Friday, October 26, 2012

In Money Management Ownership Wins

In Money Management Ownership Wins

This post is going to make your head numb.  The firm launching the product described below wants you to get a brain cramp as quickly as possible.   They don’t want you to comprehend their scheme.  The bottom line is that this is a story about navigating conflict in order to reap fees and profits from other investors’ fees and profits.  Please try to bear with me.

Blackstone Group, the world’s largest alternative asset manager, is launching a new private equity fund that will take a minority stake in hedge fund managers.  Blackstone already manages all kinds of funds: real estate, traditional private equity, credit, and hedge fund of funds (more about this in a moment). Why should we care if Blackstone adds one more fund to its lineup?  Within the Blackstone empire of over $200 billion in client assets, the new fund figures to be a small addition to its product line up and isn’t likely to garner much attention.

Acquisition Demands (1999)

However, the product announcement illustrates the thought process of the money management business.  Blackstone has identified a niche market that is looking for capital.  Large numbers of hedge fund managers (the italics is on purpose; keep the distinction in mind between hedge funds and hedge fund managers) are seeking capital either to cash out a portion of their ownership or to provide money to expand their businesses.  Before the credit crisis and Dodd-Frank, all sorts of financial institutions were more than happy to invest in hedge fund managers.  Today that capital has dried up.  So Blackstone sees an opportunity.

The new product offering illustrates the most important point in money management.  It is far better to be an owner of a money manager than an investor in one of its funds.    Take a look at my diagram, just below, where owners are ovals and funds are rectangles.  Investors in the hedge fund (in purple, bottom right) pay a fee and profits to the hedge fund manager (light blue oval, just above).  The new fund (in lime, to the left) gets a piece of those fees and profits, but the investors in the new fund, in turn, owe Blackstone (in blue) fees and profits.  The finishing order is almost pre-determined, with the hedge fund investors finishing last, the new fund investors showing, the hedge fund manager placing and Blackstone sweeping to victory.  Some things do travel uphill.

This golden opportunity comes with an obvious conflict of interest.  As I mentioned before, Blackstone manages a hedge fund of funds (HFoF) business (the red rectangle on the left).  In fact, Blackstone is the largest allocator of capital to hedge funds in the world with $46 billion in assets.  A HFoFs selects and invests in a portfolio of hedge funds on behalf of its clients.  In other words, clients pay Blackstone a fee and potentially profit sharing, on top of the fees paid to the hedge fund, for selecting and investing in a collection of hedge funds.  Clearly, this is an expensive form of investing, as there are fees on top of fees.

So, the new fund (lime) owns a piece of hedge fund managers (light blue) and the HFoF (red) invests in hedge funds (purple).  What if one of the managers owned by the new fund manages a fund selected by the HFoF?  Do you smell a conflict? 

Will Blackstone remain entirely objective in its HFoFs business?  Or, will it be tempted to select those funds in which it has taken a minority interest in the manager? 

If the new Blackstone fund never puts capital into a manager, whose fund could be part of Blackstone’s HFoF program, is it depriving the HFoF investors of a potentially rewarding investment opportunity? 

If the new fund invests in a manager, and its HFoF invests in the manager’s fund, will Blackstone’s HFoF be willing to withdraw their clients’ money from the hedge fund if the performance lags?  If they withdraw the money, it will hurt the investors in the new fund who took a minority stake in the manager.

In all likelihood, Blackstone will resolve these conflicts by requiring their investors to acknowledge and waive the conflict.  Somewhere deep inside the partnership, documents for both their existing fund of funds business and their new venture, the investors will give Blackstone a blank check.  Giving someone the right to resolve conflicts in a business that is decidedly amoral is yet another reason why it is better to be the owner than an investor.

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