Why the Rich Get Richer
Exotic and complicated investments, unavailable to the rest of us, help explain . . .
By Ben White
Washington Post Staff Writer
Sunday, March 17, 2002; Page H01
Value chain arbitrage. Pair trades. Seagulls. Restructuring plays. Forget hedge funds. These are the true exotics of the investment world. Chances are you have never heard of them. Chances are better that you will never have access to them.
Only the rich, the liquid rich, get to play on this field. The rest of us, with our brokerage accounts and mutual funds, can heed the dusty old advice: Diversify, stay in for the long term, and forget about stock picking, because you will fail and look like a fool in the process.
But show up with $50 million and you can toss the humdrum out the window and sit down in a cozy dining room with Chris Wolfe, chief equity strategist at the J.P. Morgan Private Bank on Park Avenue. Sport that kind of cash and you can order filet mignon from a tuxedoed waiter and chat about going long on the Norwegian kroner and short on the yen.
Long on the kroner. Short on the yen. Of course! It seems so obvious now. But maybe you want a few more details. So you drop by to see Laurie Cameron, global currency strategist at the Morgan private bank. But you will have to wait. She's on the line to Geneva, speaking fluent French. When she's free, she'll tell you that going long on the kroner and shorting the yen was a hot trade. Like three weeks ago. Now it's tired.
"Everybody is already into that," she'll say. The really smart money got in when the price of oil spiked (Norway exports oil).
But perhaps high-level currency trading is not your bag. No problem. At breakneck speed and with obvious relish, Wolfe will rip through a dizzying array of other splashy investments for you to ponder as he polishes off a French dip and fries. You could try the seagull, but that's also a "goofy currency trade," so best leave it aside.
Perhaps you'll try value chain arbitrage. How does it work? Simple. Take a sector -- say, telecommunications. At the top of the chain are carriers. Beneath them are the suppliers, such as optical-network equipment maker JDS Uniphase, which depend on the carriers for revenue. If you think a carrier is going to delay capital spending, then you assume it will hurt JDS and others in the chain, so you short those stocks -- borrowing shares to sell at a high price, paying for them later when their price drops and pocketing the difference.
Or you could steer some of your capital into restructuring plays. All you have to do is know what sleeping giant is likely to respond well to a dash of fresh capital, stronger management or some other medicine. Take Japan, for instance. Some private equity investment managers are using their wealthy clients' money to buy up cheap Japanese properties -- banks, resorts, auto-parts factories -- believing that with better utilization of information technology and better management they will ultimately shoot up in value and turn a healthy sale profit.
Maybe you want to do a pair trade. This is another variation on the long-short strategy. You identify two firms racing to come to market with a hot new drug or technology. When one gets a clear leg up on the other and you see a big news event coming, you go long on the winner and short the loser and come out shining. Maybe.
But let's say you haven't come to the table with $50 million. Maybe you are someone other than a tassel-loafered Mr. Big with a fat bankroll -- perhaps just a shabby reporter curious about how the rich get richer at such a faster pace than the rest of us.
In that case, Wolfe will pause mid-bite and glower at you.
"Okay," he'll say. "But how are you going to make this into something other than a 'Look at all these things rich people have access to that you don't' kind of story?" And you will answer: "I'm not. Because they do."
By now you probably know all you care to about hedge funds, the clubby, regulation-lite limited partnerships open mainly to "high-net-worth individuals," generally those with at least $1 million in investment capital. You know that some hedgies, most notably billionaire financier-turned-philanthropist George Soros, drove their funds to astronomical returns, beating the markets by factors of 400 percent or more and making some people very, scarily, rich. You probably also know that overall, the 6,000 or so hedge funds thought to exist (no one really knows how many there are, since they don't have to register with the SEC) have not, over the long run, beaten the market.
And while not beating the market, they have charged huge fees, generally 20 percent of trading profits for hotshot managers, on top of annual fees of 1 to 2 percent. (Mutual funds, in contrast, charge 1 to 2 percent a year to cover costs and fees.) Some hedge funds -- Long-Term Capital Management springs to mind -- have failed spectacularly on heavily leveraged investments. Others have posted a couple of years of gains, bragged to high heaven and then disappeared into the night.
Some still make big money, of course. In 2001, according to an index maintained by Hennessee Group LLC, a hedge-fund advisory firm, the 23 types of hedge funds monitored posted close to a 4 percent total return. The Dow Jones industrial average, meanwhile, dropped 7 percent. The Standard & Poor's 500-stock index lost 13 percent, and the technology-heavy Nasdaq Stock Market composite index sank 21 percent.
Hedge funds that specialize in stocks of financial services firms performed best in 2001, returning 16 percent on invested capital, in part on shrewd bets that firms with large loan exposure, such as J.P. Morgan Chase, would suffer.
Chances are you did not make nearly as much on these gains as those capable of investing $1 million did. But you could have made something. Big pension funds now dabble in the hedge world, making up 8 percent of total invested capital, according to Hennessee. There are also a handful of mutual fund companies that now employ the "long-short" strategy.
There are also many "funds of funds" that, for less money than it takes to buy into a hedge fund itself (though still a lot), allow you to own a piece of a number of hedge funds.
Beyond the hedge world, the rich get richer faster in a number of other ways, including private banks such as the one at J.P. Morgan. They also have access to independent private equity firms and can hire cream-of-the-crop money managers to handle their affairs personally.
In the private equity world, the Carlyle Group is among the better known, mainly for its success in aerospace investing and connections to former president George Bush and members of his administration. Carlyle deals both with institutional investors (including the California Public Employees' Retirement System) and high-net-worth individuals.
Just how "high net worth"? Harry Alverson, a managing director and fundraiser for Carlyle, says he generally sits down with families and individuals worth at least $100 million. A typical week takes him to New York, London, Geneva and Paris.
Carlyle, which manages $12.5 billion for about 450 investors, generally requires at least a $5 million commitment from individuals. For their money, rich investors get access to a 500-member global staff. Part of the key to Carlyle's success, fund officials say, is that they hire Koreans in Korea, Japanese in Japan, Brits in Britain and so forth. The group invests in four basic areas: leveraged buyouts, high-yield bonds (sometimes known as junk bonds), real estate and venture capital.
Risk levels can be sky-high. But gains can be equally fat. Chris Ullman, vice president for corporate communications at Carlyle, says the average overall annual return, before fees, is 36 percent. That's $1.8 million on a $5 million investment. Not bad. Some areas produce more than others. Real estate has been hot lately.
Unlike your typical investment company, however, the firm mostly ignores the blue-chip, fully leased property. Instead, it looks for the neglected, troubled building that might need major repair or not be fully occupied. Then it pumps in money, turns the building around and sells it for a big gain. Or, from time to time, a big loss.
And the big losses come. For example, Hicks, Muse, Tate & Furst, a big private equity firm specializing in the leveraged buyout, decided to branch out into telecom investing in 1999, pumping $1 billion into four start-ups. They all went bankrupt.
J.P. Morgan's Wolfe says he would not advise his mother to get into any of these alternative investments, even though she is whip-smart and runs her own company.
"Take someone with $50,000 in capital to invest," he said. "There is no way you could advise them to get into any of this stuff. There's just too much risk."
One final advantage the rich often enjoy over the not-so-rich is the ability to purchase the skills of top-flight money managers. For instance, consider Microsoft founder and chairman Bill Gates, the world's wealthiest man. Much of his wealth remains parked in Microsoft stock. But since 1995, Gates has relied on financial wizard Michael Larson to manage a good chunk of his holdings through Cascade Investment LLC.
Little is known about Cascade, which discloses only the occasional major stock transaction to the SEC. The firm's Kirkland, Wash., office is not listed. What little is known is that the firm is thought to control about $10 billion.
And Larson is far from alone in ditching the brokerage house or the mutual fund company for the hedge fund, the private equity firm or the one rich client. And why not? The rewards are often far higher, and the credit is all yours. "You can manage a lot less money, and you can make a lot more money," said Charles Gradante, chief investment officer at Hennessee Group. "Plus you generally have a lot more freedom. It all adds up." For the managers and for their wealthy clients.
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