Dumb Money by Daniel Gross

Author:Daniel Gross
Language: eng
Format: epub
Publisher: Simon & Schuster

CHAPTER VI

Hedge Fund Nation

In the last, degenerative stage of a bubble, the phenomenon always jumps the shark. Surfers who have prospered by riding the waves believe they can walk on water and take the trend to ludicrous extremes. The energy and enthusiasm crosses the fortified borders separating the financial realm from the political and cultural worlds. The investment craze, once limited to first-moving professional investors, is pitched to second-, third-, and fourth-moving amateurs. More people pile on, desperate not to miss out. That is what happened in the age of Dumber Money in 2006 and 2007, the prelude to the inevitable pop. If this were the Roman Empire, the Era of Dumber Money would be the reign of Caligula.

Hedge funds and private equity firms were holding a nonstop jam session, playing the music that got Citigroup’s Chuck Prince up on the floor and boogeying. Success and debt combined to transform the new industries into huge, increasingly irresistible forces. According to a splashy October 2007 McKinsey report on the rising class of new financial power brokers—hedge funds, private equity firms, sovereign wealth funds, and emerging markets—assets of hedge funds rose from $625 billion (in 4,598 funds) in 2002 to nearly $1.7 trillion (in about 7,000 funds) in the first quarter of 2007. Drawing a line forward—consultants have a genetic susceptibility to Pro Forma disease—McKinsey suggested hedge funds’ assets could rise to $3.5 trillion by 2012. Private equity funds’ assets under management rose from $323 billion in 2000 to $709 billion in 2006. In 2006 alone, US private equity firms raised $179 billion. The borders between hedge funds and private equity firms, two peas in the Dumber Money pod, began to erode. Blackstone, a private equity fund, opened hedge funds, and hedge funds like Cerberus Capital Management, which had started life trading distressed bonds, began taking ownership of entire companies.

For this new crowd of big swinging dicks, the ability to borrow vast sums of money functioned as powerful implants. More impressive than the size of their deals was the income they produced. For all their storied histories, mission statements, and vast global footprints, investment banks like Lehman Brothers and Merrill Lynch were essentially conduits for compensation. A typical Wall Street firm pays 50 percent or more of its revenues in salaries and bonuses. But hedge funds and private equity funds paid out virtually all their revenues as compensation, which made them the envy of their financial services brethren. Hedge fund and private equity managers get a small management fee—1 percent or 2 percent of assets under management—plus 20 percent of investment profits. A $1-billion fund up 20 percent for the year throws off $20 million to spend on overhead and $40 million in incentive fees to distribute to employees. Since it does not cost much more to manage $1 billion than it does to manage $100 million, larger funds were even more profitable. And funds that were really good, like the quantitative Renaissance Technologies hedge fund, could keep an even larger chunk of the profits.

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