Shakeup expected to enrich survivors

Who will step up when Wall Street's titans step down?

As Goldman Sachs Group Inc. and Morgan Stanley convert themselves into more conservative commercial banks, a group of well-funded private-equity firms and hedge funds stand to gain by looking into the riskier side of the Street.

Some are already communicating that message, while acknowledging how the stunning weeklong shakeup has damaged Wall Street's established order.

On Thursday, amid the Merrill Lynch-Lehman Brothers-AIG turmoil, Stephen Schwarzman, head of private-equity firm Blackstone Group, sent a voice mail to the firm's 1,300 employees: “Our businesses were set up to benefit from market turmoil and scarce capital.”

While noting that the events on Wall Street “are disturbing for each of us on a personal level,” he said that “virtually all of our businesses will benefit once the dust settles.”

With the historic changes at Goldman, Morgan, Merrill Lynch and Lehman, hedge and private-equity firms are seen as stepping further into the risk-taking fold. The list includes Fortress Investment Group and Och-Ziff Capital Management, which have both hedge and private-equity funds.

The advantages of firms like these: the ability to attract talent, command a steady supply of money to invest and have the size and diversity to borrow more money.

“A lot of these people running private-equity and hedge funds walked away from the banks. I view this is as sort of an outsourcing model” that will become more pronounced, says William Wilhelm, a University of Virginia finance professor who is a specialist on the history of investment banking.

Some of Wall Street's most highly paid traders and deal advisers are likely to flee to smaller hedge funds and boutique advisers such as Bruce Wasserstein's Lazard Ltd. and Evercore Partners, Wilhelm says.

Even if Goldman and Morgan Stanley ultimately get bigger by merging with deposit banks, the effect could be the same. Size will compel more elite specialists who are used to big paychecks to go elsewhere, he says.

That isn't to say all is rosy in the hedge-fund and private-equity world. Weaker hedge funds are more vulnerable now than ever.

Tighter lending standards at banks, combined with market volatility and losses at many funds, are expected to quash many underperformers out of business this year – another way that bigger, stronger fund managers could become even more dominant.

Private-equity firms have also struggled with the financial-services industry during the past year. Blackstone's stock has dropped by more than 50 percent from its June 2007 peak.