More minority shares
Investment bankers say they expect to see many more hedge funds trading minority stakes to larger financial services companies in need of their alpha generation capabilities for a capital infusion.
Some deals have been focused on securing capital for growth and operations as well as the wider distribution channels of the buyer, while others — especially among private equity shops — are about cashing out senior executives and securing a permanent source of capital.
Investment bankers say powerful forces are pushing private equity and hedge fund managers to bulk up their operations.
“Rapid growth rates, high fees and the rising demand for institutional-quality money management are all combining to shift the alternatives industry,” said Eric Weber, chief operating officer and principal at Freeman & Co., New York, an investment bank specializing in asset management companies.
“In the old days, alternative asset managers were not really viewed as having long-term equity value. They were more like an attorney’s practice, which likely would close when the lawyer retired. Communication with clients was a lot looser, along with due diligence and compliance. With so many large investors coming into alternatives, expectations have changed and managers have to provide a much more robust infrastructure,” Mr. Weber said.
One recent deal neatly twists together institutional investor demand for both private equity and hedge fund strategies: K2 Advisors LLC, Stamford, Conn., sold a minority stake to TA Associates, Boston. K2 manages $5.5 billion in hedge funds of funds for a largely institutional client base; TA manages $10 billion from institutions in private equity.
Terms were not disclosed, but David C. Saunders, a K2 founding managing director, said the capital infusion will assist K2 in growing its business to accommodate more institutional investor demand.
“I think the marketplace soon will differentiate between hedge funds of funds by size and capabilities. We need capital to move up a notch in order to be one of those larger firms of choice,” Mr. Saunders said.
Expand ownership
The infusion from TA will provide K2’s founders — who do not intend to retire now — with a modest cash payment that Mr. Saunders would not specify. It also will be used to expand company ownership to a wider base of K2 employees, to attract significant new talent and to invest about $100 million in new and existing strategies, Mr. Saunders said.
Other recent minority stake deals include the 20% share that Lehman Brothers Inc., New York, took in quantitative hedge fund specialist D.E. Shaw Group; New York-based Morgan Stanley Investment Management’s stakes in Avenue Capital Group and several other hedge funds; and Frankfurt-based Deutsche Bank AG’s minority stake in private equity investment management and advisory firm Aldus Equity LLC.
While the buyers of minority stakes obviously gain access to specialist investment strategies, the sellers gain not just capital, but also the instant credibility of their much larger, well-established strategic partners, said Ted J. Gooden, partner, Berkshire Capital Securities LLC, New York, an investment bank specializing in money management firms.
“Who you pair with matters, even though many of the boutique hedge funds that are selling minority stakes are substantial in their own right … What they are looking for is a AAA-rated balance sheet partner that’s 100 years old, public, with great distribution and a blue-chip name… Selling a stake to the right buyer is like a Good Housekeeping stamp of approval; institutionalization by association. Potential clients assume all the necessary due diligence has been very well done by the larger partner, and that reduces entity risk in the mind of the investor,” Mr. Gooden said.
New dynamic
Freeman & Co.’s Mr. Weber said a new M&A dynamic came into play when hedge fund firms started to look for sources of new capital to shore up operations. Hedge funds have pushed away from the 100% acquisition model of the past and buyers have been willing to follow, Mr. Weber said.
“Hedge fund managers don’t want to sell all of their firms and buyers don’t want to buy it all. Hedge funds want to hang on to their independence and control of their investment strategies. They gain new rigor as a firm through a part owner that puts some governance requirements on the firm, like formal board of directors, regular audits and reviews. This is a good selling point for many firms interested in managing institutional assets. And the buyer definitely doesn’t want to buy all of a hedge fund firm because they don’t want to have to deal with issues like huge bonus pools,” Mr. Weber said.
For other alternative managers, especially executives at larger, more diversified private equity firms, part of the motivation behind selling a portion of their firms to the public is to gain permanent capital to operate and grow their businesses, and to cash out and make room for a new generation of company owners.
Because most of the founders’ reward isn’t realized until each fund makes a profit, executives sell parts of their businesses publicly or privately to gain access to their wealth. A permanent source of funding also makes succession easier by giving the second-tier executives ownership in the firm, said one industry executive who declined to be identified.
Plus, creating the next generation of owners-managers gives the firm more stability and strengthens its franchise, said Robert Lee, director of equity research at Keefe, Bruyette & Woods Inc., a research and consulting firm in New York. “It’s no different than any other industry that has matured and grown and potentially has a lot of equity value built up in the business,” Mr. Lee said.
Industry insiders say that private equity firms are filing IPOs because private equity is at the top of its cycle, making now a good time to sell. When private equity returns are high, so are the values of the firms doing the deals, insiders explained. Returns are expected to drop, which likely will result in a decrease in the value of private equity firms, the experts say.
Right now, “it’s the perfect storm,” said Roger B. Kafker, managing director, TA Associates. The public markets and investors are willing to pay high prices for large, substantial private equity and hedge fund businesses such as Fortress and Blackstone, he said. That’s why at least three of the biggest buyout firms are lined up to go public, including KKR and Apollo, he said.
And permanent sources of funding are attractive because the permanent capital grows as the organization grows, said Thomas C. Franco, partner at buyout firm Clayton, Dubilier & Rice, New York.
