KKR is used to making firsts. The first public company buyout, the first billion-dollar buyout and the largest leveraged buyout in history. But when the private equity giant bought a 25 percent stake in Marshall Wace, one of the world’s best-known hedge funds last September, it was following a path carved out by its rivals.
Carlyle has been taking stakes in hedge fund managers since 2010, Blackstone is currently raising a fund to buy minority stakes in hedge funds (it has struck three deals so far) and Goldman Sachs has recently closed Petershill II, a $1.4 billion fund raised to take slices of hedge funds.
And the premier buyout firms are competing with specialist firms whose sole business is acquiring hedge fund stakes. The best known of these is Dyal Capital Partners, a unit of Neuberger Berman’s private equity arm, which part-owns 14 hedge funds.
“This is not a market that is new. If you look pre-financial crisis there was a significant amount of capital dedicated to these transactions,” says the managing director of a firm raising a fund to invest in hedge fund managers.
Not that the path has been smooth. The financial crisis and SEC investigations into hedge fund fraud dented appetite for such deals. Credit Suisse closed its in-house unit AMF, Carlyle cooled on the market after investors asked to pull nearly $2 billion from its Claren Road Asset Management hedge fund and Goldman Sachs was in talks to sell Petershill after a number of bets soured.
KKR itself had an in-house hedge fund it closed in 2014 after struggling to raise money. “Building one-off direct hedge funds within KKR wasn’t going to fully meet our clients’ needs or fully leverage our platform,” said Scott Nuttall, KKR’s head of global capital and asset management, speaking at the time of the Marshall Wace deal. “Many of our clients want to do more with fewer partners across alternative asset classes.”
But the last few years have been good to hedge funds. Assets under management hit a record $3 trillion at the end of 2015 – and this has spurred a revival of interest in minority stake deals.
Alongside the new Blackstone and Goldman Sachs funds, Credit Suisse is also back in the market, betting that a third-party fund rather than balance sheet capital will prove a more durable long-term strategy. And whether a firm is taking a stake in a hedge fund from its balance sheet – like KKR – or from a fund, provides a clue to future intent.
“Firms raising dedicated funds invest and return proceeds just like a traditional deal – it just happens to be in other asset managers. [However], those acquiring from the balance sheet [like KKR and Carlyle], are obviously diversifying away from their core businesses,” says the exe-cutive director at a specialist hedge fund investor.
“It’s going to be harder to stay pure private equity. Becoming a one-stop shop investment manager providing a full solution – liquid, illiquid, debt, equity – gives you more fundraising power.”
While diversification to cement status as a fully-fledged alternatives manager is an oft-cited rationale for these investments, KKR hinted at another motivator. “This is a driver of fee growth for us,” said Nuttall last year.
Or as one private equity executive put it: “We like to structure these deals as a revenue-share as we like the alignment of interest.”
Owning a slice of a hedge fund manager enables sharing of the lucrative fees they charge: as much as 2 percent of assets and 20 percent of profits (although many have moved to 1.5 percent and 15 percent). In the private equity industry the “2 and 20” model has long been a bug-bear for limited partners.
In November, CalPERS revealed it had paid $3.4 billion in fees to private equity managers since 1990 and with a shake-up of private equity fees looking ever-more likely, tapping alternative long-term fee sources makes sense.
But despite the handsome fee rewards these deals bring, some question how private equity firms – used to control and demanding change – will drive improvements through minority investments.
“There’s not a lot of strategic value in much of the investment we see from private equity. It’s delivering capital, but it’s minority so there’s no control. It’s reasonably passive,” says one hedge fund investment specialist.
“If you’re investing in a multi-billion dollar hedge fund that has multiple products, established infrastructure and deep distribution channels there aren’t a lot of uses for new capital.”
An investor in mid-market hedge fund managers puts it more bluntly: “If a $2 billion-plus hedge fund is selling a minority it’s a monetisation event [for the owners].”
Selling the investment story to LPs is therefore likely to prove a stiff challenge.
“The main questions I have would be around where the uplift is going to come from and the security of the investment,” says the managing director at one of Europe’s largest funds-of-funds, pointing to hedge fund scandals as reasons for caution. And with the increased interest in these deals comes valuation pressure.
“There’s probably $8 billion or more of funds now chasing a relatively small number of the larger managers,” says one hedge fund manager.
Private equity has a mixed track record of expanding into hedge funds, and this time they hope to have found the right formula. But if they haven’t, resilient demand for hedge funds, rich fees and a hunger for true alternative manager status makes it certain the big firms will keep trying.