Let's Make A Deal
On Wall Street, hedge funds and buyout funds are on a shopping spree--it feels like the 1980s all over again. Meet the new MASTERS OF THE UNIVERSE.
(FORTUNE Magazine) – Wall Street has been shaping and redirecting the nation's economy ever since brokers first gathered under the buttonwood tree in the late 18th century. The Street financed wars and underwrote shipping lines. It floated the bonds that built American industry, and later spawned the corporate raiders who took them apart. Most recently it funded the unprecedented technology boom. Wall Street has no social or economic agenda, though, other than to make more coin. It defines each decade by a trillion-dollar game of "hot or not." The only constant is that before you know it, the money is on the move again. But today Wall Street's restless capital seems to be flowing back to a place it's been before. Two decades after Tom Wolfe dubbed hotshot LBO artists in white-collared power shirts Masters of the Universe, Wall Street has fallen back in love with the Deal. Buyouts, takeovers, and activist investing are all the rage again. Dozens of high-profile companies have been acquired or had their cages rattled, not so much by acquisitive CEOs or by rogue operators armed with junk bonds, but by two new bold castes of investors who are growing more flush and confident by the quarter. On the one hand are private-equity or buyout funds--some of which are supermuscular versions of firms that first made headlines two decades ago. On the other hand is a sprawl of hedge funds, which are not only snapping up huge stakes in companies but also redefining trading in bonds, futures, and commodities--even the way Wall Street itself works.
The growth of buyout funds and hedge funds has implications that extend beyond the Street to businesspeople, investors, and retirees everywhere. If you work for a midsized or even large-cap company, you could wake up one morning to find that your new boss is a smooth-talking financial engineer who wants to cut costs. If you've watched CNBC lately, you may be scratching your head over the barrage of ads inviting you to invest in a futures hedge fund run by a telegenic Austrian. If you are a retired teacher in New Jersey, you may find that a chunk of your pension has been allocated to a fund and therefore is subject to almost no regulatory oversight--so if the fund bets wrong, it blows a hole in your future.
How did we get here? As returns in stocks flagged over the past half-decade, money flooded into "alternative assets": hedge funds and buyout funds. High-profile success stories sucked more money in and also drew more talented money managers to the game, and that begot even more capital, human and otherwise. Today both hedge funds and buyout funds are by almost every measure as big and powerful as they've ever been--and climbing. It is estimated that there are 8,000 hedge funds (since they are only lightly regulated, an estimate is the best you can do), which collectively attracted $27.4 billion in the first quarter of 2005. That brings the industry's assets to more than $1 trillion, according to Hedge Fund Research, a firm that studies the sector. As for buyouts, the average announced buyout fund had almost $750 million in the first quarter of 2005. There are now ten funds larger than $5 billion, according to the research firm Venture Economics. And depending on the size, a hedge fund manager can make tens of millions of dollars and up annually.
No wonder there are whispers that both businesses are due for a comeuppance. Rising interest rates and hiccups in esoteric bond products and junk-bond financing, never mind fierce competition for investments, are likely to drive down returns and cause some flameouts. But for now the clout is being wielded not so much by the Goldmans and Merrills and Morgans as by private operators like buyout funds Texas Pacific Group and Thomas H. Lee and hedge funds Farallon and Citadel. None of these, by the way, is based in New York City. Wall Street is a highly caffeinated state of mind.
With all the economic agita the nation has suffered over the past five years, one might think that people would harbor some serious negativity about the Street. True, many retail investors have turned their backs on the stock market and are putting their money into real estate instead. And as President Bush is finding out the hard way, Americans are reluctant to trust brokers with their Social Security accounts. But the big money players--institutions and superwealthy individuals--haven't lost faith in Wall Street; they're just betting on it in a new way.
Despite all the crooked analysts and Enron enablers who have staggered past us recently, you don't hear much Wall Street bashing right now. That's partly because the political left and right are too busy skewering each other, and partly because neither side wants to make war on a gold mine of campaign contributions. But Wall Street may also be immune to much of the vitriol simply because we have a soft spot for its unabashed capitalism.
In his controversial book, Freedom Just Around the Corner, historian Walter McDougall argues that hustlers and hustling are central to American history--and even make up a key chunk of our national character. What could exemplify that spirit better than Wall Street, where the only end product is money itself? No wonder this place attracts our Gordon Gekkos. Just listen to Michael Douglas, who won an Oscar for the Gekko role in the 1987 hit Wall Street: "Investment bankers are always telling me--usually late at night, when they're pretty well oiled--that Gordon Gekko is the reason they got into the business. Which is a little scary. They say, 'Greed is good!' I say, 'Wait a minute. Gekko is the bad guy.'"
Gekko was merciless--but if he were on the Street today, the hedge fund guys would eat him alive. If Wall Street is the domain of the alpha (almost always) male, then hedge and buyout funds are run by alpha extremes. I once asked a trader why so many top dogs keep going after they become billionaires. "If I ever made $100 million, I'd call it quits," I told him. "That," he said, "is why you'll never make $100 million."
I'm meditating on that point during lunch on the 48th floor of a Manhattan skyscraper with Julian Robertson, 72. Five years ago he shuttered his $20 billion hedge fund after sustaining multibillion-dollar losses and redemptions. But now this alpha extreme is back--bring it on! He's seeded 18 hedge funds with some $5.5 billion in their coffers. "Hedge funds are the best form of investment because so much of the manager's net worth is tied up in the fund," he says. "But the difficult part is that more and more money is being run this way. You'd rather compete against anybody but a hedge fund. The number of funds is growing like crazy. At some point you regress to the mean."
To avoid that, hedge funds are going beyond the traditional long-short model, by which a manager can bet on stocks rising and falling, and also combine such bets to limit risk. (Incidentally, the ability to short stocks and deploy exotic financial instruments is what distinguishes wild-and-woolly hedge funds from regulated mutual funds.) Today the only generalization one can make about hedge funds is that they are partnerships constructed to give the managers of the fund a share of the profits earned on the investors' money. "People talk about hedge funds as an asset class," says Tiger Williams, who runs a trading company for hedge funds. "But there are really only four asset classes: stocks, bonds, currencies, and commodities. A hedge fund is just a pool of capital with a lucrative compensation scheme."
Today hedge funds invest in everything from pork bellies to Swiss real estate to the rupiah. Three big U.S. funds--Citadel, Och-Ziff, and Perry--recently provided the extra capital billionaire Malcolm Glazer needed to take over legendary British soccer club Manchester United. Eddie Lampert's ESL now controls Sears and Kmart, a combination Lampert orchestrated himself. Another hedge fund, Highfields, has threatened to take over Circuit City. The self-consciously swashbuckling Pirate fund launched a proxy fight to oust the board of Cornell Cos., a prison operator. Fortress Investment Group reportedly bought $270 million in loans from Bank of America that are collateralized by Michael Jackson's 50% interest in the Beatles catalog. A hedge fund manager even co-owns the Boston Red Sox, for Pete's sake--though that may bear watching, since most of owner John Henry's funds are estimated to be down significantly this year.
While hedge funds are just now growing into their prime, buyout funds have already made their bones on Wall Street. They first roiled corporate America back in the 1980s, when KKR outdueled CEO Ross Johnson for RJR by ponying up a still-record $25 billion. But LBOs went out of fashion in the 1990s, and venture capital took center stage. (The year 1998 was difficult. Tom Lee calls his fund from that year his "son-in-law fund." Meaning? "Not exactly what we had in mind," Lee says.)
Now KKR is rolling again (see "KKR: The Sequel"), and while neither it nor its top competitors--Blackstone, Carlyle, Tom Lee, TPG--have yet to do a deal anywhere near the size of RJR, their new megadeals are remarkable. Buyout funds raised $54 billion last year--twice what they drew in 2003. KKR and its partners are buying Toys "R" Us, Texas Pacific is buying Neiman Marcus, Tom Lee bought Warner Music, and Ripplewood is buying Maytag. (Earlier this year Ripplewood took some of its assets public on the Euronext Brussels exchange; if the experiment sparks a trend, retail investors will have a way into this business.)
"Ten years ago there would be 50 people at a private-equity conference. Today probably 1,000 people would come," says Charles Baillie, co-head of private equity at Goldman Sachs. "Historically this business was 5% to 7% of the M&A market in the U.S. Now it's probably 12% to 13%. Private-equity firms have become an incredible source of business for Wall Street." There's another measure of the power of buyout funds: the list of high-powered executives making a second (or third) career in the business: Jack Welch, Paul O'Neill, and Lou Gerstner are all doing work for buyout firms.
But is too much money chasing too few deals? "I've raised five equity funds over the past 20 years, and every time I go out to raise money, they ask that question," says Tom Lee. "Our markets have expanded. I'm looking at companies today that I never got a chance to see before." Lee argues that buyout funds are moving from buying small-cap companies to mid-caps and that the business has only begun to scratch the surface of big companies with market values over $10 billion.
Still, even with those hints of new supply, the demand side of the business has now become so competitive that many of the biggest buyouts are done as auctions (potentially not good for the buyer). There's so much hunger for a piece of the action, in fact, that some sharks are learning to share: Increasingly common are so-called club deals like the $11.4 billion SunGard Data Systems buyout (see following story), in which seven funds took over the company. But as interest rates rise, shakeout is inevitable: "We haven't been through a particularly tough economic period lately," says Stewart Gross of Lightyear Capital. "Folks who have been paying high prices and using a lot of leverage could be looking at a lot of pain down the road if that unfolds."
As these ravenous buyout and hedge funds have grown, they've inevitably begun to eat out of the same bowl. Hedge funds have been buying up big pieces of high-yield debt, which has helped the buyout guys get their deals done. And some hedge funds, especially those that specialize in distressed investing like Cerberus (named after the three-headed dog that in Greek mythology guards the entrance to Hades), have been acting like buyout funds by acquiring whole companies. Certainly Eddie Lampert's hedge fund is behaving like a buyout fund.
If you wanted to invest in Fidelity Magellan, you could find out all you'd want to know about its performance before making a decision. Hedge and buyout funds, though, are black boxes--information about them is released sparingly, at the discretion of the manager. That means vast sums of money are moving into ... who knows what? It's said that the best-performing hedge fund of this decade is a little-known financial services fund called Bay Pond, with an average annual return of some 40%, run by one Nick Adams at Boston's giant Wellington Group. Adams is Wellington's secret weapon, and the firm wants to keep him that way. My request to speak with him was denied. New regulations taking effect next February will barely lift the hedge fund veil, since the regs require only that hedge fund managers register with the SEC so it can begin to keep track of whose running the funds.
That lack of transparency hasn't scared away investors; the hedge fund business is a popularity contest reminiscent of junior high school. "Basically, if you can't raise $200 million within 24 months, you're toast. Institutions won't touch you," says one hedge fund trader. Ah, but hit that threshold and you might be golden. "Money is made early in a hedge fund's life cycle," says Art Black, whose company, BBR, steers $2.5 billion of clients' money into hedge funds and other investments. "Studies show that as assets grow, performance falls off. We like to get in a fund that has capped at between $300 million and $500 million." After that, it gets tougher and tougher to make money, especially when a fund grows to $5 billion. "The selections are fewer and fewer at the buffet table," says Robertson. "You make $400 million, and that's only an 8% return. Then you have to make more next year."
Those at the top of the food chain--funds with $10 billion or more--sweat bullets looking to build a sustainable business model. Lee Ainslie, who heads Maverick Capital, with $11 billion under management, shares responsibility with nine sector managers who monitor the firm's investments, allowing it to maintain the agility of a smaller fund. "We are focused on sustaining success over the next decade, not just a few quarters," says Ainslie.
So just how well have hedge funds done for investors? Not badly, on average. According to the Hennessee Group, the average hedge fund returned 14.9% annually from 1987 through 2004, compared with 11.9% for the S&P 500. Drill down, though, and things get complicated. Own the wrong fund--like Long-Term Capital, which blew up in 1998, erasing $4 billion of capital and almost taking out our entire financial system--and you'd be wiped out. Last year the average hedge fund returned only 8.3%, 2.6% less than the market. This year, through the end of April, hedge funds were down 1.6%, which was less than the market, according to Hennessee.
As is to be expected in a universe this big, some funds are reeling--especially convertible arbitrage funds, which have been bashed by tightening credit spreads, and funds that trade futures, which generally need prices to move in one direction for a sustained period. One British fund, Bailey Coates, is rumored to have incurred significant losses and redemptions this year. Founding partner Jonathan Bailey partly blamed short-sellers trading against his firm's positions. And then there's Superfund, an Austrian company that has seen one of its funds decline by more than 20% this year. Superfund, which is managed by Christian Baha, 37, has a retail store on Fifth Avenue in Manhattan. Baha pitches his funds ad nauseam on CNBC ("Regulations prevent me from describing it on television"). Superfund accepts investments as small as $5,000. Caveat investor.
As the fund businesses gather billions each quarter, they garner ever-increasing attention from Wall Street's mainstream: the investment banks that are selling picks and shovels to these prospectors. "Prime brokerage"--the business of serving hedge funds, mostly by lending them money for leveraging trades--has become one of the fastest-growing moneymakers on the Street. Goldman Sachs derived nearly $1.3 billion in revenues last year from this business, up from $1 billion in 2003. And prime brokerage doesn't include trading commissions from hedge funds. Goldman reported $2.7 billion from its equities-sales business and while the firm won't break it down, it's safe to assume that a huge chunk of that volume--say $700 million plus--was from hedge funds. So at least $2 billion, or 10% of the firm's $20 billion in revenues last year, came from hedge funds.
Later the same day that I visited Julian Robertson, I walked over to the 47th-floor office of another of Wall Street's most notable hunters, Carl Icahn, who became infamous as a corporate raider in the 1980s. I've spoken with Icahn many times over the years, but I've never found him in a better mood. Which makes sense. In addition to his personal multibillion-dollar war chest, Icahn now has a $2.5 billion hedge fund (which he's looking to build to $10 billion) that's up single digits this year. And the world is coming to Icahn these days. "I'm just doing what I've always done," he says. "I buy into companies that aren't performing well and try to get 'em to change." What's different now is that where in the 1980s and 1990s most shareholders didn't want to get involved publicly in a hostile deal, today they're more likely to cheer him on. That's because so many of those shareholders are now hedge funds. "Unlike many mutual funds that are more concerned with offending companies, hedge funds will vote with me because they want to see the stock go up," Icahn says. "So you tell me which funds are looking out for their investors? Maybe that's why mutual funds' returns aren't nearly as good as hedge funds'." As for competing with buyout funds to buy companies, Icahn shrugs. "No, no, I don't compete with them. They pay retail. I pay wholesale."
And how does Icahn see this new Age of the Deal panning out? He says he has no idea. "I'll tell you this, though. I've never seen so much money flowing into the market as today. It's amazing." He pauses for a minute. "Actually it's almost scary."