Who will step up when Wall Street's titans step down?
As Goldman Sachs Group Inc. and Morgan Stanley convert themselves into more conservative commercial banks, a group of well-funded private-equity firms and hedge funds stand to gain by hewing to the riskier side of the Street.
Some are already communicating that message, while acknowledging how the stunning, weeklong shake-up has damaged Wall Street's established order.
On Thursday, after Merrill Lynch & Co. agreed to be sold to Bank of America Corp., Lehman Brothers Holdings Inc. filed for bankruptcy-court protection, and insurer American International Group Inc. was rescued by the government, Stephen Schwarzman, head of private-equity firm Blackstone Group, sent a voice mail to the firm's 1,300 employees: "Our businesses were set up to benefit from market turmoil and scarce capital."
While saying that the events on Wall Street "are disturbing for each of us on a personal level," he noted that "in the aftermath of the current situation, virtually all of our businesses will benefit once the dust settles."
Meanwhile, Citadel Investment Group LLC, a hedge-fund firm under Kenneth Griffin that manages about $20 billion in assets, is in early discussions to further broaden its footprint in the banking world. Citadel has been considering creating a division that would advise midsize and large banks on technology balance-sheet issues. This sort of capital-advisory business is the bread-and-butter of investment banks, and would be a first for Citadel and rare for the hedge-fund industry, according to a person familiar with the discussions.
The company already looks more like a diversified financial-services firm than the typical hedge-fund firm. It has the largest options market-making business in the U.S. and provides back-office services to other hedge funds. Some see the latter as a precursor to Citadel's having a full-fledged prime brokerage in-house -- turf that is near and dear to Morgan Stanley and Goldman.
With the historic changes at Goldman, Morgan, Merrill Lynch and Lehman, hedge and private-equity firms are seen as stepping further into the risk-taking fold. The list includes Fortress Investment Group and Och-Ziff Capital Management, which have both hedge and private-equity funds.
The advantages of firms like these: the ability to attract talent, command a steady supply of money to invest and have the size and diversity to borrow more money.
"A lot of these people running private-equity and hedge funds walked away from the banks. I view this is as sort of an outsourcing model" that will become more pronounced, says William J. Wilhelm, a University of Virginia finance professor who is a specialist on the history of investment banking.
Some of Wall Street's most highly paid traders and deal advisers are likely to flee to smaller hedge funds and boutique advisers such as Bruce Wasserstein's Lazard Ltd. and Evercore Partners, Mr. Wilhelm says.
Even if Goldman and Morgan Stanley ultimately get bigger by merging with deposit banks, the effect could be the same. Size will compel more elite specialists who are used to big paychecks to go elsewhere, he says.
That isn't to say all is rosy in the hedge-fund and private-equity world. Weaker hedge funds are more vulnerable now than ever. Tighter lending standards at banks, combined with market volatility and losses at many funds, are expected to quash many underperformers out of business this year -- another way that bigger, stronger fund managers could become even more dominant.
Private-equity firms have also struggled with the financial-services industry during the past year. Blackstone's stock has dropped by more than 50% from its June 2007 peak. And while large buyout firms are slowly increasing their lending capabilities, that won't change their dependence on large banks to fund the leveraged-buyout business.
Still, firms like Mr. Schwarzman's Blackstone raise cash that is available over a long term. By comparison, much of the funding of investment banks is done on a short-term basis. Large buyout firms also keep little net debt at the corporate level. Blackstone Group had only $225 million of net debt on its corporate balance sheet as of June 30.
With the LBO market virtually closed, Blackstone has rotated into less conventional private-equity investments. With big banks motivated to reduce their holdings of troubled corporate debt, Blackstone last quarter acquired about $8 billion of distressed leveraged loans.
Och-Ziff has $33 billion in assets spread out among its hedge and private-equity funds and lending arm. Though life as a publicly traded company hasn't been exactly smooth, selling shares gave Och-Ziff what is known as "permanent capital" for ramping up its investments internationally.
Moreover, Och-Ziff uses barely any leverage -- that is, money borrowed from securities firms to take bigger risks through amplified bets. This minimal leverage often makes Och-Ziff's returns less dazzling than some competitors, but it also makes it less dependent on the willingness of big banks to lend money -- something the credit crisis has made them leery of.
Business - WSJ.com