Hedge Funds Inc.

(page 2 of 2)

"We are seeing an institutionalization of private equity firms," says Gregg Slager, a partner with consultant Ernst & Young Transaction Advisory Services. "This is a natural evolution to a professionally managed asset class."

Private equity returns look like they're headed lower, too. As the firms have raised billions of dollars, they have had to turn to large-cap deals where it's harder to find a bargain-basement deal. Big companies, which have the resources to hire bankers and other expensive advisors, are more difficult to buy on the cheap. "As private equity firms go after bigger companies, they probably would admit that their returns are a bit lower, 20% rather than 25%," says Monte Brem, CEO of Leucadia Capital Partners, a private equity firm that was launched this year in La Jolla, Calif. "It's a function of the amount of capital being deployed."

The amounts are getting huge. On May 20, a private equity group at Goldman Sachs (GS) and TPG Capital agreed to pay $27.5 billion for wireless operator Alltel (AT) (see BusinessWeek.com, 5/21/07, "Private Equity Dials Up Alltel"). The deal comes a week after Cerberus Capital Management said it would buy the Chrysler operation from DaimlerChrysler (DCX) for $7.4 billion, plus the assumption of $18 billion in liabilities (see BusinessWeek.com, 5/14/07, "Cerberus Nabs Chrysler").

Outsized Returns

The changing approach of alternative asset managers is likely to have an impact on returns, but experts don't agree on exactly what that will be. Discolo fears that returns will drop as a result. But Charles Rossotti, a senior advisor at the Carlyle Group and a director at Merrill Lynch (MER), expects a different kind of fallout. "The conventional wisdom says that as more money flows into the sector, it will drive returns down," he says. "I think that has yet to be shown to be true. I think that what's really happening is that the disparity between the performance of the top quartile and the bottom quartile of alternative investments is getting wider than it is in other industries."

Perhaps. But one thing is clear: Hedge fund managers and others in alternative assets are making rational decisions about what is best for them. The concern for Discolo and others is that hedge fund managers have decided they don't need to take on big risks to get their own personal, outsized returns. "I think that so much money is coming in that hedge funds are getting wealthy from the management fees," he says.

See BusinessWeek.com's slide show for a roundup of the top-performing U.S. hedge funds.

Rosenbush is a senior writer for BusinessWeek.com in New York.