January was a bad month for hedge funds. Depending what average you looked at (different services define strategies somewhat differently and have distinct comparison groups), a loss of 2% was a pretty typical figure, and I have heard rumors of quite a few funds, particularly quants, taking double-digit hits.
The wounded are coming to light. Citi has halted redemptions on a medium-sized fund, $500 million CSO Partners, a corporate bond player. The fund’s manager, John Pickett, made the mistake of placing a big order from a single leveraged loan deal right before the market turned sour. Worse, Pickett tried to back out of the buy, claiming the terms were changed on him, but was unsuccessful, leading to the fund’s losses. But either way, it was a breach of basic investment protocol to place such a big wager on one transaction.
As the front page Wall Street Journal article recounts, Citigroup’s hedge funds on the whole have not done all that well:
Citigroup Inc. has barred investors in one of its hedge funds from withdrawing their money, another black eye for the financial behemoth’s troubled foray into new types of investments.
Citigroup suspended redemptions in CSO Partners, a fund specializing in corporate debt, after investors tried to yank more than 30% of the fund’s roughly $500 million in assets. To stabilize the fund, which had an 11% loss last year, Citigroup last month injected $100 million. The fund’s longtime manager, John Pickett, has left, following a bitter dispute with Citigroup executives and complaints from investors that he put too much money into a single investment that went bad.
Alternative-investment products such as hedge funds are a relatively small business for Citigroup, which has about $2.4 trillion in assets. Citigroup’s more than 80 alternative products held $61.9 billion in assets as of Sept. 30, of which about $11.5 billion represented Citigroup’s own capital…
A large Citigroup hedge fund called Falcon Strategies suffered a 30% decline last year as its bets on the credit markets backfired. Old Lane Partners, a hedge fund now run by Citigroup that was founded by Mr. Pandit and other former Morgan Stanley executives, has shown lackluster performance, posting a 1.8% loss in January….
Even Goldman Sachs Group Inc., which has thrived amid the volatile market, has had trouble with its hedge funds. Its Global Alpha fund, which bets on macroeconomic trends, was down 39% last year, though it’s up a bit this year. Another $6 billion Goldman fund that started this year has stumbled out of the gate, according to investors, losing more than 5% in January.
The weak performance by CSO Partners and other Citigroup hedge funds contributed to an 89% decline in fourth-quarter net income by the bank’s alternative-investment unit. Its profit fell to $61 million from $549 million a year earlier….
The CSO Partners fund ran into trouble last June when Mr. Pickett, the fund manager, placed an order for hundreds of millions of dollars in loans. The size of the order exceeded internal trading limits at Citigroup, according to people familiar with the situation. A lawyer for Mr. Pickett declined to comment.
CSO, which stands for Corporate Special Opportunities, was started in 1999 with Citigroup’s own capital. In 2004, it began accepting money from outside investors such as pension funds and wealthy individuals. Those investors now account for most of the fund’s assets.
Since its start, the hedge fund has been run by Mr. Pickett, who in the late 1980s joined Salomon Brothers, now part of Citigroup, as a bond analyst in New York. Mr. Pickett was well-regarded on Wall Street. Some colleagues say he was one of the most talented credit traders they’ve known. CSO, based in London, compiled a solid track record investing in European and U.S. corporate debt, gaining about 27% since opening to outsiders.
Mr. Pickett’s big order last June was for several hundred million dollars of leveraged loans that a group of banks was selling in a private auction on behalf of a German media company, according to people involved in the transaction. At the time, CSO had roughly $700 million in assets, meaning that Mr. Pickett wanted to commit more than half of the hedge fund’s assets.
Some investors in the fund contend that executives at Citigroup didn’t supervise Mr. Pickett closely enough. “I don’t understand…how it would have been possible for him to take on a position that was disproportionately large,” says one investor in CSO.
Citigroup defends its handling of the situation. Spokesman Jon Diat said CSO and similar funds “are subject to comprehensive internal fiduciary risk oversight, risk management practices and senior-level management supervision.”
The seven banks running the June auction allocated CSO a bundle of loans with a price tag of more than €500 million ($730 million), say the people involved in the transaction. Mr. Pickett tried to back out, saying the banks in the deal changed the loan terms after he submitted his bid.
There was a lot riding on whether Mr. Pickett could cancel his order. The credit crisis roiling financial markets last summer was eroding the value of the loans. If they wound up on the CSO’s books, the hedge fund’s performance would suffer.
Mr. Pickett argued that it was his fiduciary duty to investors to cancel the order. He proposed to Citigroup executives that the fund sue the banks arranging the transaction.
Executives at Morgan Stanley, a lead bank on the loan deal, cried foul. They called Mr. Havens, who was Mr. Pickett’s superior and former head of global sales and distribution at Morgan Stanley.
Mr. Havens essentially sided with Morgan Stanley. He and James O’Brien, another Morgan Stanley fixed-income veteran who joined Citigroup in October, instructed Mr. Pickett to not initiate any legal action. They also began trying to negotiate a settlement with Morgan Stanley over the deal.
Mr. Pickett responded by accusing Messrs. Havens and O’Brien of ignoring the fund’s fiduciary duty and having a potential conflict of interest given their ties to Morgan Stanley, say people familiar with the events. Mr. Diat, the Citigroup spokesman, declined to comment on behalf of Messrs. Havens and O’Brien. Morgan Stanley spokesman Mark Lake declined to comment.
Negotiations between the banks and Mr. Pickett dragged on for months. “There was an army of lawyers on both sides,” says a person familiar with the matter.
In early December, Citigroup executives agreed to a settlement proposed by Morgan Stanley. Under the deal, CSO would purchase €512 million (about $746 million) of the loans at face value, even though they were trading for 86% to 93% of their face value, according to a letter that CSO sent to investors. The agreement also required CSO to pay the banks’ legal expenses.
Had it not purchased the loans and paid the legal costs, CSO would have reported a modest positive return for 2007 — not a 10.9% loss.
On Dec. 12, the week after the settlement, Mr. Pickett handed in his resignation.
Within weeks, anxious investors were trying to pull their money out of CSO. Mr. Pickett’s successor, Michael Micko, said in a Jan. 25 letter to investors that the fund had received requests to withdraw more than 30% of the fund’s capital. Explaining why CSO was halting redemptions, Mr. Micko said that if the fund granted all of those requests, it would have to sell valuable assets at deep discounts.
“This would be to the detriment of all investors,” the letter said.