By Katherine Burton and Saijel Kishan
Sept. 16 (Bloomberg) -- Ken Griffin started trading convertible bonds 22 years ago from his Harvard University dorm room. Now he’s moving away from the investments that made him a billionaire hedge-fund manager -- and unraveled last year, leaving clients with a 55 percent loss, almost three times the industry average.
Citadel Investment Group LLC, Griffin’s $13.5 billion firm, is reducing its two biggest funds’ holdings of convertible bonds and other so-called relative-value trades that try to profit from small price differences in related securities, and amplify the gains with debt. At last year’s peak in May, the firm used borrowings of nine times net assets to hold $145 billion in gross assets. That was triple the average leverage ratio of hedge funds, according to a report from JPMorgan Chase & Co.
Griffin, 40, boasted a 26 percent annualized return in his first 17 years of business. Last year he suffered his biggest loss as the funds sold assets to reduce borrowings.
“This was the first time in 20 years that we have played defense,” Griffin, president and chief executive officer, said in an interview at Citadel’s Chicago headquarters, after recently returning from Europe, his first vacation since the bankruptcy of Lehman Brothers Holdings Inc. a year ago. “In other crises, we had enough firepower in reserve. We could be buyers.”
Shift in Strategy
Still, he has hired 70 people to operate a full-service investment bank, which he says will compete with Goldman Sachs Group Inc. and Morgan Stanley. He started three hedge funds, which are being marketed around the world by a six-person team. And his flagship funds, Kensington and Wellington, have returned about 52 percent through Sept. 1, in part on a rebound in convertible bonds.
“It was an incredible time in market history,” said Griffin. “Today our team is solidly focused on the future.”
His shift in investment strategy, he said, involves relying more on fundamental research to make trades than on bets based on the historic relationships between two securities.
That may not satisfy some of the 300 or so clients in Kensington and Wellington, which would have to return an additional 46 percent each to make investors whole and to collect performance fees.
Citadel suspended redemptions last year as investors sought to pull about $1.5 billion in assets. It’s set to release $250 million at the end of this month, and Griffin said he expects more than $500 million will be returned to investors by the end of the year.
Investor Disappointment
One longtime Citadel investor, Jean-Francois Vert, CEO of Allianz Alternative Asset Management in Paris, said he plans to reduce his position.
“We are very disappointed by the poor liquidity and performance of Citadel,” Vert said, adding that he favors any strategy shift that allows the firm to reduce leverage and give money back to investors.
Griffin, who founded Citadel in 1990 at the age of 22 with $4.6 million, built what investors and other managers considered a formidable business that lived up to its name: an impenetrable fortress. He did it by buying when others were in trouble. By the end of 2007, he was managing $21 billion, trading everything from U.S. stocks and energy to corporate bonds. His firm was the 13th largest hedge-fund manager that year, according to Institutional Investor’s AR magazine.
Looking at Lehman
Griffin made commitments of at least a year for 85 percent of the funds he borrowed, unlike managers who focused on borrowing money for six months or less. His investors were locked up for as long as two years.
“We built the firm to be invincible,” said Griffin. “Of course our successes engendered our confidence.”
The confidence led Griffin, along with a partner, to consider buying assets of Lehman in the months before the New York-based firm collapsed, he said.
“There were a number of businesses at Lehman that were of interest to us,” Griffin said.
He declined to provide the name of the partner, describe the assets they wanted to buy or say why the talks fell apart.
Citadel’s first big distressed deal was in 2006, when it took over the energy positions of Amaranth Advisors LLC, the hedge-fund firm in Greenwich, Connecticut, that lost $6.6 billion betting on natural gas. The following year Griffin bought most of the assets of Sowood Capital Management LP, a Boston-based hedge-fund manager that closed after it lost 60 percent on wrong-way bets on corporate bonds and loans.
E*Trade
Griffin’s biggest deal was in 2007, when he pumped $2.55 billion into E*Trade Financial Corp., the New York-based online broker, including $800 million of securities tied to mortgages. That trade has been profitable, said Chief Operating Officer Gerald Beeson.
As the financial crisis gathered steam in 2007, Griffin continued to buy when others were selling. Citadel started increasing its purchases of convertible bonds and added to the positions in 2008 as the securities got cheaper. Convertible bonds, which can be exchanged for stock once shares hit a predetermined level, accounted for about 20 percent of Griffin’s biggest funds last year.
‘No Disagreement’
After the forced sale of Bear Stearns Cos. to JPMorgan Chase in March 2008, Griffin visited the 35th-floor office of Brad Begle, Citadel’s head of convertible bonds. He told him to buy more because they were cheap, according to people familiar with the matter.
Begle, who declined to comment, protested because he feared the market would drop, according to the people. Griffin says the two were of one mind about the size of the position.
“There was no disagreement about the increase,” he said. “There might have been a disagreement about the pace of the increase.”
By Nov. 30, the funds had about $13 billion in bets that convertible-bond prices would rise, according to an investor report. Another $8 billion was in positions that would profit if stocks tied to those convertible bonds fell.
The funds also lost money on high-yield bonds and investment-grade bonds hedged with credit-default swaps, which protect buyers in the event of a default. Citadel was betting that the gap between the default swaps and the bonds would narrow. Instead, they widened as lenders left the market and investors bet that more companies would default.
Mounting Losses
In the fourth quarter of the year, Citadel’s losses mounted as markets for convertible bonds and loans went into a free fall. Beeson, 37, was on the phone almost daily with lenders, including Deutsche Bank AG, Goldman Sachs and at least 20 others, he said in an interview.
The fund met collateral calls with cash, which dropped from about 35 percent of assets to 20 percent by the end of the fourth quarter. It sold stocks and other easily tradable assets to replenish the cash.
“Buying time was the most we could do,” said Griffin. “You have to make sure you are generating cash well before the moment you need the cash.”
While Citadel executives say they expect the Kensington and Wellington funds to continue to be the cornerstone of their asset-management business, the firm has started three hedge funds this year that focus on single strategies -- macroeconomic trends, equities and convertible bonds. Citadel plans to start a distressed-mortgage fund by the end of 2009 and a distressed corporate-bond fund next year, Griffin said.
Fundraising
The new funds are meant to appeal to clients who want to do their own asset allocation, rather than invest in Citadel’s multistrategy funds. Kensington and Wellington charge expenses, which have ranged from 3 percent to 6 percent of assets, and take 20 percent of investment gains. Griffin covered the expense fees last year. The new funds are more in line with industry standards of 2 percent of assets and 20 percent of gains.
Citadel has raised about $500 million from new and current investors for those funds since the second quarter, Griffin said. New York-based Blackstone Group LP’s $25 billion fund of funds group has attracted $2.5 billion this year, and Paul Tudor Jones’s Tudor Investment Corp., of Greenwich, Connecticut, raised $1.9 billion between March and July.
Return to Roots
“Citadel’s impregnable position in the hedge-fund industry is not as strong as it was before 2008,” said John Trammell, president of New York-based Cadogan Management LLC, which invests $3.7 billion in hedge funds and doesn’t have money with Citadel. “It may be difficult for them to regain that status following last year’s losses.”
Jones and Louis Bacon, CEO of New York-based hedge-fund firm Moore Capital Management LLC, have said this year that they would return to their roots of investing in the most liquid markets rather than harder-to-sell assets such as private equity.
While Griffin is moving away from his roots, he’s also ratcheting down leverage. Citadel lowered its leverage ratio to about 8-to-1 as of November, according to a Citadel investor report.
“I was where I wanted to be on that Friday” before Lehman declared bankruptcy, Griffin said of his portfolio at the time. “In retrospect, I wish I had had less leverage.”
To contact the reporters on this story: Katherine Burton in Chicago at kburton@bloomberg.net; Saijel Kishan in Chicago at skishan@bloomberg.net
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