The Evolving Structure of Capital Markets: Hedge Funds As Newly-Public Investment Banks

There was a story in Monday's Wall Street Journal from the "Breakingviews.com" column concerning hedge fund managers going public via existing investment bank hookups, rather than via IPOs.

According to the column,

"Shares in Fortress Investment Group and Bear Stearns have fallen more than 50% since the days after Fortress's initial public offering last February. The two recently discussed whether they had more than that in common, according to the Financial Times. Although no deal transpired, the implication is that Fortress was looking to become more than just a hedge fund and private-equity manager. Like some other fund groups, it has intentions eventually to compete on Wall Street's turf.

Ambitious rival managers such as Citadel Investment Group might take note. Citadel is just one of several fund firms that were rumored to be on the brink of going public until the markets turned against them. Such firms might find inspiration in the abortive Fortress-Bear talks.

For alternative-asset managers that lack a stock-market currency, it is tougher to expand quickly. Yet Citadel, for one, has the ambition to take on Wall Street. It already has turned trading know-how into separate businesses, and its executives clearly relish creating an institution with a Goldman Sachs-like reputation. For Citadel or another privately held rival, a bigger deal with a publicly traded investment bank, perhaps modeled on the Fortress-Bear idea, could simultaneously help achieve strategic diversification and provide a traded stock."

My question is, why are these firms planning to take on existing publicly-held investment banking firms?

What's so special about the business of underwriting? Is the market for underwriting enjoying better margins, or substantial new growth? Last time I looked, it hasn't been a source of extraordinary profits for quite some time.

Trading doesn't require being publicly held, unless the firm wants to make a huge jump in assets committed to that business line. Judging by last year's results, most investment banks didn't do all that well for themselves. Two apparently superior risk management, Goldman Sachs and Lehman, come to mind.

But Paulson Capital, the alleged big winner in shorting the mortgage securities market, is a privately-held hedge fund. So successful asset management doesn't require going public, either.

Why would Fortress or Citadel want to become full-fledged, publicly-held companies in what seems to be a cutthroat business in which several existing players- Bear, Morgan Stanley and Merrill- are actually shrinking, due to sizable losses in 2007?

If anything, capital markets have become much more efficient in the last decade, leading the sector's competitors to risk more of their own capital in proprietary trading. It was the lack of growth and margins that caused Stan O'Neal, late of Merrill, to take so much risk in buying a mortgage originator and holding so much structured finance paper.

Why would a successful, profitable, privately-held hedge fund or private equity group want to expose themselves to public scrutiny?

I wrote a series about some of these issues when Blackstone went public, the last of which may be found here. My guess is that Citadel and Fortress are hoping that the current market turmoil will obscure investors from properly assessing the future value of the core of these firms' businesses.

Going public now, via marriage with an existing outfit, will let them, similarly to Blackstone's owners, collect cash for the presumed value of their business up front, and let new shareholders bear the brunt of any downward valuation corrections.

Between current competitiveness in the sector, recent losses by experienced players, and a lack of significant bases of differentiation and advantage as I wrote here recently, it's difficult for me to see how a newly-public hedge fund or private equity group will perform substantially better than the current crop of investment banks on Wall Street.

Is it simply a case of these firms' managements wanting a higher cash-out value from a publicly-traded stock for the same business? I think it is.

That, or simply a common case of good old-fashioned hubris. An attitude on the part of the senior partners of these private financial services firms that they can swagger into the publicly-held sector and take business from Goldman and Lehman, or make more money competing with them.

Either way, if this occurs, it's going to be a very interesting show to watch.