The Year of Secret Capital

Hedge funds are sexy. Asset managers are gigantic. Custody banks are… custody banks. 

But these organizations are simply playing with other people’s money. Ask the average person on the street—or, astoundingly, even some people within the world of asset management—and they will offer little insight into whose money it actually is. Of course, it’s largely the result of asset owners—pensions, endowments, foundations, sovereign funds, healthcare organizations, and insurance general accounts—that mega-firms such as Bridgewater and Blackrock exist. Yet few know it. 

I call this money secret capital. 

Twelve months ago, I labeled 2011 “The Year of Stasis” because I felt that the institutional investing world was living up to its reputation of being a cruise ship, not a kayak: when it actually changes course, it does so slowly. 

I am not suggesting 2012 was The Year of Secret Capital, where your average market participant came to understand that it wasn’t the environs of the Upper East Side or Beverly Hills that buoyed the asset management industry and, in many ways, the financial system as a whole. It wasn’t. In the asset owner/asset manager relationship, this wasn’t the year that power finally shifted towards the former. 

But 2013 just might be. 

Power, academically described, is the ability to produce a change in behavior in another. In my September Issue editor’s letter, I wrote the following about the basis of power: 

The great Speaker of the House, Sam Rayburn, had a room. Formally, it was H-128, a moderately sized but ornately decorated, high-ceilinged chamber on the first floor of the Capitol. Informally, it was the Board of Education (or simply “downstairs” to Rayburn), the room back to which the portly Texan would invite a few favored lawmakers to have a drink following a day’s work on the House floor. To be in this room was to be in power. The all-controlling Chairmen of the mighty standing committees of Congress frequented it; Democratic Party policy was often decided in it; Harry Truman, who one day in 1945 had just finished presiding over the Senate as Vice President, received the phone call there informing him that he was, following the sudden death of Franklin Roosevelt, now President. To be outside this room while the Board was in session was to make painfully clear to the uninvited that they were not the paramount possessors of power in Washington. Thus, as a young Congressman new to Washington in the 1940s, Lyndon Baines Johnson, along with nearly every member of Congress, obsessed over one question: “How do I get in that room?” 

We all want to be in that room. Anyone who says otherwise is lying. That room, at its most fundamental, is power—the acquisition, maintenance, and spending of power. From the President of the United States to the private-equity titan to the backcountry bumpkin, we all want to influence the actions of others. This is because we all require resources: shelter and food at its most basic, adoration and affection at its more trivial. Power is the avenue by which these resources are won or lost. 

What I failed to do—on purpose—was to deal directly with the idea of power as it applies to the asset management industrial complex. I’ll do so now. If power in American politics is getting in that room, power in asset management is the ability to align the interests of those who allocate the capital with those that invest it on the allocator’s behalf.

This isn’t just about fees, although proper fee structure—the basis of which should be incentivized pay that rewards long-term performance—is essential. It isn’t paying so little that asset owners starve asset managers of skilled employees and necessary resources. It isn’t paying so much that asset manager can simply gather capital instead of invest them well. It’s about making it so both sides win, and lose, together. 

It doesn’t end at fees. It also includes aligning asset owner and asset manager relationship expectations: what’s reported, when it’s reported, how long the relationship is expected to last, what can cause the relationship to end prematurely, and so on. 

The best firms understand this—or at least make a pretense of understanding it. It should be no surprise that the hedge fund that has most aggressively courted institutional assets—Ray Dalio’s Bridgewater Associates—is also the largest, and possibly the most respected, firm of its kind. 

aiCIO founder Charlie Ruffel alluded to this with a column in November—“The Death of (Most) Asset Managers.” In it, Charlie predicted “we are about to see a great concentration of institutional assets in a handful of firms.” Due to changing demands from asset owners—namely, liability-driven solutions and pension-risk transfers in the corporate pension space, a reliance on investment outsourcing and alternatives in the endowment, foundation, and public pension space—Charlie predicted that perhaps 80% of existing asset managers would perish in the coming years. “Much of the change stems from the radically different demands of the ultimate consumer, particularly institutional investors,” he wrote, implying that before this change, the ultimate consumer—the secret capital of which I now write—wasn’t being heard. 

But why might now be The Year of Secret Capital, explicitly? 

Serendipitously, a recent article in New York Magazine lends some insight. “There’s a key scene in Big where Tom Hanks wakes up, stumbles out of bed, looks in the mirror, and discovers that he’s been turned from a 12-year-old boy into a full-grown, powerful man,” wrote Kevin Roose in the magazine’s Intelligencer section. He continued: “Something like that happened in the financial world last week, when the California State Teachers Retirement System [CalSTRS]…found itself bossing around Cerberus Capital Management.” Cerberus, it turns out, owns the company whose product—the Bushmaster semiautomatic rifle—was used to end the lives of 26 innocents in Newtown, Connecticut. CalSTRS has $750 million with Cerberus; Cerberus quickly announced its intention to sell the maker of the Bushmaster. “Pension funds occupy a lower rung on the Wall Street ladder than private-equity firms and are seen by the industry (their own managers included) as less sophisticated market players. But they have more clout than they realize,” Roose correctly concluded before pointing out that as of now, 52% of private equity capital comes from pensions and endowments—the “lower rung” he and many speak of. 

I’m willing to bet this article wouldn’t have made it into the pages of New York five years ago. The cruise ship that is institutional investing has turned, it seems. It will never be a kayak, but five years after the Great Dislocation, secret capital is seemingly more cognizant of its own power and, like Chris Ailman’s CalSTRS, is willing to act on it. I have no inside knowledge (well, I do), but I’m willing to bet Ailman (at #31 in 2012) will be moving his way up aiCIO’s Power 100 in 2013. 

But why now? Simple: Combining Ruffel and Roose’s arguments—the demand for new services and the willingness to boss around asset managers—creates a strong argument that now, more so than in the past, is a time ripe for the emergence of secret capital. Both trends portend the death of asset management if asset owners are ignored, and nothing forces a shift in power like the threat of termination. 

More appropriately, then, maybe 2013 will be the year that secret capital becomes its opposite: not-so-secret capital.