With the rush of capital flowing into hedge funds and private equity funds we should not be surprised to see some of the problems of gigantism begin to creep into the actions of these managers. We were reminded of this by a story authored by Dennis K. Berman and Monica Langley in the Wall Street Journal.

They retrace the steps taken by the private equity firm Cerebrus Capital Management to become the controlling shareholder in GMAC the erstwhile finance arm of General Motors (GM). They recount how Cerebrus transformed itself over a decade from a "vulture lender" hedge fund into the private equity behemoth they are today.

It is interesting to note how Cerebrus has followed what is becoming a typical path for fund managers these days. As the size of their funds increase the nature of their goals implicitly (or explicitly) change through time.

The goal of any new fund manager is to generate high investment returns given their investment strategy. Without good returns no manager can expect to survive over the long term.

The next goal of any fund manager is to generate wealth-building type fees. These can come from investment returns, but they also come from attracting additional capital from existing and new fundholders. As this capital rushes in the managers are often forced to diversify into new strategies.

The final stage is may be the trickiest. Even at this point many hedge funds or private equity firms can still cease to exist. Whether driven by poor performance or divisions driven by the egos of management the entity is still a fleeting one. It is only when a fund is successful enough and has a management with the ambition can it reach the final stage. That stage is one of permanence in which a lasting legacy can be built.

That seems to be where Cerebrus is today. The question is at this stage whether investment decisions are being made solely with investment returns in mind. In addition to wanting to use GMAC a vehicle to enter new businesses there were other non-monetary goals cited like, "…the investment as a kind of patriotic act."

While these goals may be worthy ones they are not necessarily the ones that will serve the best interests of the fundholders. Conflicting goals do not make for the best investment decisions.

The size and ambition of the GMAC deal represent a coming-of-age for the 14-year-old investment firm. "This is their RJR," said one person involved in GMAC skirmishing, referring to the breakthrough 1989 KKR deal.

What many people might forget is that the RJR deal was not a particularly pleasant one for KKR. One could argue that KKR experienced a "winner's curse" in regards to that deal.

None of this takes away from the fact that Cerebrus is an unmitigated success. However that success has lead it to a point where the conflicting goals of investment returns and size intersect. By the accounts in the WSJ article the GMAC deal is a significant bet on creating a lasting financial conglomerate. While we would not bet against Cerebrus at this point, it is unlikely to be a journey without some bumps in the road.

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