This means that traders and teams that were previously running only the firm's capital will be part of fund structures that will trade both firm and client capital. Interesting. Very, very interesting. This is something I know a little bit about, having run a group called DB Advisors which was, in essence, exactly the same business. We ran about $4 billion of prop risk and $2 billion of client capital as part of a Registered Investment Advisor that was wholly-owned by Deutsche Bank (NYSE:DB).
This structure can be great or it can fail miserably, and few have gotten it right. Based upon my reading of how Goldman is doing it, they are getting the big things right (no surprise). That said, running a successful operation of this type involves walking a very fine line, the reasons for which I'll share with you. But first, for background I'll pull a few extracts from the NYT article to give you context for my comments.
Now Raanan A. Agus, 39, head of that (Principal Strategies) desk, is starting a hedge fund, but with a twist. His fund will be inside Goldman Sachs itself.
In a first for Goldman, Mr. Agus will move part of his principal strategies team — the formal name for the equity proprietary desk, which had been known as the risk arbitrage desk — to the bank’s asset management division to start a hedge fund that some insiders speculate could reach $10 billion.
The fund, which does not have a name yet, will receive money from Goldman and raise money from its private clients and outside investors, according to people with knowledge of the fund.
The decision to move Mr. Agus highlights the importance of hedge funds for investment banks because of the potential revenue they can generate and as an option the banks can market to their wealthy clients. Inside the securities division of Goldman Sachs, Mr. Agus puts up the firm’s own capital.
With Mr. Agus’s shift into the asset management division, he and his team can gather money from Goldman Sachs, its clients and outside investors, offering Goldman three benefits: a fund for its clients to invest in, a stream of fees from the funds and the ability for Goldman to put more money at risk — through the hedge fund, and in principal strategies.
This will allow Goldman to try and make money in both places: the securities division with the remaining principal strategies group and in asset management with the new hedge fund (two of the bank’s internal hedge funds, Goldman Sachs principal strategies and its special situations group, account 12 to 15 percent of the firm’s revenues, according to one person briefed on the firm’s results).
So, the punch line: Goldman is taking one of the prizes of its securities division (and, in fact, the entire firm), Principal Strategies, and handing it over to the asset management division. This could only happen in a place where politics take a back seat to business rationale, and, quite frankly, I am not aware of too many shops like this. This "playing well together" concept might be the single greatest asset Goldman has over other firms, and it is grossly undervalued by the market.
Goldman's people are great, sure. But there are lots of great people at other firms as well. In my opinion what distinguishes the firm from its peers are two key things: (1) a culture of teamwork, and; (2) excellence in risk management. Goldman is, at its core, a hedge fund with an advisory, underwriting and asset management fee component, and the only way this works is because the firm is so good at taking and managing prudent risks and leveraging relationships and insights across its business lines. Anyway, it is this distinguishing feature that gives it a shot to make this new venture work.
This all sounds really good. So what's the issue? Well, these platforms have some inherent issues that need to be considered when building them out. If Mr. Agus and his pals took their team outside, they'd get 2/20 and plenty of Day 1 assets to manage. They'd also get to build a brand just like Mr. Singh, Mr. Mindich and Mr. Steyer have, which has value in and of itself if, say, you want to go public someday. So, why accept an internal deal where, by definition, they will not be getting the full 2/20 and will not be readily thought of as an independent, branded entity? Three key reasons:
1. Reduced management and administrative headaches. Setting up a robust, multi-billion hedge fund platform takes time, effort and money. But more importantly, it is a major distraction to what a top trader/investor wants to be doing - making money. And then there is the ongoing management, compliance, record keeping, vendor management, etc. It is no walk in the park, let me tell you. So by setting up this business within Goldman, much of this burden will be offloaded to its prime brokerage unit and other internal teams. While setting up a platform like this even in a well-oiled machine like Goldman isn't easy, it is far easier than doing it de novo as a new independent hedge fund.
2. Enhanced asset gathering power. A person with a reputation and a track record like Mr. Agus would certainly be able to raise $1-$2 billion+ upon launch. But again, this takes time and effort. By staying in-house and having the full Goldman asset gathering operation at your disposal, not only is the process easier but the sheer amount of assets raised will likely be far greater. It is a pretty compelling pitch to say "Top trader performance with world-class controls and infrastructure from Goldman." Don't you think this message would resonate with institutional investors? I know it will. We used the same rap at DB Advisors and it is both true and represents a powerful selling point.
3. Flexibility and portability. Though I am not privy to Mr. Agus' deal, I'd be willing to be A LOT of money that his contract contemplates things such as taking his audited track record should he want to set up an independent fund outside of Goldman; taking his brand; and taking his team. In exchange, I am virtually certain that Goldman is getting guaranteed fund capacity; possibly preferential fees; either an implicit or guaranteed share of their prime brokerage business; serving as the asset gathering conduit for the independent fund; and maybe an option on a share of the GP. And you know what, this makes sense and is fair. We did some of these things at DB Advisors because they were fair and worked for both the manager and for the bank.
One key to making these structures work is to for there to be seamless communication and team play between the securities and asset management divisions, since the securities division's core competencies (risk-taking and risk management) and the asset management division's core competencies (fiduciary management, distribution and client management) are both complementary and absolutely necessary for the venture to succeed. Competing interests, politics and BS only hurt what could be a supremely profitable, value-added business.
The other big key is for the manager contracts to be sufficiently flexible to provide for hedge-fund like compensation as well as portability should the manager wish to move their team outside the firm. If the manager wishes to move outside, however, the firm gets a package of benefits that reflects the value they've helped create during the manager's tenure. And this feature is critical because without it, you won't be able to attract and retain the best managers - period. What you'll end up with is an assemblage of traders that emerge from a structure that promotes adverse selection, as no star manager will allow themselves to be trapped without a clear path to taking what they've built outside the firm. And this is very, very hard for a lot of firms to cope with, viewing traders leaving as a failure. But it is only a failure if you don't get value in return.
Ah, this brings me back to 2003-04 when I was dealing with these exact issues at DB Advisors. Goldman has the right culture and the right human capital to make this work. It is a smart move this is good for both shareholders and clients alike.