Goldman Sachs Group Inc. last year bought stakes in Shumway Capital Partners LLC and Level Global Investors LP, as a way for its clients to share in the fees of the two multibillion-dollar hedge funds.
This month, both firms decided to kick out fee-paying investors, rendering the investments Goldman Sachs made through a private-equity fund potentially worthless.
The liquidations highlight the risks asset managers, buyout funds and banks face as they seek to buy minority holdings in hedge funds to broaden their offerings for investors or share in the funds’ fee income. Last year there were 13 hedge-fund deals in the U.S. valued at $1.4 billion, the greatest number of transactions since at least 2006, according to New York-based consultant Cambridge International Partners Inc. More deals may end up failing, said Adam Sussman, director of research at Tabb Group LLC in New York, a consulting firm to the financial services industry.
“Stakes in hedge funds are generally not good investments,” said Sussman. “They are particularly high-risk given the many moving parts, such as employee turnover, a decline in assets under management and decaying returns.”
Morgan Stanley, which five years ago spent $400 million on FrontPoint Partners LLC, has marked down the investment to $30 million and is unloading the firm.
The number of such deals is picking up because incentives are rising for both buyers and sellers. Private-equity firms are diversifying their revenue by adding hedge-fund strategies after the financial crisis eroded demand for leveraged buyouts.
Carlyle Group in December purchased 55 percent of Claren Road Asset Management, a $4.5 billion hedge fund, to help the Washington-based buyout firm produce a steadier income stream.
A previous effort by Carlyle to add hedge funds failed in 2008 when the firm liquidated a pool hurt by investments in mortgage securities.
Apollo Global Management LLC, the buyout firm run by Leon Black, the same month agreed to make a $75 million convertible note investment in HFA Holdings Ltd., the parent company of Lighthouse Investment Partners LLC, a manager of funds of hedge funds with $4.5 billion under management. Through the alliance, Apollo will add hedge-fund and managed-account products to its offerings for investors.
Banks and mutual fund companies say taking stakes in hedge funds allows them to offer their investors strategies that can beat markets and protect them from declines. Hedge-fund assets also earn higher fees than assets in traditional mutual funds.
Credit Suisse Group AG in September agreed to buy 30 percent of New York-based York Capital Management for at least $425 million to give its clients access to a hedge fund manager. That transaction was the largest of 2010.
“Our clients will have access to a top-tier suite of products, independently managed by York, and benefit from using York’s proven approach that has delivered superior returns to investors across market cycles,” Rob Shafir, chief executive officer of the bank’s asset-management division, said when the deal was announced.
For York’s founder Jamie Dinan, 51, the sale reduced his ownership in the firm and introduced an institutional holder, which he deemed important for the long-term future of the firm after his eventual retirement. Dinan said he and his partners signed retention agreements, and will invest the majority of the after-tax proceeds of the sale into the funds.
For smaller hedge funds, securing an institutional backer with a large distribution network helps attract new clients such as wealthy individuals or pension funds. Boston-based Pelagos in November sold a 20 percent stake to Franklin Resources Inc., owner of the Franklin and Templeton mutual funds. The commodities fund managed $377 million at the time of the sale.
“There’s a fundamental belief in the hedge fund industry that only ‘institutionalized’ firms will be able to raise money from large investors -- and that means having more than $1 billion under management,” said Ron Geffner, a partner at Sadis & Goldberg LLP in New York. “That’s why the smaller firms are selling.”
In addition to strategic purchasers, there are financial buyers like Goldman’s $1 billion Petershill Fund, which started in 2007 to make minority investments in about 15 hedge funds. Goldman plans to eventually sell the fund to the public. So far, Petershill, run by London-based Jonathan Sorrell, has bought stakes of between 8 percent and 20 percent in nine hedge funds.
Two of the funds have been home runs. In October 2007, it bought a 10 percent stake in the then $10 billion Winton Capital Management, a London-based fund that trades based on computer models. The firm now manages about $16 billion. The next year, it bought a fifth of London-based Capula Investment Management LLP. Capula’s assets have more than doubled to $7 billion.
Petershill, which bought a minority stake in Claren Road in 2008, made money when it sold its holding, according to two people familiar with the matter. Overall, Petershill’s investments are profitable, they said.
Yet the experience with Shumway and Level Global illustrates the perils of buying passive, minority holdings of a business. Shumway was hit by redemptions after its founder Chris Shumway named a new chief investment officer and said he would focus on finding a few, large money-making ideas. When he decided to throw out the rest of his fee-paying clients, Goldman Sachs was left with no fee revenue in which to share.
Shumway, 45, may end up buying back his stake back from the Goldman fund, according to a person familiar with the Greenwich- based hedge fund. Officials for Goldman and Shumway declined to comment.
Goldman’s Level Global stake is now worthless. The firm, founded by David Ganek and Anthony Chiasson in 2003, was among hedge funds raided by the FBI in November as part of a federal insider-trading probe. Ganek, 47, told clients last week he will close the fund and return investor money. Level Global isn’t a target of the investigation and hasn’t been alleged to have engaged in any misconduct, the firm told clients.
The insider-trading probe also hit FrontPoint, which liquidated its $1.5 billion health-care fund after its portfolio manager allegedly received inside information about the result of Human Genome Science Inc. trials for the drug Albuferon. The Greenwich, Connecticut-based firm got another $1.5 billion in redemption requests after the news was reported. Neither FrontPoint nor its fund manager have been accused of wrongdoing.
“The track record of M&A in hedge funds and asset management in general is poor,” said Daniel Celeghin, a partner at Casey, Quirk & Associates LLC, a financial consulting firm based in Darien, Connecticut. “Most deals haven’t been very successful in terms of value creation because those involved were not on the same page.”
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