The Investment Banking Business: Money Management

In an article last month, I gave an overview of the investment banking industry from the perspective of the actual business of investment banking. These days, though, the firms we typically refer to as investment banks do a whole heck of a lot more than just investment banking.

Recently, firms like Blackstone and Fortress (NYSE: FIG  ) , which have become publicly traded companies, and KKR and Och-Ziff, which are poised to do the same, have been stealing the spotlight in the finance world. Many investors seem to think that these companies are their first chance to benefit from the booming alternative asset management business. The truth is, plenty of opportunities have been out there hiding behind the "investment banking" moniker.

Traditional asset management
Though alternative asset management has been growing rapidly at many of the investment banks, the lion's share of their assets under management is still in fairly standard equity, fixed-income, and money market funds. For instance, of Goldman Sachs' (NYSE: GS  ) $676 billion under management at the end of its last fiscal year, $531 billion was in traditional funds. Similarly, Lehman Brothers (NYSE: LEH  ) , which owns Neuberger Berman, has 91% of its $225 billion under management in traditional funds.

Similar to asset managers like Legg Mason, the investment banks make money from these funds primarily through the fees they charge investors. Some of the investment banks, such as JPMorgan Chase (NYSE: JPM  ) and Merrill Lynch (NYSE: MER  ) , provide asset management services to the broad retail market, while some of the others, like Goldman and Bear Stearns (NYSE: BSC  ) , focus primarily on institutions and high-net-worth individuals.

Private equity
In the past, the big-name standalone private-equity funds like Blackstone, KKR, and TPG have gotten all the notice when it comes to the PE business. As the major investment banks continue to leverage their intellectual capital and financial expertise, though, they are becoming increasingly significant players in the industry.

Among the major U.S. banks, it's Goldman Sachs that's made the biggest splash into PE. As of fiscal year-end 2006, Goldman had $44 billion of corporate and real estate private equity funds under management. This compares favorably to the $53 billion of corporate and real estate PE funds that Blackstone reported in its IPO prospectus. As if that's not enough, Goldman announced earlier this year a new $20 billion private equity fund. Though not at Goldman's level, many of the other investment banks, such as Lehman Brothers and Morgan Stanley (NYSE: MS  ) , also have captive private-equity arms.

The investment banks make money from their PE funds in a few different ways. First, they collect fees for managing the funds. As soon as the PE fund gets investor money invested in a deal, the fund starts charging its investors a management fee, usually in the 2% range.

The funds also get a big chunk of the investment profits once they pass a pre-set hurdle. This take is often as much as 20%. And the banks also make money from their funds by making principal investments in their own funds.

Hedge funds
Investment banks haven't missed out on the other major class of alternative assets, either. Similar to the private equity funds, hedge funds are a very lucrative business because of the fees involved for the fund manager. They also typically charge a 2% management fee and 20% of profits over a certain point.

It's hard to find an investment bank that hasn't gotten involved in hedge funds. Among the many that have in-house hedge funds are Bear Stearns, Goldman Sachs, JPMorgan, and Credit Suisse.

Results from the captive hedge funds have been mixed. In recent news, two of Bear Stearns' credit-based hedge funds have been absolutely punished -- at this point, $3.50 and an ownership unit in one of those funds might get you a Starbucks latte. Goldman Sachs hasn't been immune to hedge fund problems, either -- its flagship fund, Global Alpha, has had some very well-covered struggles.

Will these banks end up walking away from hedge funds altogether? Not likely, since they'd also be walking away from a heck of a lot of fees. The more likely scenario is some shake-ups at the banks that are lagging. Hedge fund managers are expendable in the same way major league pitchers are -- if the arm on one seems to be giving out, there are hordes of youngsters with peppy arms throwing 95 and absolutely salivating for a shot in the big leagues.

Goldman Sachs' co-head of investment management recently stepped down, suggesting that the firm is ready to spill some blood getting that part of its business back on track. There has already been some shuffling going on over at Bear, and there's likely plenty more to come.

The wrap
"Investment bank" may be an easy way to refer to the group of major diversified financial players, but it hardly gives a full picture of the business at these banks anymore. As individual and institutional investors alike look for more places to put their money, the i-banks have been more than happy to offer all types of new investment vehicles with all types of new fees. As the alternative asset classes continue to become more institutionalized and even more accepted by institutional investors, this will likely become an even larger income stream for the investment banks.

More financial Foolishness:

JPMorgan Chase is a Motley Fool Income Investor recommendation. Find out why with a 30-day free trial of the newsletter. Legg Mason is a Motley Fool Inside Value pick.

Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned. The Fool's disclosure policy is getting ready to start the next hit reality TV show, So You Want to Be a Hedge Fund Manager. I hear Fox has dibs on it.


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