I don’t make many predictions in this column, but this week I am going to make one. Within the next two to three years, alternative investments will disappear. Before you start laughing at this outlandish prediction, read a bit further. I’m not predicting that hedge funds or private equity funds will cease to exist. Instead the industry is going to strip off the label and come up with something new.
In most businesses, underperforming products vanish from the shelves. In money management, products that don’t succeed simply change their names. Although my former industry likes to feature portfolio managers and performance, its true genius is in packaging its products. After conquering the institutional world, private equity and hedge fund managers are taking aim at you. The last big market for their services is the retail investor, and they plan to manage a sizable chunk of your assets. For big financial services companies, alternative investments are the final frontier. Rather than discuss the investment strategies, performance (or lack thereof), or fees associated with these offerings, I thought I’d explore how leveraged buyouts became private equity, how hedge funds transformed themselves into absolute return strategies and then liquid-alternative investments, and how all these exotic managers crowded under the alternative umbrella.
Let’s start with private equity, where creating a retail product is slightly problematic since the underlying investments are illiquid, and most retail investors demand daily liquidity. Plenty of large private equity firms are exploring closed-end funds and mutual funds as a way to entice retail investors. The technical details are less important than the marketing strategy. Private equity is nothing more than a leveraged buyout or LBO. The manager takes a little bit of your money and adds a considerable amount of debt in order to take a company private, buy unwanted divisions of conglomerates, or cash out a family owned enterprise.
More benign, exclusive
In the early 1980s, the LBO was a perfectly acceptable term because most managers were investing on behalf of themselves and their financial colleagues. However, many deals ran into trouble around the time of the stock market crash in 1987 and the savings & loan crisis a few years later. When the industry decided to market to outside investors, especially public pension plans, a name that included the word leverage just wouldn’t do. So the LBO was repackaged as private equity, which has a more benign and exclusive ring to it. However, private equity was still an LBO, and firing workers remained one of its principal tactics. Handing out reams of pink slips doesn’t go over too well with the trustees of public pensions. As a result, we’ve seen private equity begin to insert the word growth into its marketing materials. For example, the industry’s lobbying organization in Washington started out as the Private Equity Council but changed the name to Private Equity Growth Capital Council in 2010. The product hasn’t changed. It is still an LBO that often engages in wholesale layoffs, but emphasizing growth is much better for marketing purposes.
The “blank check” offering is one of private equities’ new ploys to attract retail investors. The PE firm partners with an investment bank to raise an initial public offering for a company that is nothing more than a shell. After paying hefty commissions and fees to the banker, the manager goes hunting for a suitable investment with your money. If you invest in one of these companies, you’ve given a PE manager a blank check. Meanwhile you’re left to wonder whether the blank check company or the PE manager’s institutional clients will get the best deals. It’s clever marketing, but an iffy proposition for retail investors.
Absolute return strategies
Next we’ll examine the packaging of hedge funds. As I’ve discussed in previous columns, the hedge fund isn’t an asset class like stocks, bonds or real estate. Rather it encompasses a wide variety of strategies that are sold to institutions and wealthy investors in unregistered (non-mutual fund) vehicles. Hedge funds use various combinations of stocks, bonds and their derivatives. While some hedge funds are extremely risky, others are relatively conservative. The beauty of the hedge fund is that managers can charge significantly higher fees than they can extract from ordinary investment services. Once again, it’s all about packaging.
So long as hedge fund managers marketed to endowments and the super wealthy, the hedge fund moniker was acceptable and had an appropriately exclusive cachet. However, when the industry decided to expand into the world of pensions, they needed a more acceptable name. In the early 2000s, hedge fund managers marketed their wares as “absolute return strategies.” The idea was to offer public pensions a consistent annual return without the occasional downside of the stock market. Absolute return was a great marketing concept, and trustees and legislators were favorably disposed to the proposition, especially since the words “hedge fund” never passed anyone lips. As chief investment officer for North Carolina, I am sorry to admit that I used this verbal trick.
There was one small problem. Absolute return strategies didn’t work, as we discovered during the credit crisis. All too many hedge funds failed to deliver adequate returns during favorable markets, and then let down pension plans in bad periods. However, hedge funds didn’t go away. They simply abandoned the absolute return label and morphed into alternative investments. Alternative investments (hedge funds in drag) are enjoying a huge surge among public pension plans, including the North Carolina Retirement System. Just like private equity, the key element is marketing, not investment results. At the scale required to satisfy all those public pensions clamoring for alternative investments, the hedge fund industry simply cannot deliver. However, they sure can market.
Raiders now activists
Within the world of hedge funds, there’s been a remarkable repackaging by one niche of the hedge fund community. Corporate raiders have used the magic of investment marketing to transform themselves into activist investors. Can you imagine a pension plan committing capital to a corporate raider? Carl Icahn and William Ackermann would be far less successful in attracting investors if they hadn’t morphed into activist investors. By labeling themselves as activists, corporate raiders sound as if they’re good guys. Their tactics and goals haven’t changed, but by shedding the name corporate raider, they’ve been able to get rid of their black hats.
Hedge fund managers have already prepared for the day when the public pension fund bonanza comes to an end. The products are attractively packaged as “Liquid-Alternative Investments” and have developed a small but growing toehold in the mutual fund industry. The offerings are designed to mimic their hedge fund counterparts. Last year, retail investors poured $40 billion into these products. However, these strategies still constitute less than 5 percent of mutual fund holdings. As retail investors have moved more of their holdings into equity and fixed-income index products, mutual fund distributors and brokerage firms have discovered that alternative-liquid investments and private equity are good ways to protect their profits.
At some time in the next few years, the phrase “alternative investment” will disappear from the marketing lexicon of money management. Having failed to produce superior returns, alternatives will join the mainstream and become integrated with all the other active stock and bond strategies. Investment marketing is extremely powerful. Try to resist.
Andrew Silton’s Meditations on Money columns can be found twice a month in The N&O’s Work&Money section. He is a retired money manager living in Chapel Hill. He was CIO for the North Carolina Retirement System from 2002-2005. He writes the blog http://meditationonmoneymanagement.blogspot.com/