Convergence Redux

Now things are getting interesting. I wake up this morning and read that Carlyle is entering (or, rather, re-entering) the hedge fund business. To say I have perspective and insights on this particular situation is the understatement of the century. I must say I wasn't surprised - all you need to do is read last week's post on the topic of Private Equity/Hedge Fund convergence to see that a move like this didn't come out of left field. I was interested to discover that one of my old Deutsche Bank colleagues, Ralph Reynolds, will be heading this new hedge fund initiative at Carlyle. I also happen to know that Carlyle has been toying around with this initiative for at least three years, and have a keen perspective on why things didn't work the first time around. All that said, I think this issue of Hedge Fund/Private Equity convergence comes down to two fundamental issues - culture and compensation. Sure, there are "glamour" issues such as the potential conflicts of interest between those trading in the public markets (the hedge fund guys) and those with access to non-public information (the private equity guys), but these risks can be managed through a strong control environment. No, the much more interesting questions to address are: (1) will these efforts work; and (2) why are these efforts happening in the first place?

Will these efforts work? Good question, hard to answer. The first issue comes down to a melding of cultures which are very, very different. Private equity guys are deal guys. They tend to be pretty good communicators. The have a modicum of patience. They understand the concept of delayed gratification, i.e., waiting for the big payout when the investment is liquidiated or a large dividend is scooped out of the portfolio company. Hedge fund managers, conversely, are often lousy communicators, highly impatient, and want to be paid yesterday. OK, so maybe the private equity guys and hedge fund guys won't go bowling together on Wednesday nights. But what about setting them up in separate, walled-off units with an eye towards addressing both the conflicts issues and the culture issues? OK, I'll buy that. But there is this one lingering issue gnawing at me - compensation.

This is where culture and cash really get into it. You have a bunch of senior people with huge egos with the same company name on the business card. They each have giant bank accounts and the trappings of financial success. But one set of guys gets a few million bucks a year and then a big wad of cash 5-7 years later, while the other set of guys get $25 million a year, every year, right now. How do you reconcile this fundamental structural difference between private equity and hedge funds? Insanely hard if not impossible.

In my experience firms that have set up hedge fund platforms without having a deep understanding of how hedge fund managers think have often wanted to split profits with the managers 50/50, i.e., each gets 1% management fee and 10% performance fee (as part of the 2% and 20% paid by the client). This generally will lead to "adverse selection" as the true "rock stars" will never accept such a deal and what you are left with are strictly B-type traders. Maybe an exception to the rule is at a place like FrontPoint where they have created an equity culture to go along with the cash compensation culture, but I personally don't know too many folks that dig that model. As a rule, great traders want their money and they want it now, and they don't want to pay exorbitant amounts for infrastructure. This is what has driven many great proprietary traders from places like Goldman and Morgan Stanley to start their own firms, because the implicit cap on compensation (no Wall Street trader that makes $500 million for the firm  gets paid $100 million or anything near it) wears on these people over time and drives them to want it all by becoming their own master.

Now we can get into the why of this step. What about an initiative of this sort at a place like Carlyle, which is an asset-gathering powerhouse and could probably raise $5 billion for an ice-making plant in Antarctica? It appears that they are bringing Ralph in-house as opposed to seeding a multi-strategy hedge fund platform like TPG did with Dinakar Singh at TPG-Axon. TPG made an investment and created an affiliation around a superstar trader. Ralph is one of the best risk managers on the Street, is super smart and has tremendous instincts, but he is not a position trader like a Dinakar Singh and I can't imagine that Carlyle is hiring him with the same mind-set. I am sure that Ralph will bring in an array of trading teams and will need to develop a compensation and risk management model that works for Carlyle. So, given this, how does Carlyle and Mr. Rubenstein get paid for setting up this unit? If star hedge fund traders want the lion's share of the performance compensation, how does the firm make real money (and I mean real, as Carlyle doesn't do stuff that fails to move the meter) without setting themselves up to fail by creating an unattractive environment for A-type traders? I can think of only three answers: (1) not focusing on near-term cash return, per se, but focusing on creating a diverisified alternative investment firm in order to prepare to go public; (2) tarting themselves before going public; or (3) doing an IPO.

Unless they want to try and form a Blackstone Alternative Asset Management-type (BAAM) unit a la Tom Hill, I fail to see another angle. BAAM is obviously wildly successful but has been at it for a long time, and the fund-of-funds business will come under increasing pressure over time as the rise of multi-strategy funds make the need to pay for asset allocation less important. Further, Ralph is not a fund-of-funds guy and a star in that business, he is a star in the trading business. So it really doesn't seem like Carlyle-as-BAAM is the goal. If Carlyle files to go public any time soon, you read it hear first. My only question is - when is KKR stepping up to the plate?

Comments

[Roger]

Greg, I get your point, but my supposition is that multi-strategy funds growing into institutional complexes will be built by rock-star PMs who will hire and recruit bright, aspring analysts and PMs. These folks will not be earning full fees and carry, but earning a payout based on their book (just like a Wall Street prop desk). The fact that they are not getting paid full management and performance fees cushions against the inevitable risks of netting when some books perform and some do poorly. Now these folks can grow up and become rock stars in their own right - at which point they will leave and hang out their own shingle. The multi-strategy complexes will be living in an constant environment of creative destruction, where the best will rise and leave, new stars will emerge and weak performers will get forced out. I am convinced that this is the way it will play out.

Concerning those managers who are skilled but don't want to deal with the business and marketing aspects of running a fund, I know all about this - the platform I ran, DB Advisors, had this concept as its raison d'etre. And yes, a place like Carlyle might be a good home for them. But these guys wanted and got a lot of the carry, more than, based upon my knowledge, David Rubenstein would ever want to pay out. We'll see how it plays out.

[Greg Battle]

Your adverse selection argument can also be applied to the multi-strategy fund world in terms of an inability to attract the top talent. It's the exact same issue, there is a netting risk. How do you fairly compensate a good manager if the other managers have had a crappy year leaving the fund flat? Do you really think a fund can attract the best talent when the P&L interests are pooled? Given this and your barbell analogy, one side will have local focused rock-star mono-strategy funds, while the other side will have more global multi-strategy B-list managers with pooled incentives/rewards. Given your experience in this area, I'd be interested to hear your thoughts.

In my scenario below, I'm taking into account the idea that not every rock-star PM is a profit maximizing entrepreneur. Many are only concerned with markets, not hand holding investors or operational issues (or hiring/managing people to handle those duties). All PE/HF Chinese-wall issues (benefits?) notwithstanding, I submit that having the institutional quality marketing and operational team at say a Carlyle would be an asset to any rock star hedge fund PM.

Of course, our definition of a rock-star/A-list PM is open for interpretation. Age, experience, track record and most of all, negotiation skill all come into play.

[Roger]

Greg, I didn't forget about the management company issue, it's just that I think you are missing the forest for the trees. The scenario you've outlined is precisely why firms like Carlyle will have a tough time attracting the best talent, namely, because a top manager won't stand for a 0 and 16 structure. While your previous comments have focused on the value placed on asset gathering, which I agree with, I think you are overstating the value to top managers whose brand is sufficiently attractive to generate asset inflows on their own. Further, they wouldn't need to pay 2 and 4 in any event to get a top money-raiser to work for them, so the whole scenario you've outlined to my mind is a recipe for classic adverse selection.

[Greg Battle]

I know, I'm WAY behind in commenting on this, but I'm new to the site and intrigued by the commentary.

Here's my take on how private equity companies can and will successfully start A-class hedge fund businesses.

Everyone only focuses on the management and performance fee income, but forgets about the equity in the management company. If the PE guys are raising the capital, trust, they (meaning the top PE partners) will own the lion's share of the equity of the hedge fund's management company. It's not about appeasing all the PE analysts and VPs, just the top brass. If anything, they will give the hedge fund investment teams more of the performance fee income, maybe 80% (16% of profits for a 2 and 20 shop) or hell, all of it, and retain the entire management fee. The incentives will be aligned properly; PE guys will work hard to raise capital, leverage their brand to extend the lockup period, and keep the business afloat, while the hedge fund teams will "eat what they kill" without being burdened by operational humdrummery.

What self-respecting partner at Carlyle wouldn't want to say, double his yearly salary while still reaping his "big wad of cash" every 5-7 years? To PE guys, the hedge fund business is merely a portfolio company that they are stripping the most predictable cash flow stream out of. And if they want some of the performance upside, leverage your branding to nudge up the performance fee to 25% or 30%. (Not to mention the ability of the PE partners to invest in the hedge funds for free as they won't pay management fees.)

The trickier issue is when hedge funds try to start private equity businesses. Designing that compensation system will be a worse nightmare then you've detailed. You will definitely see sub-par private equity teams in this scenario.