A Billion-Dollar Business in Making the Richest 1% Even Richer

Alternative asset managers quietly manage trillions of dollars around the world, but very few people have access to their funds. Ordinary investors are more likely to own index funds, or mutual funds managed by companies like T. Rowe Price rather than private funds from the likes of Oaktree Capital Group that are more common among the ultra-wealthy.

In this segment from Industry Focus: Financials, join The Motley Fool's Gaby Lapera and Jordan Wathen for a brief discussion on who invests in these exclusive funds, and how alternative asset managers make money managing the money of the super rich.

Gaby Lapera: Generally, 

it's not your average investor who's giving money to these alternative asset managers. It's super-wealthy individuals or families, pension funds, and, am I forgetting someone? I feel like I am.

Wathen: Pension funds, state governments, colleges. The Ivy League schools have $250 billion combined between all of them; they're major investors in this kind of world. The big commonality with all these investors is they're generally tax-free. The managers who manage this money can invest differently because their investors don't care about whether or not the returns are long-term capital gains or short-term capital gains. It really doesn't matter because they're not paying taxes anyway.

Lapera: Yeah. The next question would be, how do they make money? As we've answered, it depends on the asset manager, because they might specialize in different things. For example, Blackstone specializes in private equity, but it also does some real estate and hedge-fund solutions.

Wathen: Right. Blackstone is really known for private equity, but their hedge-fund solutions business has grown really big. To define that, it's basically a fund of funds. Someone comes to Blackstone with $1 billion and they say, "We want to invest in the world's best hedge funds, help us find them," and then they take a small cut for doing that. So there's really a bunch of different ways that they can make money.

And, as we talked about, the big difference with alternative asset managers is the fee structures are different. If we look at the world of mutual funds, a company like T. Rowe Price, which manages billions upon billions of dollars, it manages them in traditional mutual funds, things that you and I might own, not private equity funds or whatever. It earns a simple 1% or 0.8% management fee on the assets it manages, and that's it. Alternative asset managers, on the other hand, their funds are structured so they get a management fee, plus incentive fees when they generate returns in excess of a hurdle rate. The investor might want 8% a year, and beyond that, the fund company, if they generate 10% per year, they'll get 20% of that upside, of the 2% over 8%.

Lapera: Exactly. Listeners, what you might be hearing is, these asset managers make money in two different ways. One is through the fees, which sometimes are dependent on assets under management and a bunch of other things. The other thing that they might make money on is their actual investments. Hopefully, they're investing in such a way that they're actually creating profit. But when you talk about investing in an asset management firm, like I said, you're probably not talking about actually giving your money to the asset management firm; you're talking about buying stock in the asset management firm.

Wathen: Generally, these companies, say, Oaktree Capital Group, for example, they manage something like $100 billion of assets. They also have about $1.5 billion that's invested in their funds. But for the most part, the big earnings driver is the fees they generate on the $100 billion, rather than the $1.5 billion of their own capital that they manage.