Hedge Fund Move Backfires On Carlyle Group

Diversification is generally meant to mitigate risk. But when it pushes an investor outside its comfort zone, the results can be sub-optimal.

Consider The Carlyle Group. With 60 individual funds being deployed in four separate investment disciplines on three continents, the Washington, D.C.-based firm is among the most diversified in the market. But its launch in March 2007 of hedge fund Carlyle-Blue Wave Partners Management proved to be one roll of the dice too many.

The multi-strategy hedge fund overburdened itself with residential mortgage-backed securities just two months before that market imploded. As of year-end 2007, the fund reportedly had a return of negative 17 percent, and in 2008 the fund plummeted to about $600 million in assets, down from a peak of about $900 million, due to losses and redemptions, a source familiar with the matter told Buyouts.

Earlier this year, Blue Wave tried to ease the pain by inviting investors into a newly-formed equity investment strategy within the fund. As of late July, the equity side of the fund was up more than 2 percent in 2008, putting it well ahead of the performance of the S&P 500 over the same period, our source said. But it wasn’t enough to stem the tide. On July 31, the firm said it would start liquidating Blue Wave’s holdings.

“Despite the rallying on the equity side, it was just a difficult market overall and investor pull-back continued to hurt the fund,” our source said. As investors in the fund sought redemptions, the fund was unable to achieve the critical mass of assets under management necessary to support its infrastructure.

At the time of its launch, Blue Wave had about 55 professionals supporting it. As losses and redemptions began pouring in, the staff was cut. As of July 31, the fund employed about 41 professionals, all of whom are expected to leave Carlyle Group as the fund is liquidated, our source said.

In the world of institutional investing, reputation is paramount. Diversifying into a new asset class and falling short can have lasting effects. One possibility is that limited partners may be hesitant to allocate money to another of the firm’s new strategies. “When you’re a start-up hedge fund and you don’t have a track record and you’re trying to bring in investors, if you do poorly in your first periods you can have a bunch of redemptions.,” noted Bradley Kulman, a partner at New York law firm Stroock & Stroock & Lavan. “Carlyle has a sterling reputation as a private equity manager, but now they’ve got a black eye from Blue Wave.”

In fact, Carlyle Group is not the only private equity firm to lose hold of a hedge fund in the middle of an economic slump. In 2002—the heart of yet another downturn—Greenberg-Summit Partners, the hedge fund affiliate of Boston private equity shop Summit Partners, wound down its Mt. Everest Fund due to losses. That fund, which was launched in 1997 and headed up by former Fidelity Investments money manager Lawrence Greenberg, had placed its bets in small-cap and emerging growth companies and at one point managed more than $1 billion in assets.

All told, at least nine well-known general partners have expanded into the hedge fund market, including The Blackstone Group, Kohlberg Kravis Roberts and TPG, with total investments currently worth at least $40 billion, according to information compiled by Buyouts. In the past five years alone these firms have launched no less than 14 new buyout-affiliated hedge funds with investment strategies focusing on long/short stock plays, dislocations in the leveraged loan market, and foreign currencies, among others. (See accompanying table for more information.)

Long And Short Of It

To be sure, buyout firms enjoy plenty of advantages from raising hedge funds. They provide a way for shops to use expertise they’ve developed in evaluating private companies to make money in public equity and debt opportunities; they supply another lucrative stream of management fees, as well as profit-shares that tend to bear fruit earlier than they do for buyout funds; and they provide an outlet for talented fund managers looking to do something different.

The returns aren’t bad either. Overall, a well-diversified hedge fund portfolio can serve investors well. For full-year 2007, the Credit Suisse/Tremont Hedge Fund Index, which tracked the performance of 481 hedge funds across a diverse range of strategies, reported returns averaging 12.56 percent.

Hedge fund investors can also be remarkably forgiving, such as those that put John Meriwether back in business after the 1998 implosion of Long-Term Capital Management. Investors also gave Summit Partners a free pass after its Mt. Everest days. The year after the fund wound down Summit Partners re-launched a new hedge fund strategy, Alydar Capital, which currently manages more than $2.5 billion in assets in three separate vehicles.

There’s a good chance that Carlyle Group won’t feel too much pain either. The $600 million in assets in the Blue Wave fund represents just a fraction of the firm’s overall $82.7 billion under management. The firm likes to point to its 21-year track record of generating aggregate rates of return north of 30 percent. And, according to our source, “the door remains open” to the possibility of Carlyle Group launching another hedge fund in the future, according to the source.

Then again, buyout firms thinking about getting into the business face a host of risks and challenges, beyond that of raising a fund that performs poorly.

“It takes a certain level of administrative personnel to do this, so you need at least some critical mass to have the infrastructure of people like a general counsel, compliance director and people like that,” said Michael Wolitzer, a partner at New York law firm Simpson Thacher & Bartlett. Wolitzer, who counts a number of the larger buyout/hedge fund managers as clients, said the smallest client he has worked with to have both an active private equity fund and a hedge fund has had assets in each of at least $2 billion to $2.5 billion.

Roger Kafker, managing director TA Associates, which has $12 billion under management, said that the firm’s skill set would probably transfer nicely to a hedge fund strategy when it comes to things like credit analysis. And the firm is no stranger to the concept: Summit Partners, which manages more than $2.5 billion in hedge funds, actually spun out of TA Associates in the early 1980s and was among the first private equity firms to diversify into the hedge fund market when it did so in 1997.

But the firm has no interest in shorting stocks, looking for distressed debt opportunities, or other hedge-fund-like activities. “It’s a question of focus,” said Kafker. “We’re in the long-term investment business. We’re looking out three to five years in the future [while hedge funds are] looking out three to five months.”