On Wall St: Generation game for hedge funds

Talk about a one-man band. Buried in the risk factors of Och-Ziff’s initial public offering prospectus are warnings of what could happen if founder Daniel Och “dies or ceases to perform his duties” at the hedge fund. That would trigger a special redemption right for investors in the funds which “could, therefore, ultimately result in a loss of substantially all of our earnings.”

That nuclear warning is presumably an exaggeration of the group’s reliance on Mr Och, injected into the prospectus by fastidious lawyers. But it underlines how the hedge funds and private equity groups rushing to go public in the US still depend heavily on their founders. And what challenges could emerge when the time comes for a generational change.

The latest crop of alternative asset managers going public still have their founders’ names above the door. KKR is dominated by cousins Henry Kravis and George Roberts (the second K and the R respectively). GLG Partners is run by Noam Gottesman, who founded it alongside Pierre Lagrange and Jonathan Green.

Even Blackstone, a seemingly generic name, is no such thing. Founders Steve Schwarzman and Pete Peterson more subtly stamped their identities and their family roots on the business through a name that combines Schwarz (German for black) and Petros (Greek for stone). And, of course, Mr Schwarzman has recently become increasingly synonymous with the private equity group during the wave of publicity surrounding its initial public offering.

In a sense, that cult of personality is reassuring for shareholders. They know that the individuals who successfully built the businesses are still in charge of keeping them on track. With big ongoing stakes in the management companies, at least until they decide to sell, they remain highly incentivised to keep earnings and hence share prices strong.

But that is also a risk. Coupled with their big stakes and dominant characters, the founders have often structured the voting power in their companies in a way that ensures they retain pretty much total power. Shareholders (or unitholders as they are known in the case of KKR and Blackstone because of the convoluted structures) are basically along for the ride. More than most companies, they are putting absolute faith in the decisions of a few, or even one, top executive.

It increases the importance of what happens when the next generation takes over. After all, a big reason for the IPOs – particularly at the private equity groups – is to make sure that the firms continue as real institutions and there is a smooth transfer of power when the top dogs stand down and reduce their ownership stakes. Mr Peterson, aged 81, has already cashed out most of his Blackstone stake. Mr Kravis, Mr Roberts and Mr Schwarzman, all now over 60, will presumably not go on working forever.

Any sign they are ready to step down will focus attention squarely on the capabilities of the next tier of management. The structure of the private equity groups in particular is such that full control over running the business will remain within the partnership group - even though the proportion owned by ordinary external unitholders is likely to increase over time as the founders sell their shares.

Partners at Och-Ziff have a slightly less rigid lock on control into the future. But, a change of generation at the top will accentuate a different issue.

After the IPO, Mr Och and his key lieutenants will not be paid in a way that shows up fully in the company’s profit and loss account. Instead, they will enjoy the distributions they receive from significant stakes they have in the business. That will help boost operating margins in the short-term. When they move on, however, the new chiefs that replace them will presumably expect either handsome equity grants or more cash each year to keep them incentivised. Both of those would be expensed through the profit and loss account.

Mr Och is only 46 and the other partners are even younger. When he does decide to go, it is highly unlikely that funds under management will evaporate with him (as the risk factors warn). But external shareholders could be faced with more than just a new individual, or team, running the show. They might also have to stomach a hit to margins as new salaries kick in for the next generation of hedge fund bigwigs.

thorold.barker@ft.com