Is Buying Hedge Fund Managers A Good Call?

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Blackstone (NYSE: BX) is a massive asset management firm. It's so large, in fact, that it has to make bold moves in order to keep growing. Its aggressive move into single-family homes is an example. Now there's a rumor that the company is going to buy into hedge fund managers. Is this a good idea right now?

Blackstone

Blackstone was founded by current CEO Stephen A. Schwarzman and Peter G. Peterson in 1985 with $400,000. Today, the company has around 1,800 employees, 24 offices around the world, and more than $200 billion in assets under management. Its customers include public and corporate pension funds, academic, cultural and charitable organizations, corporations, and individual investors. Its expertise spans private equity, real estate, credit markets, hedge funds, and mergers and acquisitions, among others. Essentially Blackstone is big and diversified.

Big companies need to make big moves to keep the top and bottom lines moving higher. For example, in the housing market, Blackstone is one of the key players trying to create an institutional market for single family homes. Typically left to mom and pop investors because of the complexity of dealing with so many individual assets, the burst of the housing bubble allowed Blackstone to buy more than 16,000 homes. That's enough to start generating synergies if the business makes use of the Internet to interact with renters and if the homes can be purchased in close proximity to each other.

Clearly, the moribund housing market was ripe for getting in at low prices. Blackstone did so in a big way.

Hedge Funds

Is there a similar opportunity in hedge funds? That depends, but there is certainly a chance to make purchases.

The hedge fund industry is largely reclusive, despite a few vocal standouts, and ego driven. The people who start hedge funds don't do it because they're concerned they might fail—they do it because they are certain they will win. These facts can make dealing with hedge funds an unusual and risky venture. It's why investors need to be relatively wealthy to invest in a hedge fund.

Often relatively small, hedge funds that have been started by one or two people are increasingly looking for a way to move on. For example, if the original managers are ready to retire, but haven't fully considered how to do so, there's the question of an exit strategy. World famous George Soros simply closed up shop, returning money to investors. Others would like to cash out instead of just shutting down. This is the opportunity that Blackstone is eying.

Buying From Willing Sellers

With plenty of money at its disposal, Blackstone is rumored to be looking to buy minority stakes in hedge funds looking to sell. Taking a stake in a solidly performing hedge fund is clearly a great idea. How you actually figure out which hedge funds have a distinct and lasting advantage in the industry, however, is much more complex.

Blackstone works with hedge funds, providing investors access through its many services. So researching these arcane investments isn't new to the company and it has preexisting relationships with many hedge funds. Both good things, but mistakes can be costly. And other companies have had mixed results.

Och-Ziff Capital Management Group (NYSE: OZM)

Och-Ziff, a publicly traded hedge fund, was founded in 1994 by Daniel S. Och. It has over $30 billion in assets under management and more than 450 employees across offices in New York City, London, Hong Kong, Mumbai, and Beijing. It made the leap into the public sphere in the back half of the last decade. It is generally considered a well run company.

Although one has to take into consideration that Och-Ziff came public during the 2007 to 2009 recession and related bear market, the shares haven't been particularly great performers. In fact, they are down more than 50% over the last five years or so. This hedge fund would have been a pretty lousy investment option even though it's a respected outfit. Can Blackstone avoid these types of companies? It's a big risk.

<img src="http://media.ycharts.com/charts/279a8a44fa58077a74e6b47e78fb516a.png" />

OZM data by YCharts

Political Risk

Then there's the issue of tax changes. Right now, the hedge fund industry enjoys the so-called "two and 20" fee structure, in which asset managers are paid 2% of assets and 20% of profits. The 20% of profits is particularly beneficial since that income generally receives favorable capital gains tax rates. This loophole, called carried interest, is in the news right now because politicians are looking to have it closed.

In fact, Carlyle Group LP (NASDAQ: CG) co-founder David Rubenstein noted during a quarterly conference call a couple of months ago that he believed the elimination of the carried interest tax "loophole" will be an issue in a second Obama term. The president basically told the world that Rubenstein was correct in an interview that aired before the Super Bowl. If that's not a shot across the bow, what is?

If the carried interest loophole is closed, it could have notable implications for the industry. Indeed, how investment managers get paid will have to reexamined. At the very least, the profits for the asset managers will be significantly curtailed by increased taxes.

Timing is Everything

With the government looking to raise money in any way it can, some hedge funds could be trying to get out of the business before it changes for what they would view as the worse. That makes complete sense and increases the chances that Blackstone will find happy sellers. However, it could also allow Blackstone to get in at a better price than it might have a few years ago.

The drop in Och-Ziff and several other publicly traded alternative asset managers could also be an indication that prices are low enough to offset the political risks and leave plenty of upside potential should the stock market continue higher.

Blackstone has grown to its current size by taking risks that have worked out. It's now large enough that taking risks and losing isn't such a big deal. In fact, its own shares haven't exactly been star performers, either. Investors who have always wanted to get into hedge funds should watch Blackstone and the carried interest debate. Buying this financial giant might be a good way to participate with a skilled investor—ultimately buying the hedge funds instead of investing with them.


Reuben Gregg Brewer has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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