Why you should care
Strapping on their sneakers, the smart guys remind all the rest of us: They don’t have to outrun the bear; they just have to outrun us.
It’s ironic that when America (and the world) got mad at Wall Street, the folks we got mad at, the investment banks, were yesterday’s news. Indeed, while Goldman Sachs and Morgan Stanley became the names that everyone knew, the guys taking home truly serious coin worked at firms with names like SAC, Farallon and Paulson & Co.
Those firms are hedge funds, and the guys who run those hedge funds — Steve Cohen, Tom Steyer, John Paulson — make not just $1-5 million a year, but $5-500 million. The change in power was never clearer than when J.P. Morgan, the king of all the old-guard investment banks, lost around $6 billion late last year because of Bruno Iksil, the so-called London Whale. Remember that? He worked for J.P. Morgan’s Structured Credit Portfolio. It was supposed to just be a passive risk-management vehicle for the firm’s Chief Investment Office, but it was instead acting weirdly like…yup, a hedge fund.
But even the hedge fund business is not as good as it once was. They took a bit — just a bit — of a licking during the recent financial crisis. And so not surprisingly, the smartest guys on the Street have already moved on to the next big thing.
What is it?
Not surprisingly, the smartest guys on the Street have already moved on to the next big thing.
The next fortunes on Wall Street are being made and maintained in a new kind of investment firm that is like the love child of private equity firms (think Mitt Romney’s Bain Capital and KKR) and hedge funds. Some in the biz refer to these firms as “alternative asset manager conglomerates” but they really should be called “hybrid hedge funds.”
Just as with hedge funds, there are often no limits on the sectors these hybrids can invest in. Whether it’s buying gold and oil, purchasing stock or backing a new movie, hedge funds can do whatever it takes to make money. By comparison, private equity funds usually must promise their investors that they will stick to just one or two sectors — clean energy companies or media entities, for example.
But while traditional hedge funds get to invest widely, the down side is that the hedge fund’s own investors have regular opportunities to pull back their money, often after only about 60 or 90 days notice. On the other hand, while private equity funds cannot invest as widely, they know that they may have a decade to deliver a good return before investors can vote them off an island.
As many hedge fund managers discovered, sometimes quite painfully during the economic crisis, it can be very beneficial to have a little more time to turn things around and reassure jittery investors. After the economic crisis, hedge funds devoted energy to finding other types of capital to manage, including insurance and permanent capital funds, according to Michael Millette, who heads the Structured Finance Business at Goldman Sachs. Which is why, says Millette, hedge funds, like private equity firms, sought longer-term capital and “to fund less liquid investments.”
The banner stretching over all of these moves reads “Perm Cap” for “permanent capital.”
So now the smarty-pants on Wall Street have created these hybrid hedge funds that combine investing flexibility with more comfortable time frames and longer-term sources of capital. There are numerous ways that the big funds are accomplishing this.
Sometimes it means buying reinsurance entities and using them as longer-term investment vehicles, in which shareholders can sell the stock but the capital is permanently invested — as Paulson & Co., Greenlight Capital and Third Point have notably done. And sometimes it means buying large blocks of life insurance, which is what Apollo Global Management or Harbinger Capital did, and then investing the proceeds for as long as the life insurance liabilities stay on the books.
The banner stretching over all of these moves reads “Perm Cap,” for “permanent capital.” As Millette puts it, some big hedge funds are essentially “migrating from a world where they are primarily managing fund assets for a fee into a world where they are managing a whole series of pools of permanent or long-term capital, in some cases as principal, each of which has different road rules.”
So why does such a migration matter to the rest of us? For starters, asset managers with strong reputations and brands will offer a broader range of investment products. But you can also expect that just as the mutual fund industry consolidated, before long there will only be 10 or so of these big branded hybrid hedge funds left standing, with names like Apollo, Blackstone and Black Rock.
On the one hand, this will make it easier for less sophisticated investors to find a brand that they trust, and it means that the big brands will “have more pockets to fund more types of assets,” says Millette.
For the rest of us, this could also mean having some of Wall Street’s most aggressive and least regulated companies moving into the mainstream and occupying Main Street, so to speak. So we would all do well to pay attention to the names of these funds: They could easily be the ones that buy your local television station, manage your pension or acquire your favorite sports team as they increasingly expand their portfolios — and their presence in our lives.