By Andrew S. Kofman
When two of the largest players in an industry come together to do a deal, people tend to sit up and take notice. And when the $101 billion Austin-based Teacher Retirement System of Texas in February acquired a $250 million equity interest in the $120 billion hedge fund firm Bridgewater Associates, the deal attracted plenty of attention. Still, it bears an even closer look. While management company equity transactions are not uncommon, the Bridgewater deal should be a wake-up call for both hedge fund managers and institutional investors who are seeking to maximize their returns.
Bridgewater CEO Ray Dalio, who founded the Westport, Connecticut–based firm in 1975, is methodically implementing a succession plan that includes distributing the ownership of Bridgewater to people other than himself. By putting a clear strategy in place, Dalio is reducing uncertainty about the future of his firm, thereby increasing its value. The transaction also enables him to take some of his own net worth off the table. At a time when many hedge funds, including several of the industry’s leaders, are evolving to the point where the succession question is a priority for their employees and their investors, the success that Dalio is achieving is noteworthy.
Dalio, who is 62, is reportedly planning further reductions in his ownership in the coming years. He is incentivizing his employees to purchase additional equity, a process that may significantly reduce the CEO’s ownership, given his multiyear time horizon (particularly as third-party financing may be available to cover a portion of employees’ purchases).
There are still other options. During the February 16, 2012, board meeting of the Teacher Retirement System of Texas, at which the trustees and staff discussed the Bridgewater deal, Texas Teachers’ senior director of private markets Richard Hall stated that “a good portion of the [Texas Teachers] return — at least half” would come from annual distributions that come as part of owning a hedge fund business. Hall’s remark reminds us that returns could come both from yearly profit distributions and from some additional source. This other source could be a liquidity event, such as an initial public offering. It is unlikely that Texas Teachers is expecting an IPO or some other exit event anytime soon. But opportunities will present themselves.
The evolution of the ownership of the $74.8 billion Los Angeles–based alternative investment firm Oaktree Capital Management highlights the various corporate balance sheet options that are available to owners of well-run firms. Before going public in April of this year, Oaktree’s co-founders, including chairman Howard Marks, sold equity in stages — first to the firm’s employees, then to the firm’s clients, then to institutional investors in a private placement.
From the perspective of institutional investors — like Texas Teachers — that have the benefit of long-term investment horizons, private investments in the general partnership of a hedge fund firm can make more sense than being just a limited partner. That’s particularly true right now. The combination of heightened sensitivity to liquidity concerns, choppy and heavily regulated public markets, and limited credit has created a range of investment challenges but also opportunities for long-term investors. Other sophisticated institutional asset owners have made similar deals in the past. For example, the country’s largest public pension plan — the $233.2 billion California Public Employees’ Retirement System in Sacramento, California — has pursued this path, taking an equity stake in the Carlyle Group and several other alternative asset managers.
These kinds of transactions require creative — and for some investors, uncomfortable — thinking. New valuation and risk management approaches are needed. Investors would do well to build diversified portfolios of ownership stakes, protect their interests through customized transaction structures, and risk-weight the combined capital exposed to a manager and that manager’s funds.
Finally, the Texas Teachers deal with Bridgewater illustrates that the amount of money that investors are pumping into hedge funds continues to grow. Just five years ago the Texas state legislature capped Texas Teachers’ hedge fund allocation at 5 percent of assets; last year the legislature doubled that allocation, and this year the retirement plan purchased the Bridgewater stake. Notwithstanding the public focus on the challenges and flaws of hedge funds, their market-share expansion seems to have a great deal of room to run. AR
Andrew S. Kofman is an independent asset management consultant with nearly 20 years of investment management experience.