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INVESTMENT BANKING - Banking on Performance
Credit Suisse's Joseph Hershberger is at the nexus of a wave of alternative investment manager sales.
In the fall of 2004, Joseph Hershberger, then an investment banker with Putnam Lovell NBF Securities in New York, advised Greenwich, Connecticut°©based hedge fund firm AQR Capital Management on the $250 million sale of a minority stake in its business. The acquirer was Affiliated Managers Group, a Prides Crossing, Massachusetts°©based company known for investing in boutique asset managers and then helping them grow. The deal, which followed on the heels of JPMorgan Chase & Co.'s reported $1.3 billion acquisition of a majority stake in New York multistrategy hedge fund firm Highbridge Capital Management, went virtually unnoticed.
"When I worked on the AQR sale to AMG, demand for alternative managers was mainly for fund-of-funds managers," says Hershberger. "There really wasn't any interest in taking a stake in a hedge fund company."
What a difference a few years make.
Today hedge fund firms are increasingly the subject of not only mergers and acquisitions but also of IPOs, bond issues and other capital markets activity. On the heels of Fortress Investment Group's successful $634 million IPO in February, many of the world's biggest hedge fund firms, including AQR, are rumored to be looking to tap the capital markets. In early July, Och-Ziff Capital Management Group, a New York°©based firm with $26.8 billion in assets, turned rumor into reality when it filed with the Securities and Exchange Commission for an IPO that could raise as much as $2 billion.
Hoping to capture a piece of the rising deal flow and the fees it will generate, investment banks are rushing to create advisory teams to cater to hedge funds. In January, Zurich-based Credit Suisse hired Hershberger and Putnam Lovell's head of investment banking, Steven Pierson -- a move the firm hopes will bolster its chances of winning new hedge fund business.
AQR principal David Kabiller, who has known Hershberger since 1998, says Hershberger was one of the few investment bankers who had an early appreciation for the value inherent in hedge fund management. "It was clear early on that Joe understood the business of asset management and how it was evolving," says Kabiller, who left Goldman Sachs Asset Management in January 1998 with Clifford Asness, Robert Krail and John Liew to found AQR. "He appreciated that hedge funds were part of that evolution."
After graduating from Chicago's Northwestern University, where he majored in economics, Hershberger, 44, began his Wall Street career in 1985 as a financial services analyst at New York°©based investment bank Drexel Burnham Lambert. After Drexel declared bankruptcy in February 1990 following the collapse of the junk bond market,
Hershberger joined Putnam Lovell, a small bank specializing in providing M&A advice to asset management firms. It was there that he worked on his first hedge fund deal, advising London-based Global Asset Management on its 1999 sale to Swiss bank UBS for an estimated $575 million to $675 million in cash and stock. GAM had the bulk of its assets -- which totaled $13.9 billion at the time -- in long-only funds and funds of hedge funds. A year later Hershberger represented Glenwood Group, a Chicago firm with $570 million in funds of hedge funds, on its $110 million sale to London-based Man Group.
"I became aware that nontraditional asset managers offered real investment opportunities and that providing clients with access to such firms was going to become increasingly important," Hershberger says of those early deals.
Not everyone was as quick to embrace alternatives. In the early part of the decade, when Los Angeles°©based manager Oaktree Capital Group considered selling a minority stake of itself to another firm, there weren't any takers.
With $18 billion in assets under management, debt specialist Oaktree was unusual. Though it was not a hedge fund firm, roughly half its assets were in alternative investments, including private equity, a small hedge fund business and distressed-debt funds -- all of which came with higher performance fees than those of traditional asset management. Advised by New York°©based Goldman Sachs, Oaktree's efforts to sell a minority stake to a silent partner never went anywhere because potential buyers could not agree on terms. Hershberger says buyers questioned the sustainability of the performance fees and were reluctant to make long-term commitments. "They just didn't think there was any equity value in these businesses," he says.
Then in 2003 a group of institutional investors, Oaktree clients, did take a small stake in the firm. As assets grew and the markets witnessed the level of wealth hedge fund firms generate year on year, investor perception began to change. "It was clear to me that the capital markets were catching on to the equity value inherent in hedge funds," says Hershberger.
At Putnam Lovell, however, Hershberger was limited to mergers and acquisitions because the firm did not have underwriting capabilities. "M&A is fine for some players, but others prefer a capital markets solution and continued independence," he says, explaining his decision to move to Credit Suisse. "Being unable to offer that solution, I didn't feel that I could give my clients unbiased advice."
Hershberger has been busy since he and Pierson joined Credit Suisse. He has met with countless hedge fund managers and private equity firms to talk about their strategic options and has conferred with traditional money management firms about what acquisition opportunities might be open to them in the alternative investment sector. Credit Suisse was among the underwriters on New York°©based private equity firm Blackstone Group's $4.1 billion IPO in June.
Investors' growing appetite for hedge funds is being satiated in many ways. Last December, Citadel Investment Group became the first hedge fund firm to issue investment-grade bonds. The Chicago-based firm sold $500 million in five-year notes priced at 190 basis points over Treasuries. This May, Oaktree, again advised by Goldman Sachs, raised $880 million by selling 15 percent of its shares on Goldman Sachs Tradable Unregistered Equity -- the firm's new private exchange, where issuers offer shares to be held and traded by institutional investors with $100 million or more in assets. Because the company is not issuing shares to the public, it does not have to comply with the disclosure requirements of public markets and can limit the amount of information it provides these shareholders.
In June, GLG Partners, a $20 billion London-based multistrategy hedge fund firm, announced plans to go public on the New York Stock Exchange through an unusual reverse takeover of Freedom Acquisition Holdings, a publicly traded vehicle that had been set up for just such a purpose. The deal is expected to close early in the fourth quarter.
The rush of hedge fund and private equity firms into the capital markets has not gone unnoticed. Regulators and legislators in the U.S. and U.K. are looking closely at the taxes being paid by alternative asset managers. In June, U.S. Senators Max Baucus of Montana and Chuck Grassley of Iowa introduced a bipartisan bill that would close a loophole that enables publicly traded partnerships to pay a 15 percent tax rate. If their bill is passed into law, listed partnerships would have to pay a much higher corporate tax rate of 35 percent, although firms like Fortress and Blackstone that have already gone public could be grandfathered from the new rules for several years.
So far, the proposed legislation has had little impact on the pipeline of deals, says Hershberger. Institutional Investor Staff Writer Imogen Rose-Smith sat down with him in his New York office recently to discuss the capital markets' new love for the hedge fund industry.
Institutional Investor: What is driving the current M&A and IPO activity among hedge funds?
Joseph Hershberger: Over the next five to ten years, the alternative investment business -- hedge fund managers in particular -- will receive a wave of money from institutional investors, especially corporate and state pension funds. Up until now funds of funds have been the gatekeepers for institutions looking to gain exposure to the industry. But there are clients who are choosing to go direct, and these institutions are going to invest with the big, brand-name players. Whether you're part of Goldman Sachs or Credit Suisse, Oaktree or Och-Ziff, it's going to help if you have capital, brand and transparency.
What do you mean by transparency?
I'm not referring to transparency in terms of positions or even the finer details of the investment process. But investors want to know how the risk is managed, who owns the business and how people are paid. The process of bringing outside investors into the management company creates an obligation to disclose all that is material in the operating of that business. And institutional investors in the funds can gain comfort and achieve a higher level of due diligence by having the ability to pick up a prospectus or an annual report.
Was D.E. Shaw & Co. looking to build brand when it sold a minority stake to Lehman Brothers this past March?
D.E. Shaw doesn't need to sell a stake to Lehman Brothers to establish its credentials with the institutional community. But there may be distribution opportunities for its products through Lehman's franchise, and there are ways in which the firms can do business together to enhance Lehman's return. The deal is also a way for [D.E. Shaw founder and CEO] David Shaw to get personal balance-sheet diversification.
What was the significance of the Fortress IPO?
The private acquisition market had been undervaluing performance fees. The Fortress IPO established that performance fees, though somewhat volatile, have a substantial intrinsic value.
Does that mean buyers can expect to pay more for stakes in alternative asset management firms?
It's not that simple. There's a pricing discount in the private market relative to the public market. The issue is whether or not you get something strategic out of the private transaction that mitigates that discount. Many managers don't want to be public companies.
Disclosure. Dealing with shareholders. The amount of time you have to spend talking about your business and explaining results. There are several new constituencies to interact with and that takes time. But the model is changing. Many of the managers that are public or thinking about going public are choosing not to provide earnings guidance or are choosing private markets where they can structure the nature of their dialogue with investors.
Why in 2004 did AQR want to sell a stake in its business to AMG?
They wanted to diversify their personal balance sheets, and they wanted a long-term, sophisticated partner that wouldn't interfere with their business. Not every hedge fund wants to be part of a larger entity.
Surely there will be hedge fund acquisitions that fail.
Interestingly enough, I don't think you'll find a lot of minority interest acquisitions that go bad. Where you can get into problems is when an acquirer buys all the equity -- that is a tricky thing to make work.
Why is the IPO route more attractive to alternative investment firms than to traditional asset managers?
There is a deeper pool of buyers for long-only asset managers than for hedge fund managers. As people get comfortable with the hedge fund business, that will change. It is changing as we speak. But right now the market is not there in the same way, with the same depth, that exists for long-only managers. So the public markets are a good alternative for managers looking to raise capital.
Is the need for permanent capital a major factor?
A hedge fund manager needs capital to set up new strategies. Permanent capital also provides an anchor for times when the markets become disjointed and investors get skittish. There are times when investors act irrationally, withdrawing capital and impacting the equity value of a firm precisely at the point when there may be the biggest investment opportunities. I think that's why these funds want a little bit of wealth diversification.
But aren't some hedge funds going to make bad investment decisions?
Portfolio management is a skill. Not all firms will be great managers; some will make mistakes -- just like some of the long-only guys do. The question is, Will there be some systemic event that rocks the market? Roughly every seven years or so, there is an event that takes everyone by surprise that isn't built into people's risk management models. The question really becomes, Who has the right risk management metric and infrastructure in place?
Will institutional investors eventually take minority stakes in hedge funds?
It will depend on whether or not they want to be in the business of investing in managers or the business of having managers invest securities portfolios on their behalf. Some institutions have invested in managers in the long-only business. We've yet to really see it with hedge funds, but it's a significant opportunity.
Hedge funds have also been looking to raise capital by issuing shares through publicly traded, closed-end funds. Does this create a two-tiered system?
Closed-end permanent capital vehicles are different. Shares can trade at a discount to net asset value -- a slightly different return stream than for the typical limited partnership. Certain investors that can't go into a firm's main funds because of investment restrictions are able to invest in the permanent capital vehicle, so it opens up a new universe of investors. Although there's not yet much liquidity in these closed-end funds, there is some, and investors value that.
But don't publicly traded closed-end funds create a second, lesser class of investors?
I don't think they're second-class investors at all. These funds are simply capital with a very long-term investment horizon. In some of these vehicles, firms have the freedom to do things in terms of investing that they can't do in their regular hedge funds.
What do you think of Citadel's bond issue?
It's a great way for Citadel to diversify its financing -- whether for additional liquidity or leverage.
Initially, Citadel's notes were poorly received. Why?
I think it just took a while for a market to develop in the bonds. Initially, the bonds didn't trade well, but now the spread is much tighter. Standard & Poor's recently upgraded them to a BBB+ rating.
Do you expect to see similar deals?
Yes, from funds that employ a lot of leverage.
What is the appeal for highly leveraged funds?
Citadel issued its bond at the fund level, which acts like a loan. Today a lot of these loans come from prime brokerages and are collateralized by the fund's securities. When those securities fall in value, there's a margin call and the funding dries up. The funding from a bond exists through its maturity -- the capital is there regardless of what happens in the markets.
Is there any part of the capital markets that is not fully valuing the hedge fund industry?
The debt capital markets are way behind the equity markets as far as getting comfortable with performance fees and valuations.
What are hedge funds telling you?
Hedge funds see a lot of change in their business and are trying to figure out what others are doing and what they should be doing. They want to be sure they're well positioned vis-à-vis the competition, and as they see competitors doing things differently, they question their own strategies.
How much of the capital markets activity is about hedge fund partners cashing in?
If you're a hedge fund manager, there is enormous temptation to capture the full equity value in the business that you've built. But the deals are also about raising capital. Was Goldman Sachs' going public about the partners cashing in, or was it about raising capital? It was about both. They needed capital and had an excellent use for it. All of these alternative investment managers that are going public have good use for their capital.
If the proposed changes to the tax code become law, will hedge funds still be interested in going public?
I don't think the tax changes would have a material impact on firms going public. Valuations and earnings are strong -- the multiples are still pretty attractive. It's not about the structure. It's about the business, and investors like the business. Deals will continue to get done. But on the margin there may be a few firms that view the potential tax changes as a disincentive.
What is the appeal for GLG going public through a merger rather than doing an IPO?
Speed is an important factor. All their competitors are seriously examining the public market, and this deal gets GLG out there quickly. Firms like Och-Ziff are further along the road than GLG, and the IPO window doesn't stay open forever. Right now is an attractive time to go public.
GLG says one reason it's merging with Freedom Acquisitions, which will result in an NYSE listing, is to gain more U.S. clients. Is a U.S. listing really that important?
Absolutely. The hedge fund business is becoming a global game, and GLG is predominantly a European player. They're not in the U.S., and they need to be if they want to maintain their leadership position. A U.S. listing puts them on the map in a major way. Look what it's done for Fortress.