By Katrina Dean Allen
After two expensive, messy and ultimately failed attempts at building a hedge fund business, Citi is trying again—with a new platform, a new name and a couple of former senior Morgan Stanley executives at the helm.
The bank made its first big splash into hedge funds in 2004, with the launch of Tribeca Global Management, and Citi executives boldly declared the firm's intention to raise $20 billion across some 50 strategies. But performance proved to be weak, and Citi shut down Tribeca three years later.
Citi's next attempt—the $800 million acquisition of former Morgan Stanley senior executive Vikram Pandit's $4.41n billion hedge fund Old Lane in 2007—was also a flop. Old Lane suffered losses and investor redemptions; the fund was shuttered barely a year after Citi bought it.
Given all the baggage, it's not surprising that investors are skeptical of the born-again Citi hedge fund platform. "They have a huge uphill battle ahead of them," says Timothy Barrett, executive director and chief investment officer for the San Bernardino County Employees' Retirement Association.
Citi executives argue that they shouldn't be written off just yet. The executives say they have spent the past year working on a major house cleaning, clearing out old strategies left after the dissolution of Old Lane and Tribeca and closing a total of seven funds. The hedge fund platform has shrunk to $1.7 billion from $17.73 billion at its peak in July 2007, which included $5.5 billion in structured investment vehicles that ultimately blew up, as well as the $4.41 billion from Old Lane.
Citi has deleveraged the remaining funds, renegotiated or terminated more than 300 trading agreements and moved counterparty risk to regulated banks and away from broker/dealers. The team also moved the division's property investment, private equity fund of funds, fund of funds and managed futures businesses into Citi Holdings.
The newly restructured business is called Citi Capital Advisors, and its new leaders are Jonathan Dorfman and James O'Brien, two 20-year Morgan Stanley fixed-income veterans who joined Citi at the end of 2007 to head up its fixed-income division when Citi acquired the pair's asset management firm, Carlton Hill Global Advisors. Dorfman and O'Brien took over as co-heads of the group in early 2009 when Edward Kelly became chief financial officer of Citigroup. Kelly has since moved to become vice chairman. In addition to managing the alternatives platform, the pair also run the market strategies group, which houses the firm's internally managed hedge funds.
Building a successful, long-term hedge fund business is not easy in the best of times, but Citi is trying again under arguably the most difficult conditions it has ever faced.
Citi is the last big investment bank to repay the $45 billion in TARP money it received from the government. Pandit, now Citi's chief executive, says the firm's top priority is to pay back the loan. To do it, Citi will need to buy back the $20.5 billion in preferred shares still held by the government. At presstime, Citi was planning to raise the capital largely by issuing common stock and said it would also replace some of the cash it agreed to pay employees with $1.7 billion in stock. Citi's share price fell further in response to the news, and investors expressed concern about dilution of their holdings. Meanwhile, the Treasury said it would begin unwinding its 34% stake in Citi, selling $5 billion of its stock to start and then selling the remaining amount over the next 12 months.
"Institutions want to see track records and stability," says a senior executive at a multi-billion investment and wealth management firm. He added that for the bank platform to be successful, investors will have to buy into Citi's ability to do more in terms of oversight. "One of the things that has made Goldman Sachs so attractive is that, in theory, it has people in place who are really good at managing risk."
And although Citi is out courting investors for the new venture, it is certain to encounter negative talk from those who are suing the firm's shuttered Falcon funds over investment losses and those who invested in the now-liquidated Corporate Special Opportunities Partners credit fund, who are still smarting over the fact that the fund's managers suspended redemptions last year. Not to mention that any portfolio managers who Citi tries to recruit will almost certainly remember that at the height of the crisis, the bank pulled cash from several successful strategies, forcing those managers to wind down.
Despite the clear obstacles the firm faces, O'Brien says CCA's parent company is satisfied with the new division and with the streamlining that has taken place over the past 18 months.
"During the crisis period in 2008, Citi fully supported our efforts and didn't redeem any of its seed capital from our funds," he says. He adds that the high-quality teams that were retained and recruited have proven themselves through performance.
Tanya Beder, the former Caxton Associates senior executive Citi hired in May 2004 to build out Tribeca, notes that the cyclical nature of the financial market—not to mention human nature—may wear down investors after enough time passes.
"The stunning thing about human nature is the ability to forget the past rather fast," says Beder, now chairman of SBCC Group, an independent advisory firm. "And mistakes are then repeated."
CCA now consists of three platforms: market strategies, private equity and infrastructure investment. CCA manages a total of $13.4 billion in assets, including $2.7 billion in assets across its hedge fund and long-oriented funds in the market strategies group.
Under this umbrella, the fixed-income hedge fund strategies include corporate structured credit, distressed debt, mortgage/credit, global macro, emerging markets and municipals. The equity side manages two hedge fund strategies—event-driven and quantitative long/short.
Some of the strategies on the platform were left over after the overhaul, while others are recent acquisitions. One of the better performers from the previous years is Mark Franklin's EMSO, which began trading in 2000. His fund has produced a net annualized return since inception of 12.2% through November. Another is the macro strategy headed by former Old Lane portfolio manager Kevin Bespolka, who headed rates and foreign exchange trading at Old Lane starting in mid-2006. That fund began trading at the end of last year and, with the advantage of starting out when prices were low, has a net annualized return of 25% through November.
In the first quarter of 2008, the firm hired Rajesh Kumar, a managing principal at Halcyon Asset Management, to run a mortgage/credit strategy. That fund began trading in May 2008 and has produced a net annualized return of 24.9% through November. During the height of the crisis last year, CCA also bought Epic Asset Management, a New Jersey-based distressed-debt fund headed up by Herbert Seif and James Duplessie. The pair founded Epic in 2002 as a distressed-debt, long/short investment strategy. That fund has a net annualized return of 4.2% through November since inception.
"We didn't hire a bunch of prop traders from the sell side," says Dorfman. "We hired people who have very long track records managing money either on their own or at a buyside firm." Skeptics argue that internally managed platforms never really attract the top-tier portfolio managers, because these managers don't want to share their profits with a bank, and critics wonder if teams that decide to scrap their own businesses in favor of joining a larger entity perhaps couldn't cut it alone.
But Dorfman points out that managing a business and managing a fund are two completely different skills, and increased regulation coupled with increased demands from investors can make it difficult not to get sidetracked from a manager's core talent: running the portfolio.
"It's hard to be a stand-alone boutique in a nontransparent, operationally intensive business," he says.
To give the new funds a running start, Citi has co-invested $100 million to $250 million per fund. Although it's a seed investor, Citi is still subject to the same terms as other investors, including fees and lockups.
The thorny issue of compensation has also been addressed. Citi provides technology, compliance, legal and finance, which is allocated per strategy and is the first thing paid through the management fee. The remaining portion of the management fee is then split between CCA and the portfolio managers, who then use the proceeds to cover some of their fixed costs, such as salaries and benefits. Managers also receive 40% to 60% of the incentive fee.
The firm is also going after a new investor demographic. Citi previously focused on wealthy private banking clients, whose main interest was high returns. Some argue those demands are what drove many former managers on the platform to crank up their leverage to generate such returns.
O'Brien and Dorfman are now focusing on institutions, which are looking for more steady, safe returns, and they are pitching to the top 500 institutional investors globally, including sovereign wealth funds, pension funds, foundations, endowments and funds of funds.
"We are not going to be the top-decile manager in any strategy, because we don't take that type of risk," says O'Brien, who adds that when he and Dorfman joined the firm, the platform was leveraged about eight times. "We just want to be in the top third, with careful management of the downside risks." By September of 2008, when Lehman Brothers defaulted, the platform was unlevered on a net basis.
To succeed, however, the firm will have to convince investors not only that Citi won't repeat its past mistakes but also that the bank is well on its way to a more stable financial footing.
"This is a tough space and there are a lot of smart people out there," says one investment professional at a major pension plan. "If they are going to make it, they need to be thinking like a fiduciary and really looking out for the clients." AR