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Pandit Fast Money With Hedge Funds Proving Citigroup Dead End

Business Week

Vikram Pandit knows one way to make big money in hedge funds: sell them.

In July 2007, Pandit sold Old Lane Partners LP to Citigroup Inc. for $800 million and pocketed $165 million for his stake. Then he took over the bank’s in-house hedge-fund group, now called Citi Capital Advisors, or CCA. He became chief executive officer of the whole company just five months later.

For Pandit, the hedge-fund business was a sprint to riches. For Citigroup, it’s been a slog, Bloomberg Markets magazine reports in its April issue. When Pandit, 55, was promoted in December 2007, CCA managed $59 billion in hedge funds, private- equity pools and real estate. In 2007, it earned net income — from fees charged to clients and gains on its own money — of $672 million.

After the financial crisis, Citigroup closed some funds — it won’t say how many — and investors fled others. As of mid- February, it managed $18.6 billion. The last time Citi told shareholders how CCA performed was the first quarter of 2008, when the unit lost $509 million. Four of Citi’s seven biggest hedge funds have underperformed their indexes since they started, according to investors. Five of the seven lost money in 2011.

Pandit persevered. Since 2008, he has opened or purchased at least six new funds. In the third quarter of 2011, he invested $800 million of the bank’s own money — not cash from investors or clients — into CCA, even as traders from Goldman Sachs Group Inc. and other banks were jumping ship to start their own hedge funds in advance of the Volcker rule.

Volcker Rule

That law, championed by former Federal Reserve Chairman Paul Volcker and made part of the Dodd-Frank Act, says a deposit-taking bank’s proprietary capital can’t account for more than 3 percent of any hedge fund.

In at least four of Citi’s funds, half or more of the assets have come from Citi’s own balance sheet during the past two years, not from investors or clients of its private bank, according to interviews with people familiar with the funds and documents obtained by Bloomberg Markets. That has to change by the time the Volcker rule is fully implemented; it is scheduled to take effect in July and includes a two-year transition period.

So, in February, Pandit capitulated. John Havens, Citigroup’s chief operating officer and the chairman of CCA, told Bloomberg News that the bank planned to sell a “significant” portion of CCA to managers of the group.

Best Talent

The organization will ultimately be independent of Citi, which will help hedge-fund and private-equity managers raise money from outside investors, says Havens, 55, who worked with Pandit when both were executives at Morgan Stanley and co- founded Old Lane with him.

“Clients like independent, alternative asset managers,” Havens says in his office in downtown Manhattan. “You can attract the best talent in the owner-operator model.”

Citi plans on keeping a stake in CCA, although the percentage will drop as assets from outside investors come in and the bank takes its own money out of the funds, Havens says.

“We like the business; that’s why we took the decisions in 2008 to rebuild it,” he says.

The details and timing of the sale aren’t final, including who will run it, Havens says. He declined to say whether Jonathan Dorfman and James O’Brien, CCA’s co-heads, would be part of the deal. Friends of Vikram

Dorfman, 50, and O’Brien, 51, who both worked with Pandit at Morgan Stanley, are confidantes of the Citigroup CEO and of Havens, to whom they report. The leaders of other units, including mergers advice and private banking, answer to James “Jamie” Forese, head of Citi’s securities and banking division, of which CCA is a unit.

The fund managers eligible to be part of the management buyout also have ties to Pandit and Havens. Mukesh Patel, manager of the Event Driven Fund, and two of his assistants came from Old Lane. Kevin Bespolka, manager of the Global Macro Fund, worked for Pandit there too, as did Manu Rana, manager of the Financial Partners Fund.

The decision to sell the hedge and private-equity funds comes at a time when Citigroup is still recovering from its near-death experience four years ago. Citi needed $45 billion from the Troubled Asset Relief Program, $99 billion in loans from the Federal Reserve and $301 billion in government asset guarantees to stay alive. Its stock declined 33 percent in the 12 months ended on Feb. 13.

Asset Sales

Pandit split the bank in 2009, creating a unit called Citi Holdings, where he sequestered securities built from subprime mortgages and other toxic investments. He has offloaded various enterprises and assets, including life insurer Primerica Inc. and Student Loan Corp.

He sold 51 percent of the bank’s Smith Barney brokerage to Morgan Stanley, where he worked for 22 years before starting Old Lane. Morgan Stanley Smith Barney is a joint venture between the two banks.

It makes sense for Citigroup to add its hedge and private- equity funds to the discard pile, says Richard Staite, an analyst at Atlantic Equities LLP in London. The bank should play to its strengths — consumer lending and emerging-markets finance — says Staite, who has an “overweight” rating on Citi shares. “Strategically, they should be able to exit that and focus on lower-risk businesses,” he says.

Jeff Haindl, who runs the hedge-fund business at Zurich- based Falcon Private Bank Ltd., says the banking and fund- management cultures are a bad fit.

Independent Funds

“It’s difficult for banks, for internal and increasingly for political and regulatory reasons, to offer compensation that’s competitive with independent hedge funds,” Haindl says.

That’s why none of the biggest names in the industry — such as Steven A. Cohen of SAC Capital Advisors LP, Ray Dalio of Bridgewater Associates LP and George Soros of Soros Fund Management LLC — are at banks. Like the independents, managers at banks get paid to perform, Haindl says, yet many collect salaries and bonuses, which are less directly tied to their returns.

Investors say Citi’s funds will need stronger performance than they’ve shown in recent years to attract the outside capital Havens is seeking. The worst performer among the seven largest funds last year was the Strategic Credit Fund, which lost 14.2 percent, according to people who were solicited to invest. Credit funds, on average, climbed 1.5 percent in 2011, according to data compiled by Bloomberg. The $200 million fund is run by Fred Hoffman and manages mostly Citi capital.


The $400 million Mortgage/Credit Opportunity Fund, managed by Rajesh Kumar, lost 4.2 percent in 2011, including a 10 percent dive in August. The loss is striking because mortgage funds were the best performers among hedge funds, gaining an average of 14.5 percent, according to Bloomberg data.

Kumar’s fund returned 23 percent in 2009 and 26.5 percent in 2010, according to documents obtained by Bloomberg Markets. Betting that mortgages would continue to rise last year, he bought up shares in CreXus Investment Corp., a New York-based firm that invests in commercial mortgage-backed securities.

Kumar also pumped money into Rayonier Inc. and Weyerhaeuser Co., two U.S. timber companies that he bet would benefit from the March 2011 earthquake and tsunami in northern Japan. “As Japan rebuilds its infrastructure over the next few years, it will likely use a higher proportion of wood this time around, as wood offers better protection against earthquakes,” Kumar wrote in a March 2011 report to investors. “While the Japan crisis is a deep tragedy, we believe it offers some long-term opportunity.”

CreXus Falls

The play failed as the European debt crisis roiled credit markets and sent shares of all commodities companies lower. CreXus shares tumbled more than 20 percent in the six months following his report. Rayonier fell 11 percent and Weyerhaeuser declined 37 percent because the Japanese rebuilt more slowly than some investors had predicted, says Joshua Barber, an analyst at Stifel Nicolaus & Co. in Baltimore.

Patel’s $500 million Event Driven Fund is one of Citigroup’s better performers. Although it lost 1.8 percent last year, it has posted an average annual return of 8.5 percent since it was started in July 2008, compared with 2.4 percent for Hedge Fund Research Inc.’s index of funds that invest based on mergers, restructurings and other corporate events. Still, Patel has had trouble raising outside money. As of April 2010, all of the assets in the fund belonged to Citi, according to a CCA marketing brochure.

Franklin Excels

Another standout is the London-based Emerging Markets Special Opportunities Fund, which trades developing-country bonds and is Citigroup’s largest, with $900 million in assets. Run by Mark Franklin, the fund lost just 3.4 percent in 2008, when the average hedge fund tumbled 19 percent, according to Bloomberg data. Since Franklin started the fund in May 2000, it’s jumped 10.4 percent a year, on average, ahead of Hedge Fund Research’s Emerging Markets Index.

Even with underperformance and the inability of some funds to attract outside cash, Havens praises Dorfman and O’Brien’s work.

“I’m a rough judge; I want everything yesterday,” Havens says. “But the team has done a very good job in transforming the business, attracting the talent, building up the infrastructure.”

Dorfman and O’Brien’s efforts to run CCA under Pandit and Havens have been hampered by more than underperforming funds. Burned investors have also plagued the unit, seeking to regain millions of dollars they say CCA managers have squandered. Two investors from Aspen, Colorado — attorney Gerald Hosier and venture capitalist Jerry Murdock Jr. — were awarded $54.1 million in April 2011 by a three-person mediation panel convened by the Financial Industry Regulatory Authority, or Finra.


Hosier and Murdock said they lost $26.9 million in 2008 investing in municipal bond arbitrage hedge funds that Citigroup had marketed as low risk. The funds, called ASTA/MAT, used borrowed money to try to extract high, consistent returns from the muni market.

Citi asked a federal district court judge in Denver to throw out the award, alleging that Hosier and Murdock had signed documents acknowledging that they knew they could sustain losses. Citi filed a trove of documents, and the plaintiffs filed more, including e-mails from Citi sales personnel depicting the funds as higher-yielding, yet safe, alternatives to ordinary fixed-income securities.

In December, Judge Christine Arguello ruled for Hosier and Murdock and affirmed the award, which is among the largest ever for individual investors. More than three dozen other cases have been settled, according to Phil Aidikoff, the Beverly Hills, California, lawyer who represented Hosier and Murdock. There are more than 60 to go.

Taped Meeting

Dorfman and O’Brien joined Citi in late 2007 when Pandit bought their hedge fund, Carlton Hill Global Capital LLC. They took charge of the bank’s fixed-income hedge funds, including the muni arbitrage funds. On Dec. 18, 2007, Dorfman and O’Brien called a meeting with Reaz Islam, manager of the muni funds. Islam recorded the conversation.

Dorfman and O’Brien told Islam that they were going to remove him from his job and have him set up and market a new fund. Islam protested, saying the funds could recover once the debt markets rebounded.

Dorfman became impatient.

“One thing I have a problem with is everybody at this firm tends to say, ‘Well, it was just the market,’” he said. “That’s why the firm’s stock price is half of what it was this summer. I can’t live with that.”

O’Brien and Dorfman pressed Islam to come up with the names of 10 people they could fire to cut costs.

“Tell me now,” O’Brien said. “That’s what I want to see. That’s what I asked you for three weeks ago and again yesterday. I said, ‘Show me the names.’”

‘Nuclear Winter’

Islam pleaded to let the employees stay until they got their bonuses. Dorfman and O’Brien declined to comment on the 2007 conversation.

Three months later, Citi’s private bankers raged against the hedge-fund unit, accusing it of angering wealthy private- bank clients who had invested in the muni funds.

“Respectfully, this is Nuclear Winter!” wrote one, Andrew Basch, to Sallie Krawcheck, who then ran the wealth management unit. “In no uncertain terms did anyone ever infer a risk of this magnitude in any conference calls or live meetings.”

Islam left Citi in August 2008. Contacted in Dhaka, Bangladesh, where he is a managing partner for New York-based LR Global Partners, Islam says Hosier, Murdock and other investors in the muni funds were well aware of the dangers.

‘Idiot Proof’

“We talked about every risk in the prospectus,” he says. “The marketing materials, including the term sheet risk disclosures, were comprehensive, written in plain English and idiot-proof.”

Dorfman and O’Brien tapped Craig Henick, another municipal- bond-fund manager, to take over Islam’s duties, even though he had his own troubles. In 2007, seven Norwegian towns, including Narvik, which lies above the Arctic Circle, lost $90 million investing in securities linked to a highly leveraged muni-bond fund Henick managed, according to a complaint filed in August 2009 in federal district court in Manhattan. Narvik was forced to shut off its street lights after the loss, the complaint says. The case is pending.

The municipal-bond mess didn’t stop Citigroup from adding more hedge funds to its collection. In November 2008, the bank bought Epic Asset Management LLC, a fund run by James Duplessie and Herbert Seif.

O’Connor Roots

Duplessie, now 52, and Seif, 63, met while working for Chicago-based O’Connor & Associates, a so-called quant shop where traders used algorithms to trade futures and options. Seif, a Brooklyn College graduate, joined O’Connor in 1980 and later started trading in distressed debt, a new field. Duplessie joined O’Connor in 1991, according to a Citi biography of him.

Swiss Bank Corp. bought O’Connor in 1992, and the pair ran the SBC Restructuring and Recovery Fund. Union Bank of Switzerland merged with Swiss Bank in 1998 to form UBS AG. After the 1998 Russian debt default and the collapse of hedge fund Long-Term Capital Management LP, UBS cut back on risk. In 1999, Seif and Duplessie shut their fund, according to a person who was at the bank at the time and knew the men.

They got back together in 2002 and started Epic in Fort Lee, New Jersey. Epic returned 31 percent in 2003, its first full year in operation, according to fund records. It then raked in another 23 percent in 2004, 4 percent in 2005 and 25 percent in 2006. By that year, Epic had $140 million under management, according to a presentation on the fund prepared that April.

Imax in Eilat

Epic was just one of Seif’s pursuits in those days, according to a former investor in the fund. He also owned an Imax movie theater in Eilat, Israel, and built a large house in Jerusalem, where he spent as much time as he could, the former investor says. Seif declined to comment.

Epic’s performance faltered in 2007, when the fund dropped 3 percent. Returns deteriorated rapidly in 2008; the fund lost 15 percent in October alone. Nonetheless, in November Citi bought it for an undisclosed sum. It ended the year down 41 percent, according to a fund document.

At Epic, Duplessie and Seif had seldom made themselves available to talk to clients, former investors say, and the situation worsened at Citi, where they run the $240 million Distressed Debt Opportunity Fund. Investors who succeeded in getting Seif on the phone with a question about performance would be told to contact the chief financial officer of CCA.

Still Down

Duplessie and Seif posted better returns after the crisis, gaining 22 percent in 2009 and 19 percent in 2010. That’s not enough to make up for 2008. Investors who were in the fund before then are still down about 19 percent. The distressed-debt fund has returned 5.84 percent a year since it was launched in April 2002 compared with 8.6 percent for the Hedge Fund Research Distressed Index.

Citigroup is now marketing a new fund, called the Middle Market Direct Lending Fund, to be run by Duplessie and Seif, even though Citi’s own cash made up 65 percent of the existing distressed debt fund’s assets as recently as December 2010.

Havens says he set out in 2010 to raise $3 billion from institutional investors to invest in CCA funds, and he has already pulled in $2.6 billion — though he won’t say how much of it has gone to hedge funds as opposed to private equity.

“They’re critically important clients for this company,” he says of the investors.

The question is whether the fund group that was once Vikram Pandit’s personal domain will do better, and attract investor money, when it’s no longer part of Citigroup.