declined to comment for this article.
Stark’s Lancaster notes that at the valuations used when Fortress Investment Group, Och-Ziff Capital Management Group, The Blackstone Group and other asset management firms went public—20 times forward earnings—Deephaven would have been valued as high as $1 billion at its peak. “But the unimaginable happened—hedge funds found themselves deep below high-water marks, facing redemptions and dealing with triggered covenants in financing documents, among many other issues,” he says. “If there is going to be a trend, it will be managers looking for a soft landing for their investors, and looking to sell the business outright to achieve that.”
Today’s environment could lead to a powerful winnowing of the industry that will provoke more combinations for one simple reason, says Grail Partners’ Putnam. “It just ain’t as easy as we thought to earn alpha,” he says. “And when the job gets tougher, you have to be bigger to make money at it, to diversify clients and products, and to lay off ownership risks.”
