COVER STORY: HEDGE FUND SPECIAL REPORT
June 2002 Issue
Who wants to be a billionaire?
That's the loaded question Wall Street is asking hedge funds as it
avidly courts their business. Profits are huge, but so are the
risks. Is this the next new thing?
By Hal Lux
June 2002
Institutional Investor Magazine
Click here to view the entire Inaugural 2002 Hedge 100 ranking
results available in the Research & Rankings section of this site.
Morgan Stanley & Co. kicked off its invitation-only hedge fund
conference in January with a dinner at the Breakers Hotel in Palm
Beach. As the plates were being cleared, the 150 or so guests - a
who's who of investors in the secretive hedge fund world - awaited a
presentation on stocks by the firm's stock market strategist, Byron
Wien.
Suddenly, the lights went out, and two Morgan Stanley hedge fund
marketers appeared on giant television screens. The comely pair -
both men - sported blunt-cut blond wigs and cheerleader outfits with
pleated skirts. Giving a new twist to the term "bulge bracket," this
peculiar pep squad launched into an arm-waving cheer: "Chilton,
Chilton, he's our man, if he can't short it, no one can."
These days plenty of investment banks are all too happy to shake
their booty for Richard Chilton or, for that matter, any of his
competitors. After all, the hedge fund veteran runs Stamford,
Connecticut-based Chilton Investment Co. With $5 billion in assets,
it ranks as the 13th-biggest hedge fund in the world (see the Hedge
Fund 100, page 43). That alone assures him of Wall Street's ardent
affection: He's a prized Morgan Stanley client.
Wall Street has been doing business with hedge funds for years,
providing a wide array of services that range from the financing,
stock lending and clearing that have long been the core of what's
known as prime brokerage to equity research, complicated derivatives
structures and balance transactions that allow funds to pare taxes.
Increasingly, banks are helping hedge funds raise capital as well,
directing wealthy individual clients their way, or, more recently,
through so-called capital introduction activities steering
institutions like pension funds, endowments and foundations into
this rapidly expanding investing corner. "The largest hedge funds
are very sophisticated," says Art Mbanefo, head of the prime
brokerage and equity finance unit of Credit Suisse First Boston.
"They touch everything in an investment bank."
The competition to provide these services has never been more fierce
or the stakes higher. With Wall Street's traditional moneymaking
activities all but moribund - revenues from underwriting, advisory
work and brokerage have dried up - rapidly proliferating hedge funds
represent one of the few big growth businesses around. And they are
notoriously generous as customers; unlike mutual fund complexes that
demand deep discounts, hedge funds, eager for any leg up they can
get, happily pay full freight.
At last count more than 6,000 hedge funds around the globe were
managing $600 billion in assets, according to hedge fund consulting
firm Van Hedge Fund Advisors International. That's up dramatically
from 2,000 funds with $67 billion under management a decade ago.
Goldman, Sachs & Co. calculates that hedge fund assets will swell a
further 26 percent this year.
"The hedge fund business now is where the boutique money managers
were in the 1970s, when institutions began to move assets away from
bank trust departments," says Michael Litt, a partner at Greenwich,
Connecticut-based hedge fund management company FrontPoint Partners.
For managers of hedge funds, the rewards can be breathtaking, even
by Wall Street's jaded standards (see story, page 33). Thanks to the
typical "rake-in" of 20 percent of all investment profits (and
sometimes even sweeter deals), some top hedge fund managers have
been earning hundreds of millions of dollars each year, despite the
dispirited U.S. stock market.
The business is equally lucrative for Wall Street. With their
appetite for leverage and their typically frenetic trading styles,
hedge funds can generate more than $10 million in annual investment
banking revenue just in basic brokerage and financing services for
every billion dollars that the funds have under management. "There
are hedge funds that do 40,000 trades a day," beams John Dyment,
Deutsche Bank's hedge fund fundraising chief.
The numbers add up in a hurry. Goldman Sachs and Morgan Stanley, two
firms dueling it out with longtime leader Bear, Stearns & Co. to be
the leading brokerage to hedge funds, are each estimated to generate
at least $600 million in hedge-fund-related revenue annually.
"It's difficult to say exactly how much investment banks earn from
hedge funds," says Sanford C. Bernstein & Co. financial services
analyst Brad Hintz. "The one thing you can safely say is that the
number is huge."
Andrew Dabinett, managing director for hedge fund services at UBS
Warburg, suggests that the banks are finding that "major hedge funds
can be as important to them as mutual fund companies."
Naturally, the banks have been competing vigorously to provide hedge
fund services. But the rivalry is intensifying and expanding in
scope.
"Two years ago I would have heard from only Morgan Stanley, and only
once a quarter," says Mark Yusko, endowment chief for the University
of North Carolina, a major hedge fund investor. "Last year I would
have heard from Morgan and Goldman once a month. This morning I got
e-mails from Morgan, Goldman, Bear Stearns and ABN Amro."
Considering the stakes, this may turn out to be Wall Street's most
momentous battle for new business this decade. Just as investment
banks chased leveraged buyout artists in the 1980s and Internet
entrepreneurs in the 1990s, they now pursue hedge fund managers.
"Every major financial institution is going to try to get into the
hedge fund business," says John O'Connor, head of alternative
investments at J.P. Morgan Partners.
"Morgan is going after Goldman," says a senior Wall Street hedge
fund executive, "and Goldman is going after Morgan. Deutsche Bank is
going after both of them. And everyone is going after Bear Stearns."
Firms are doing backflips to cater to hedge funds. Goldman Sachs
runs a call-in service for traveling hedge fund marketers who want
to hook up quickly with prospective investors in any city in the
world. Morgan Stanley preps nervous new hedge fund managers for
their first meetings with clients in mock Q&A sessions called
"friendly fire." Last month J.P. Morgan Chase & Co. hosted a talk by
hedge fund wunderkind Ken Griffin, who runs Citadel Investment
Group, to the new networking group 100 Women in Hedge Funds.
Aggressive tactics abound. Firms are raiding each other for talented
marketers, and rumors of price cutting are rampant. In April UBS
Warburg grabbed Joseph Pescatore, the head of U.S. hedge fund
fundraising at Lehman Brothers; in turn, Lehman lured away Laurie
Stearn, the chief of fundraising for U.S. hedge funds at Bear
Stearns. Also in April CSFB snatched up Rod Barker, a 14-year Morgan
Stanley veteran, to head up sales for its European hedge fund
services.
Giving new meaning to the phrase "priming the pump," investment
banks have begun seeding start-up hedge funds, which then typically
become clients of their brokerage services. In November Bear Stearns
invested in Chicago-based BRI Partners, a hedge fund incubator that
provides capital to new hedge funds. CSFB formed a unit last month
that expects to help launch 12 hedge funds this year. Says Mbanefo,
"We want prime brokerage to be a flagship business."
The banks envision a panoply of other hedge fund services, from M&A
to underwriting. Last month J.P. Morgan Chase completed a $550
million securitization of assets for Glenwood Capital, a
fund-of-hedge-funds, and CSFB priced a similar $250 million deal for
Bahrain-based Investcorp.
In this fee-for-all, backbiting is commonplace. Deutsche Bank has
made big inroads into the business using novel applications of
structured products and derivatives to provide leverage for big
hedge fund organizations. This rankles rivals because it can make
traditional lending seem expensive.
"Some firms are now doing prime brokerage on the back of writing
derivatives contracts," says Bear Stearns Securities Corp. president
Richard Lindsey. "There are a few clients asking for rates on
traditional prime brokerage to match derivatives-based financing. I
think it's a risky business that will have problems at some point."
Counters Deutsche's Dyment: "Our competitors would like people to
believe that because we've done very well. No prime broker is more
conservative than Deutsche Bank. We're a bank, after all, and have
to have a rigorous credit review process."
No matter who is right, some observers worry that this hedge fund
frenzy carries risks for investors and for the wider market.
Investment banks make money on the sheer volume of trading done by
hedge funds, not on their performance. This gives banks tremendous
incentive to hype hedge fund managers and employ any fundraising
tactic. One concern: new programs in which banks guarantee the
investment principal of investors in certain funds-of-hedge-funds
(see box).
Others worry that in their efforts to please hedge funds Wall Street
may once again lose its ethical compass. In January CSFB agreed to
pay $100 million in fines to the Securities and Exchange Commission
and NASD Regulation, for distributing shares in hot IPOs to
customers, mostly hedge funds, in return for inflated commissions.
There have been other allegations that investment banks used hedge
funds to push up the price of hot IPOs in a strategy dubbed
laddering.
Some observers are simply concerned that all the competition may end
up hurting the business. Exact numbers are hard to come by, but some
Wall Street executives say fees on hedge-fund-related services -
from stock lending to balance sheet leverage - though still very
profitable have fallen by as much as 30 percent over the past year.
Says Henry McVey, a financial services industry analyst at Morgan
Stanley: "The competition between banks appears to be creating
significant pressure on margins in this business."
Investment banks have long provided prime brokerage services to
hedge funds. But the latest efforts to cultivate relationships with
the funds have escalated well beyond that.
Morgan Stanley runs dozens of road shows each quarter for hedge fund
start-ups. Goldman Sachs employs 20 professionals who do nothing but
introduce prospective investors - funds-of-hedge-funds, foundations,
private clients and, increasingly, pension funds - to hedge fund
managers. Deutsche booked 25 hotel rooms for important hedge fund
clients at the Winter Olympics in Salt Lake City.
Trying to ice deals in its own way, Goldman Sachs held its annual
European hedge fund conference on the Lido in Venice. ABN Amro hosts
a private Internet chat room where hedge fund managers can talk shop
and share their concerns with fellow managers. And to show how
seriously it's committed to the hedge fund industry, Lehman has
taken to passing out copies of a three-part University of
Massachusetts study that it partly underwrote on hedge fund
investing practices.
Wall Street's whirlwind courtship of hedge funds signifies a shift
in the firms' relationship to that industry. Just in the past year,
all major investment banks have begun to compete aggressively for
brokerage business by promising to help fledgling and established
hedge funds raise assets. Morgan Stanley pioneered this practice,
known as capital introduction, five years ago.
"The capital introduction process has clearly become much more of a
formalized and systematic effort for the investment banks," says
Averell Mortimer, founder of pioneering hedge-fund-of-funds Arden
Asset Management. "It has become a very significant part of the
hedge fund business."
Observing the battle from the trenches, Bear Stearns' Lindsey
relates this typical story: "I recently heard about a hedge fund
dinner that another bank was holding. Half of the hedge funds
speaking were Bear Stearns clients."
Many hedge funds parcel out their brokerage business expressly with
an eye to which investment banks can help them bring in the most -
and the most stable - assets. "The way hedge fund managers get rich
is by earning performance fees," points out the head of one Wall
Street hedge fund capital introduction group. "The way to earn big
fees is to run a lot of money. It's pretty straightforward." Adds
FrontPoint's Litt: "We take capital acquisition very seriously.
[Banks'] performance on this front will clearly play a role in how
much business we allocate to each of them."
Hedge fund matchmaking on Wall Street is a strange dance, however.
Fearful of lawsuits or of getting entangled in compliance issues,
investment banks don't accept money for helping hedge funds market
themselves, except in kind, in the form of brokerage business.
Investors say the banks rarely follow up on their initial
introductions to hedge fund managers. Often they don't even know if
an investor went on to put money in a hedge fund.
"Capital introduction is not an advisory service," emphasizes Thomas
Lynch, co-head of capital introduction at Goldman Sachs, whose 20
hedge fund introduction arrangers, operating out of Boston, Hong
Kong, London, New York, San Francisco and Tokyo, never bill anyone.
Adds David Barrett, one of two managing directors in Morgan
Stanley's capital introduction group, which also charges no fee: "We
are explicitly not giving advice to investors or doing the
fundraising for hedge fund managers."
Yet while they insist that they're not endorsing particular hedge
funds, officials of Morgan Stanley and Goldman Sachs have implicitly
allowed their firms' lustrous reputations to serve as a Good
Housekeeping seal of approval for the hedge funds they parade before
investors - at least in the eyes of some.
"Am I more likely to invest with a hedge fund I don't know because
they're working with Morgan? Absolutely," says an investor at a $1
billion endowment.
Hedge fund marketing executives are well aware of this halo effect.
"There is a palpable difference as a hedge fund when you are
introduced to an investor for the first time by a Goldman or a
Morgan," confides the marketing chief of one multibillion-dollar
fund. "Their capital introduction programs have become the most
efficient way to raise money."
Many of the more elite hedge funds scorn Wall Street's matchmaking
efforts. "There is no investor Morgan and Goldman can introduce us
to that we can't get to," scoffs a partner at one major fund.
Nevertheless, Ezra Mager, manager of Torrey Funds, a
fund-of-hedge-funds, suggests that in the uncommunicative hedge fund
world, capital introduction meetings can "also be an opportunity to
speak with people you are already invested with."
Rarely, however, has Wall Street been able to keep its worst
instincts in check when competing for lucrative new business, and
hedge funds aren't likely to prove the exception.
For starters, investment banks are promoting a niche market that
many think suffers from too many mediocre managers running too much
money. And firms piling in with their rich clients and marketing
prowess doesn't help matters, many say. "Investment banks have
probably accelerated the flow of capital into this business,"
laments one hedge fund investor. "That's not a good thing for
investors who are already in hedge funds. Funds will get larger
quicker and close sooner."
Matchmaking in the murky hedge fund world, moreover, can be a risky
business. This year an investor in a new hedge fund called DMG
Advisors (no relation to the former Deutsche Morgan Grenfell)
discovered that one of the firm's senior analysts had been convicted
12 years earlier of possession of chemicals with the intent to
manufacture methamphetamine - a fact that the fund had neglected to
disclose. After word leaked out, the analyst resigned and some
investors redeemed their holdings. (DMG's trading results have been
solid, and most investors did not pull out of the fund.)
Morgan Stanley's capital introduction group had helped DMG raise
money. Given the time that had elapsed since the conviction, few
people in the hedge fund industry blamed Morgan Stanley for not
knowing about the analyst's criminal record. And Morgan Stanley,
like all investment banks, says up front that it does not perform
due diligence on hedge funds or recommend them; it merely arranges
introductions. (The firm won't comment on the DMG matter.)
Still, some of Wall Street's other capital introduction executives
fear that just this sort of hands-off approach may come back to
haunt the banks. "At some point a hedge fund is going to blow up,
and some investment bank is going to be slapped with a big lawsuit,"
says one Wall Street executive. "Everyone thinks they're going to be
shielded because they're not taking money for capital introduction.
What do you think happens when a lawyer starts reading off the prime
brokerage fees that the bank earned?"
Some observers worry that investment banks' bid to simultaneously
provide hedge funds with start-up capital, fundraising assistance
and brokerage services is ripe for abuse because of the inherent
conflicts of interest.
In their rush to cater to hedge funds, investment banks are also
aiding and abetting the creation of new types of fundraising
vehicles that make even hedge fund managers nervous. So-called
guaranteed hedge-funds-of-funds notes - a structured product that is
meant to ensure that investors get back their initial outlay even if
their hedge fund blows up - have been marketed extensively to
Japanese and European investors.
Commercial banks provide the requisite credit guarantees to protect
investors' principal, although they generally don't sell guaranteed
products themselves. Many hedge fund and structured-product
specialists say that the products are often a bad deal for investors
and a potential menace to the whole hedge fund market. Some trading
experts warn that because these products virtually compel banks to
be big sellers of hedge funds during moments of market stress, they
could conceivably set off a landslide of sales that would spread
panic in the wider market (see box).
Hedge funds have always seemed a little racier and a little riskier
than ordinary investments. Yet they're hardly a new invention, and
understanding how they evolved helps explain why Wall Street finds
them so alluring now.
Dreamed up in 1949 by sociologist and former Fortune magazine
reporter A.W. Jones, who ran a "hedged" book of long and short
positions, hedge funds have a history of booms and busts.
Macro funds run by managers such as the durable George Soros (page
34) were fashionable during the late 1980s, making headline-grabbing
bets on the world's stocks, bonds and currencies and enraging the
occasional central banker or prime minister. The 1994 global bond
bust put a dent in their reputations, but the hedge fund business
quickly recovered, growing even faster until the various financial
crises of 1998 nearly took down Long-Term Capital Management and the
rest of the financial world. After a pause for the filing of
lawsuits and some reflection, the hedge fund business
characteristically revived.
Wall Street has always played a role in hedge funds. Small
organizations with no credit ratings and little infrastructure, the
funds have needed to rent the clearing and settling abilities, stock
loan inventories and balance sheets of large banks.
The prime brokerage business began in the early 1950s when A.W.
Jones hired Neuberger & Berman to clear his trades. In 1971 Lou
Ricciardelli, an ambitious clerk at the small New York brokerage
firm Seiden DeCuavas, a predecessor of Furman Selz, began
cultivating a hedge fund clientele. "There were no computers,"
recalls Ricciardelli, now a senior adviser to Deutsche Bank
Securities' prime brokerage group. "I kept the books and records by
hand."
In the 1970s he created Compuport, a computerized portfolio tracking
system especially for hedge funds. After building Wall Street's
first dedicated prime brokerage operation, Ricciardelli moved in
1982 to Morgan Stanley, where he developed a large hedge fund
servicing unit over the next decade. |
