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Private Equity’s Giants Take an Alternative Route

As private equity emerges from the Great Recession, it is discovering not just uncertain economic times and difficult fundraising but a formidable group of alternative asset firms that are sucking up assets. They’re big, growing and very hungry.

Private equity can’t quite seem to shake the financial crisis. The stock market is moving, various fiscal emergencies have for the moment eased, and a handful of big deals, notably the $24 billion battle to buy computer maker Dell, have emerged, yet the woe remains thigh-high. Returns for fund vintages 2006 and 2007 are lousy. Fundraising is difficult. There’s still $350 billion of dry powder that hasn’t been invested, and a sizable portion of that has to be moved soon or returned. There’s pressure on fees, threats against carried interest, litigation over club deals. Hugh MacArthur, Boston-based head of Bain & Co.’s global private equity practice, headlined his 2013 report “Turning the corner?” Notice the question mark.

Even the availability of cheap debt is a problem. At February’s SuperReturn International conference in Berlin, some of the biggest names in the private equity business weighed in gloomily. Apollo Global Management founder and CEO Leon Black worried about the return of bubble conditions in debt markets. Oaktree Capital Management co-founder and chairman Howard Marks warned about “precrisis behavior” by “people engaging in bullish behavior.”

It’s understandable that private equity shops feel beleaguered. On the one hand, they’re told to invest their dry powder or they’ll have to give it back. On the other hand, if they take advantage of cheap financing and overpay, they may end up with lousy returns. The choice is stark: zombiedom or self-immolation.

For all the hand-wringing, those problems do not haunt the biggest names in private equity, all of them publicly listed. These firms — Apollo, Blackstone Group, Carlyle Group, Fortress Investment Group, KKR & Co. and Oaktree — all reported economic net income (ENI) for 2012 well above that of 2011, with results surging as the year ended. Blackstone chairman and CEO Stephen Schwarzman was actually giddy in the firm’s year-end conference call. “Maybe I had one more cup of coffee than I should have,” he joked. These firms seem to have no trouble fundraising, hauling in billions of dollars in new assets and distributing billions back to fund investors. Carlyle returned some $18.7 billion last year; Blackstone handed back $18 billion.

The sheer size of these firms is striking. Blackstone now has $210 billion in assets, up 26 percent over 2011; Carlyle, $175 billion, up 16 percent; KKR, $75.5 billion, up 14 percent; Oaktree, $77 billion, up 3 percent; Apollo, $113 billion, up a whopping 51 percent. Fortress, the laggard at $53.4 billion, is still up 22 percent.

As Carlyle co-CEO David Rubenstein told a Credit Suisse conference in February: “The firms that went public during that bubble period are now pulling away from the field in this sense. These firms are diversified, they’re not just in private equity, and they’re gaining increasing market share of the available dollars going into private equity. That’s because they represent solidity, investors know they’re going to be around, they have pretty good track records, and people feel comfortable investing with them for five or ten years.”

What’s increasingly obvious is that these firms have less and less in common with traditional private equity firms — even large, global, diversified ones like Bain Capital ($67 billion in assets) or TPG Capital ($48 billion). As the firms have grown and diversified, the drivers of growth and earnings are not necessarily coming from buyouts but from alternative products like credit, distressed assets, hedge funds, real estate and special situations (or, as Blackstone calls it, tactical opportunities), as well as from capital markets. KKR calls itself a “global investment firm,” Blackstone a “global investment and advisory firm.” Apollo and Carlyle get slightly wonkier with “global alternative-investment manager” and “global alternative asset management,” respectively, despite the fact that Rubenstein has asserted that “alternative” is no longer meaningful and that private equity is mainstream.

In any event, private equity remains, when done well, remarkably lucrative. But in terms of assets under management or ENI, it no longer defines these companies, except culturally and in public perception. As Blackstone president Hamilton (Tony) James told a Goldman Sachs Group conference last December, private equity is now “the fourth-largest business [at Blackstone] by AUM and profits — and the most mature.” At SuperReturn, KKR co-founder and co-CEO Henry Kravis shot back that his firm still saw private equity as a core business and would in the future. But although he’s right — at KKR buyouts play a larger role than at Blackstone — he too is engaged in an ambitious diversification effort.

The real question is, what is emerging? As private equity staggers from the crisis years, an entire class of companies — call them alternative asset managers, though there’s something so generic about the term that Blackstone tried and failed to come up with a new name — has peeled off and is growing faster than anything else in financial services. These increasingly diversified global firms are not investment banks or traditional asset management companies, though there are resemblances and affinities to both. They’re something new, spawning a broad range of challenges and issues, from concerns over governance to fears about conflicts and complexity. Is the model sustainable? Can these machines for generating alpha continue to outperform public equity markets? How will their rise affect not only fund investors but traditional buyouts? Is this the latest version of the financial future or merely a passing fad?

A few years ago it was an open question whether private equity had much of a future. In 2010, Harvard Business School professor Josh Lerner gave a speech titled “Private Equity in a Time of Crisis: What Does the Future Hold?” Lerner was not upbeat. The credit crunch had left dozens of LBOs foundering and major deals, done at sky-high valuations in the mid-2000s, either mired in bankruptcy — from Cerberus Capital Management’s $7.4 billion purchase of carmaker Chrysler to Apollo’s $1.3 billion acquisition of retailer Linens ’n Things — or troubled, like TPG, KKR and Goldman Sachs’ $45 billion buyout of   Texas utility TXU Corp. Private equity groups slashed head count and closed offices. Fundraising froze. The industry sat on a colossal pile of cash — which hovered close to $500 billion in late 2009, according to the Private Equity Growth Capital Council — and under a swaying wall of debt.

“Given the unprecedented changes in the private equity industry, it is natural to ask the question of whether the industry . . . is likely to survive or whether it will transform itself into something entirely different,” said Lerner, whose course “Venture Capital and Private Equity” is one of the most popular electives at Harvard.

Lerner offered four scenarios. In the first the industry bounced back, as it had after earlier downturns. Private equity has always been cyclical, with performance inversely proportional to fundraising and economic cycles. In the second underperformance forced many of the largest and smallest limited partners to bail out, allowing sophisticated midsize investors to gain access to the best funds. In the third he posited a more widespread investor desertion: With firms leaning more and more on fees, net returns to limited partners fell and fundraising dried up. Buyouts tumbled from favor, as oil-and-gas partnerships had in the ’70s and ’80s. In the last scenario returns were disappointing but investors continued to pour in funds, “whether out of stubbornness, self-interest or misleading data.” Lerner compared this to venture capital after the dot-com bubble burst.

What Lerner recognized was that hard times were creating what he called a bifurcation of haves and have-nots. What he missed was that a key segment of the business was transforming itself into something new. With outside threats coming fast and furious, few noted this emergence. The U.S. economy struggled, Europe quaked, and the industry was assailed under the guise of debating Republican presidential candidate Mitt Romney’s tenure at Bain Capital. Spurred by Warren Buffett’s anecdote about his high-taxpaying secretary, carried interest festered as a political issue.

There was a related, if less public, skirmish taking place over that seeming paradox of public ownership of private equity after Fortress and Blackstone listed in 2007. This raised issues articulated most provocatively by Harvard Business School professor emeritus Michael Jensen, who had predicted in 1989 that private equity, with its tight alignment of interests among investors, sponsors and companies, would triumph over public companies with their diffuse shareholdings and agency woes. Now Jensen decried the undermining of that governance edge through heavy fees and public ownership, specifically jabbing a finger at Schwarzman and Blackstone. The market seemed to agree, as shares in the listed firms traded at steep discounts to their IPO prices.

Ironically, just as the gloom was deepest, academics, including Lerner, began to churn out studies bolstering many claims long made for private equity, which turned out not to be a job killer and did contribute to growth and productivity.

Enormous effort went into trying to quantify performance — a project dramatically recast in 2011 by Ruediger Stucke, a research fellow at the University of Oxford’s Saïd Business School, who discovered that a popular data source, Venture Economics, had stopped updating many funds a decade earlier. The incomplete data served to depress private equity performance and explained why so many firms claimed top-quartile performance. Since then many of the numbers have been rerun using other databases and the outlook has brightened, though some firms lost their bragging rights. In a paper released in February 2012, professors Robert Harris of the University of   Virginia Darden School of Business, Tim Jenkinson of Saïd and Steven Kaplan of the University of Chicago Booth School of Business offered evidence on the performance of 1,400 U.S. private equity funds (both buyouts and venture capital) from 200 institutional investors. One conclusion: The buyout funds outperformed the S&P 500 index by an average of 20 to 27 percent over the life of funds, about 3 percent a year since 1984.

There are caveats. First, these numbers are net of fees, which can be considerable given the dramatic increase in funds raised and invested over the past few decades.

Fees are a complicated subject, with lots of variation and opacity. A March 2012 paper by professors David Robinson of Duke University’s Fuqua School of Business and Berk Sensoy of Ohio State University’s Max M. Fisher College of Business contended that firms with higher fees seem able to generate higher gross returns to offset the expense (and this works vice versa: lower-performing firms can’t charge the highest fees). That’s not the case in mutual funds, where data suggests that fees and net-of-fee performance have a negative relation.

Second, private equity is inherently cyclical, and returns tend to vary inversely with the cycle. As markets grow more buoyant, fundraising and leverage both rise, firms have more money to place, and returns flatten out. Private equity performs best in difficult markets, when deals and valuations are more modest and more of the return comes from operational improvements and less from financial engineering, notes Viral Achar­ya, a finance professor at New York University’s Leonard N. Stern School of Business. McKinsey & Co.’s head of private equity, Conor Kehoe, who has collaborated with Acharya, stresses that a key metric of private equity performance is not the internal rate of return, which is determined by leverage, but alpha — the private equity return above that of a comparable public company. “Their alpha is higher in downturns,” Kehoe says. “They actually do try harder.”

Third, there’s persistence, a term that describes the ability of a firm to perform at a certain level. For years it’s been clear that top-quartile funds — many of them mature funds — generate the bulk of the returns. Kaplan notes that several studies (including a few by him and MIT Sloan School of Management professor Antoinette Schoar) find “a large and significant persistence in returns across funds of the same general partner,” with 23 percent of outperformance reliably repeated — much greater than for mutual funds or hedge funds. Ongoing research, he adds, suggests that this persistence was quite strong in earlier decades but has faded since 2000, a period that saw more fundraising and competition, particularly in the U.S. That said, all quartiles outperformed the S&P 500 even with fees, though there’s a significant difference between the top and bottom. Kaplan’s advice: Avoid the bottom, even if fees are lower.

Where does outperformance come from? That’s the mystery of carry-fueled private equity — resistant to quantification and subject to argument. In the ’80s much of the debate focused on leverage, which ran at historical highs and significantly magnified returns when buyouts were successful. Critics like the Service Employees International Union still contend that leverage, with all its risk and overtones of undeserved gain, carries the load. (Alas, leverage works both ways, and the spectacular flameout of the LBO market in the late ’80s left its mark: By 1991 fully 38 percent of the largest deals were under financial distress, according to a 1993 study by Kaplan and Harvard University economics professor Jeremy Stein.)

But Jensen’s argument for private equity’s governance edge has become widely accepted. There’s something magic in private equity’s small, active, strategically focused boards; aligned incentives; willingness to manage long term; and hiring of skilled operating and financial specialists that contributes to alpha creation. This “magic” works by regularly beating the returns of efficient public markets. In Jensen’s view a small headquarters group overseeing highly motivated managers can generate what he calls “strategic value accountability: the ability to bridge the gap between markets and the managerial organization.” But do these virtues apply to the publicly traded alternative asset manager?

The emergence of this cohort of listed, global, diversified alternative asset managers isn’t the only change that has swept private equity over the past decade. Fed by easy money, private equity, like hedge funds, raced to occupy multiple niches by size, geography and industry specialty. The alternatives firms took that diversification in-house and put it on steroids.

That evolution accelerated in the backwash of the crisis. Today, under pressure from the Volcker rule, Basel III and tough times, banks are selling off or shrinking not only their buyout operations but various alternative forays. Goldman Sachs, which raised a $20.7 billion buyout fund before the crisis, announced last September that it would reduce future private equity fundraising by half.

With the banks retreating, the alternatives managers — all of them American, Carlyle’s Rubenstein often reminds people — have become the most aggressive financial firms on the planet, expanding both organically and through acquisitions. “These are the companies best able to find the white space on the map and chase it,” says Credit Suisse analyst Howard Chen. “And that’s what they’re doing.”

Marc Spilker has been working in alternative assets since he ran that business for Goldman in the mid-’90s; he retired from the firm in 2010 and ended up president of Apollo. A number of secular trends, he asserts, have come together to create prime growth conditions for these firms. Some are long term, notably the maturity of traditional money management practices that emerged in the ’60s. Others are shorter and more cyclical: low interest rates and investors’ need for returns. This is also reflected in talent flows. With banks on the defensive, talent is migrating to the alternatives firms. As one observer says, “It’s the professionalization of the search for alpha.”

A 2012 McKinsey study suggested that alternatives amounted to $6.5 trillion in assets under management globally, more than doubling in the past five years and growing at seven times the rate of traditional asset classes. The six publicly traded U.S. firms have more than 10 percent of that — some $700 billion. Given that there’s more than $45 trillion in managed assets in total and asset allocations to alternatives are rising (to 26 percent in the U.S., more than double the allocation in 2007), there’s still plenty of room to grow. McKinsey called it “the mainstreaming of alternative assets.”

Scott Nuttall, who runs KKR’s global capital and asset management group, says that even for his firm, future growth will come from alternative businesses. “We’ve been in private equity since 1976, so anything less than three decades is new to us,” says Nuttall, who joined KKR in 1996 from Blackstone. “If you look at the end markets these businesses address, they’re much larger than private equity. Private equity is a trillion-dollar industry; these are $6 trillion in aggregate. We’re a smaller player with a lot of growth ahead of us, in bigger markets.”

The seeds of diversification were planted decades ago. Despite their “private equity” label, all these publicly traded alternatives firms displayed early on a willingness to wander. Apollo’s Black and his partners came out of the collapsing Drexel Burnham Lambert in 1990 to find LBOs done in by a dearth of high-yield financing. Black, a master of the ins and outs of debt, led a charge into distressed investing.

Alongside its LBO operation Blackstone has long run an advisory business, appropriate for a firm founded by two Lehman Brothers Holdings veterans, Schwarzman and Peter Peterson. Well before its IPO in 2007, Blackstone built a major fund-of-hedge-funds operation under another Lehman veteran, J. Tomilson Hill — it now has $46 billion under management — and a hugely successful real estate unit under Jonathan Gray. KKR, which has for some time been willing to expand its buyout approach in new ways, began to pull more functions in-house over a decade ago. Carlyle, taking a page from mutual funds and breaking with the one-fund-at-a-time practice, began in the late ’80s to build fund families, go global and brand itself like a money management complex.

The two younger firms, Oaktree and Fortress, very quickly diversified. Oaktree, formed in 1995 by five TCW Group refugees led by Marks, mixed “control investing” with distressed, high yield, convertibles and real estate. Fortress, founded in 1998 by former BlackRock partner Wesley Edens and two former UBS executives, began with private equity but quickly moved into hedge funds, real estate and debt.

All these firms were looking to maximize fee income, both by reducing the fees they paid to Wall Street and by growing assets under management. Fees can be robust. Blackstone generated $700 million in fee-related earnings in 2012, up from $272.6 million in 2011. But fee levels depend on a range of other factors: product mix, assets, fundraising, realizations.

Apollo, like several of these firms, splits its results into two streams: management, meaning the fees paid to run a business, and incentive, meaning performance fees such as carry — the potent fuel of private equity. Apollo views its products on a kind of continuum, from lower-risk businesses like credit, with management fees but no incentive, to higher-risk private equity, with a preponderance of incentive and some management income. The interplay of the two should result in high but predictable earnings.

The earnings mix of these firms reflects increasing diversification — and the flexibility that goes with it. Nearly half of Apollo’s assets belong to the credit business, which includes a range of products, from hedge funds to mezzanine funds to nonperforming asset funds to collateralized loan obligations. Credit has grown quickly, with $64 billion in assets dwarfing the $37.8 billion in private equity and more than doubling in the past year, in part thanks to two acquisitions, Stone Tower Capital, a hedge fund sponsor, and Gulf Stream Asset Management, a credit portfolio manager. Apollo’s carried interest from private equity, however, remains more than three times that of the credit business, and its economic net income from buyouts, fueled by a clutch of IPOs in 2012, came in at $1.2 billion, 75 percent of the firm’s total ENI — a good year.

Blackstone, on the other hand, generated $412 million in ENI from private equity out of more than $2 billion in total ENI in 2012; this explains president James’s “mature” comment. What is Blackstone’s biggest and most profitable unit? Real estate.

At KKR traditional buyouts remain the engine. Private equity ENI was $837 million in 2012 out of total ENI of $2.1 billion. When the firm began to diversify in 2004, it built businesses like credit, then edged into syndicating capital participation as deals got larger, then successively started oil and gas, natural-resources, real estate and hedge funds. KKR’s permanent equity, now $7 billion, allows it to invest off its balance sheet and accelerate new-business development. “If we lacked that equity, we might have missed this interesting window, with financial markets being reshaped and providers of capital realigning after the credit crunch,” Nuttall says.

All these firms moved steadily, if individually, into what KKR calls “adjacent businesses” and Oaktree calls “step-outs.” They certainly differ in their mix of businesses, though they seem to be converging on products like real estate, credit and hedge funds. (All have piled into energy.) Implicit in this diversification is an attempt not only to integrate operations and grow assets but to tame some of the cyclicality of private equity. Both fee income and permanent capital cushion firms from perturbations of stock and financing markets, even if they don’t guarantee a rich stock price.

The fee income helps insulate these firms from some political risk — lately, the threat of higher taxes, particularly on carried interest. No one knows whether the Obama administration will succeed in raising tax rates on carried interest. Most observers believe that although higher taxes would squeeze profits, they would not fundamentally affect the business. In fact, given the complex and cyclical flows of the alternatives firms from dozens of different products in multiple locations, they have far more ways of blunting a tax impact than would a stand-alone buyout shop.

One driver of alternative market share is the ability to offer major institutions an array of choices in long-term arrangements known as separate or managed accounts — products once the province of  Wall Street and asset managers. These arrangements looked particularly attractive when fundraising was difficult and institutions, notably public pension funds, sought to reduce the number of funds they invested in and gain better terms, meaning lower fees. Carlyle picked up $150 million from the Indiana Public Retirement System and an additional $750 million from the Municipal Employees’ Retirement System of Michigan, Blackstone got $1.8 billion from New Jersey’s state pension fund, and Apollo and KKR each received $3 billion from the Teacher Retirement System of Texas.

How big a trend is this? These deals have years to run and take years to negotiate. Conditions change. With fundraising picking up, the firms may not be as willing to discount fees, and the appeal of diversification may wane. The deals are arduous to close, and the universe of investors may prove small. But they indicate a strength of the alternative structure. The firms are wielding flexibility and diversification in new ways, allowing them to reward early entrants or major long-term investors — a break with traditional practice, in which management fees and carry were one-size-fits-all (typically, the classic 2-and-20: 2 percent management fee, 20 percent carry). And the firms can appeal to investors with what Credit Suisse’s Chen describes as the ability to “keep their money in motion” — that is, provide compounded returns when, say, buyout activity slows.

Standardization is breaking down in the asset management industry, replaced by complexity. The alternatives firms are complex, and they pass that on to their institutional base. Some investors favor the straightforward alignment of traditional buyouts; others want brand, choice, lower fees. Some investors fear pell-mell expansion by these firms; others see growth as validation. Everyone wants alpha. These are delicate matters of power and dependency. Institutions worry about the asymmetry of information that lurks between a firm and its investors:  The general partner always knows its positions better than investors do.

The asymmetry only deepens as product complexity grows. Investors don’t know if they’re being put into a fund to optimize returns or because the firm needs to top up a new offering. And given the length and illiquidity of these arrangements, getting out is not as easy as not re-upping for the next fund or selling stakes off in the secondary market. The firms, for their part, say they’ll be judged on performance. If they treat investors poorly or fail to outperform, they’ll shed assets.

Performance does ultimately matter. The alternatives firms are charter members of the private equity top quartile, and institutions have long battled to invest with them. Traditionally, these firms had more flexibility in fees because they were in demand.

The alternatives firms also flash aspects of latter-day investment banks, with their merchant banking, trading, capital markets and advisory operations. In early February, Blackstone picked up a securities underwriting license, joining Apollo and KKR. Blackstone has long had an advisory business. Carlyle remains an outlier: Despite scale and geographic diversification, it more closely resembles a buttoned-up money management operation than a Wall Street firm. That shouldn’t be surprising. Carlyle is based in Washington, and its three still-active founders — two businessmen (William Conway Jr. and Daniel D’Aniello) and a lawyer (Rubenstein) — lack Wall Street pedigree.

The investor critique of alternative asset firms focuses on scale, conflict and governance. Traditionally, these firms were striking for their small headquarters operations and tight partnership cultures. Carlyle’s Rubenstein often recalls that KKR had seven “people” (meaning professionals) at the time of its 1988 buyout of RJR Nabisco; KKR now has 1,000 employees, including 650 investment professionals, in 14 countries and at last count controlled 82 portfolio companies with 900,000 employees in 19 countries.

The pace of M&A among alternatives firms has quickened; they are active acquirers in a financial services industry that’s been stagnant since 2008. Some of these transactions involve new products; others, new markets. Blackstone acquired GSO Capital Partners, a diversified credit manager, in 2008, and GSO acquired U.K.-based Harbourmaster Capital, a leveraged-loan investor, four years later. To get into emerging Brazil, Blackstone bought 40 percent of Pátria Investimentos in 2010.

“Diversification has never been an end for us,” says Blackstone’s senior managing director for public markets, Joan Solotar, adding that the firm evaluates each business by asking a series of questions: Is it scalable, big enough for limited partners to care? Do we have the right people? “We’re looking for very long-term secular opportunities,” she says. Blackstone president James offered an elaboration on that thinking in December, declaring, “Scale allows you to drive higher returns.” In James’s vision core businesses spin off satellite businesses, a process he compared to cell mitosis, adding, “We’re just at the beginning of that.”

Nothing reflects that drive for mitotic growth at Blackstone like its global real estate business, the world’s largest operator of hotel properties and the No. 1 institutional owner of offices in the U.S. Blackstone recently raised a massive, $13.3 billion global real estate fund and now has $56.7 billion in real estate assets under management, up 32 percent over 2011. Last year that business generated $874 million in performance fees. In a postcrisis period with distressed real estate littering the globe and rivals struggling to survive, Blackstone has been able to clean up.

The increased scale of the alternative asset firms is likely to strain their traditional management structures. The listed firms all have growing global workforces held together by partnership cultures, particularly at the top, where founders still preside. These cultures will undoubtedly change, as Goldman Sachs’ did after that firm went public; founders retire, and businesses evolve. Managing these diverse, far-flung operations is very different from searching for buyout situations. It’s no surprise that Rubenstein often talks up the “One Carlyle” culture, in which investors come first, followed by the business and individuals (no mention of shareholders), and that a Kravis video leading off the KKR website touts “the KKR culture,” which Nuttall sums up as “one firm, one P&L, one compensation system.” But maintaining a culture in which, as Kravis recalls, “everyone could participate in everything we did” may be increasingly aspirational in a publicly owned global investment manager.

Buried in the alternatives firms’ increased scale may lurk some of the dysfunctions that have beset global, highly leveraged Wall Street firms since the passing of partnerships and the ascendancy of principal businesses. Wall Street in the ’90s embraced the notion of the “one-firm firm” and touted the merits of cross-selling the one-stop shop much as Schwarzman talks of cross-selling pools of capital. Incentives and compensation in private equity are straightforward: Partners get a piece of every deal or of their own deals. But with such scale and such a range of different products, keeping everyone aligned is more difficult.

In fact, the alternatives firms find themselves caught in a new competitive relationship with Wall Street. Sponsors, most vocally KKR, once regularly complained about competition from the banks, particularly those eager to advise, finance and invest. Now the banks worry about competition from KKR or Blackstone in capital markets and credit, and alternatives firms are increasingly ubiquitous players in businesses like real estate, with fewer regulatory constraints.

Yet the alternatives firms are not highly leveraged Wall Street firms financed by large amounts of overnight funding, either. Fees more than cover overhead, and carry fuels the businesses. Combining them, while still cyclical, should dampen volatility; there’s less temptation to leverage up the balance sheet. A critical part of these firms still depends on long-term relationships with institutions that make large, illiquid, long-term investments. As Credit Suisse’s Chen notes, Wall Street firms invest off their balance sheets, while alternatives firms generally depend on committed capital. While permanent capital reduces dependency on institutions, it also boosts alignment, making the firm more like an investor than a sponsor.

For Carlyle going public did stir up concerns about conflicts, Rubenstein tells Institutional Investor: “When we went public, some institutional investors said: ‘Wait a minute. You have an inherent conflict of interest. When you have these shareholders, you’re going to love them more than you love me.’ All of us have said the same thing: ‘Our investors come first. If we do anything that doesn’t help investors and advantages shareholders, we’re out of business.’ ”

Rubenstein insists such conflicts haven’t surfaced. But he does note a more subtle conflict that has arisen, concerning fees. As some buyout funds grew, management fees grew as well, raising issues about valuing these firms. “When we began to go public, the underwriters looked at us and said: ‘We love that, because we want to show your earnings five years out, discount it back, and we can get a valuation. When you just have carry, it’s episodic and hard to predict.’ So some people with lots of fee income were valued more than those without. Investors want you to have carry; shareholders want you to have fees.”

Limited partners always worry — they’re making serious commitments for long periods. One head of a medium-size New England college endowment fears that if these firms continue to thrive, other buyout shops will feel they must follow by going public — there’s rumbling about Bain and TPG making the leap — creating a scramble for scale and a messy shakeout. Will these firms become distracted? Will long-term partners get lost in the competition for assets? McKinsey’s Kehoe believes these firms may attract a certain kind of investor, interested in the comfort of a brand name and stability, albeit at the sacrifice of some performance.

Mario Giannini, CEO of Hamilton Lane, a Bala Cynwyd, Pennsylvania–based, $23 billion fund-of-funds firm, offers a common sentiment: “It’s still the very early days. Institutions recognize they are where they are because these folks are very good. But they also see that the brainpower was once focused on private equity, that they were aligned and that that could change. They worry about alignment a lot.”

The relationship of mutual dependency survives, but it is changing. Under current conditions institutions have little choice if they expect to exceed hurdle rates than to place their money in alternatives. Federal Reserve chairman Ben Bernanke has promised to keep interest rates low for another year, and although stock markets have shown life, no one really expects public equity returns to beat those of private equity. As a result, alternative allocations should rise, not fall.

Where will the money come from? As defined benefit plans wane, pension funds will eventually play a reduced role, but sovereign wealth funds are already providing access to large and growing asset pools. Meanwhile, there’s talk of tapping multitrillion-­dollar pools of retail funds. Rubenstein believes not only that “retailization” will occur but that it will make brand far more important. He can imagine a firm like Carlyle with a Super Bowl commercial someday. KKR has a high-net-worth operation and recently opened two funds to Charles Schwab investors — one high yield, the other special situations — while Blackstone and Carlyle offer products through bank feeder funds to high-net-worth individuals. In December, Blackstone’s James predicted the firm’s retail assets “long term” would rise from 10 percent to 50 percent of assets.

Despite forecasts like James’s, the firms are moving carefully. If relations with institutions are growing more complicated, imagine adding retail. Blackstone’s Solotar is quick to point out that her firm deals only with JPMorgan Chase & Co., not retail investors themselves. These firms have never really dealt with the public; there are liquidity issues (retail investors want it, the firms may not), service, and legal and regulatory considerations. As Rubenstein cautions: “Can an organization that has always oriented itself toward institutions democratize itself and really pay enough attention to and have enough back office to support thousands of investors? It’s a big difference between a few thousand institutions and tens of thousands of retail investors.”

The mantra of the alternative asset firms to investors in their funds is not to worry, just follow the money. As Rubenstein told the Credit Suisse conference, “That’s the best way to measure success: giving back money to investors.” Pay attention to results, not process, seemed to be the message: Don’t worry about how we do the magic.

And right now there is magic, though whether it’s cyclical or secular, a matter of timing or a question of scale, diversification and synergies, remains debatable. The alternatives firms are now entering the harvesting phase. Many of the elements of a world struggling to recover currently play to their strengths: low interest rates, flexibility, global reach, the revival of markets like real estate and the boom in areas like energy, the global needs of sovereign wealth funds and pensions, the power of brand in a world beset by uncertainties — even their mix of aging founders and younger executives. Conditions will not always be as propitious. As Chen says, “While these firms have been around for 30 years, the public markets still haven’t even seen a full cycle yet.”

Diversification is no guarantee of safety. Fortress, the smallest of the group, saw its newly issued stock implode when its three core businesses lost money in 2008. Moreover, as these firms scale up, the law of large numbers imposes itself. No alternative is easy to succeed at; it’s not hard to lose big.

But these firms have the legacy of outperformance — alpha — that has persisted, even through the golden-era vintages. There have been problems, even bankruptcies, and returns are well below historical highs, but given everything else, returns may well turn out to be decent. The firms’ private equity skills still loom large in the construction of global brands.

Investors may suffer from angst, but shareholders (with these listed partnerships, they’re technically unit holders) remain wary. While most of the listed firms are trading above their offering prices — Blackstone is still below, though its shares have risen nearly 50 percent over the past eight months, and Fortress is up but trails the other firms badly — the jury remains out on their long-term success as public vehicles. The markets can be capricious. These firms are still viewed as “private equity” shops and make a complicated case to shareholders. Chen blames some of this on what he calls a duration mismatch between short-term markets and firms dependent on longer-term investment practices.

The firms contend that shareholders, investors and employees should be aligned. But as Chen suggests, shareholders and investors often see things differently. Despite giving all that money back to fund investors and reeling in a huge catch of fresh funds, Carlyle saw 8 percent shaved off its $35 share price, up from its $22 IPO price, on February 20, the day it announced fourth-quarter results. The reason: Its portfolio value grew by only 4 percent in the quarter, compared with 7 percent a year earlier, mostly as a result of timing decisions — so-called lumpy earnings. That was enough for the market to strike, recalling one last Michael Jensen jeremiad from more than a decade ago: Public companies pay attention to Wall Street’s quarterly demands at their peril. Rubenstein does offer the reminder that even with that dip Carlyle was up 20 percent for the year, 70 percent from the IPO.

What does the future hold? That depends on where you stand. It’s unlikely we’ll see a parade of alternative asset managers as barriers to entry rise; the number could easily shrink. But given the harvesting they seem certain to continue to grow assets and grab share. Meanwhile, traditional buyout firms need to get over the hurdle of the next fund. The recent rise in equities takes pressure off pension allocations, which could help fundraising. And the middle market, private equity’s original home, seems likely to remain a haven.

Hamilton Lane’s Giannini asserts that there have been no indications that buyout firms are rushing to throw money at problem deals and that some may be satisfied with closing a fund and shifting to raise a new fund rather than blowing the fund on a Hail Mary pass. Would a giveback create a stigma? Not necessarily, he says, if returns were solid. He notes that limited partners are coming out of the crisis with greater appreciation for sponsors, including alternatives firms, for their ability to negotiate difficult markets. “We haven’t seen stupid deals,” he says. “LPs look at GPs and say, ‘They did what they said they would do.’ It’s not like 2002, with all those bad telecom and tech deals. There have been very few real disasters.”

“LPs are not particularly gloomy,” Giannini adds. “They look at portfolios globally.” What they see, he notes, are markets comparable to those of 2005–’06. Of course, that was the prelude to 2007, a year many look back on wistfully, if with trepidation. And so come the warnings. “Hot debt markets are anathema to private equity returns,” noted Blackstone’s James in December.

These warnings are signs of how far we’ve come. Golden ages aren’t supposed to recur. Just a few years ago, the conversation about private equity focused on survival. Today the future beckons for most buyout firms, though it’s one that features a changing landscape and new competitive pressures. The rise of large, publicly traded alternatives firms may be the biggest change in the business since the shift from leverage-driven returns to operational expertise two decades ago, and it may be the biggest change in money management since the hedge fund explosion of more than a decade ago. The emergence of these firms fundamentally alters the competitive equation among private equity, Wall Street and traditional money management — that is, as long as they can conjure up more magic.

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