October 2009

By Katherine Burton and Saijel Kishan Oct. 29 (Bloomberg) — Rohit D’Souza was on vacation with his family in India in May 2008 when he got a call from Ken Griffin , founder and chief executive officer of Citadel Investment Group LLC. Griffin wanted the banker, who had just quit his job as head of equity trading and sales at Merrill Lynch & Co., to help him do something no other hedge fund had ever tried. Less than two months earlier, Bear Stearns Cos. had disappeared, swallowed by JPMorgan Chase & Co. after losing billions on subprime mortgages. Griffin asked D’Souza, a 45- year-old native of Mumbai, if he would be interested in running a full-service investment bank. The phone calls and meetings continued over the next five months, with the two men clocking more than 30 hours of discussions about what such a bank would look like. They talked through September as Lehman Brothers Holdings Inc. declared bankruptcy and rumors swirled that Chicago-based Citadel, whose gross assets had reached $145 billion earlier that year, would fail. The firm’s biggest funds, Kensington and Wellington, lost 16 percent that month and started exiting unprofitable businesses to reduce borrowing. In October, as the funds tumbled another 22 percent and Griffin held a conference call with investors to allay fears he would be forced to liquidate, D’Souza said yes. Gained 20 Pounds Even as investment banks were crumbling in the worst financial crisis since the Great Depression and his own firm was teetering, Griffin, 41, says he never wavered. “We knew we were going to survive,” Griffin says of his decision to start an investment bank, sitting in the firm’s New York office on the 48th floor of the Citigroup Center a year after Lehman’s collapse. Two rows of empty desks nearby await eight new employees set to start work on the sales and trading floor of Citadel Securities. Griffin, who says he gained 20 pounds as his funds lost $9 billion in 2008 — he shed some of the weight as they rebounded 56 percent through September — was doing what he’s done throughout Citadel’s 19-year history: stepping in when others were fleeing. It was what helped him build his company into the 16th-largest hedge fund firm in the world as of September 2007, according to data compiled by Bloomberg; made Citadel the No. 1 options trader within four years of entering that business; and turned him into a billionaire. Harvard Dorm Today, Citadel manages $14 billion and employs 1,200 people. Seventy are in its securities business, about half of them advising a dozen clients, including Cumulus Media Inc. , an Atlanta-based broadcaster, and casino operator Fontainebleau Las Vegas Holdings LLC, which filed for bankruptcy in June. The rest are handling trades on behalf of 185 firms such as hedge funds Oak Hill Advisors LP and GSO Capital Partners LP. Griffin says he also plans to underwrite securities. “What has served us well over the last 20 years is a constant willingness to innovate and to go where we see opportunity,” Griffin says. “I do believe in the next five years we will have created one of the great sales and trading operations.” That kind of talk has been characteristic of Griffin since he started trading convertible bonds from his room in Cabot House as a sophomore at Harvard University in Cambridge, Massachusetts, 22 years ago. “He was always comparing himself to the biggest players on Wall Street,” says Frank Meyer , former head of Glenwood Capital Investments LLC, a firm that farms out money to hedge funds, who has known Griffin for more than two decades. “He wanted to create his own legacy in the world of finance.” Jet Crib The son of a building-supplies executive, Griffin grew up in Boca Raton, Florida, where his high school job was debugging computers for International Business Machines Corp. He graduated from Harvard in three years, with an honors degree in economics, and moved to Chicago, where Meyer gave him an office at Glenwood and $1 million to manage. A year later, at the age of 22, he started Citadel. Successful Griffin was, boasting an average annualized return of 26 percent in his first 17 years of business. His funds grew to a peak of $21 billion in 2007. He charged investors as much as 8 percent of assets to cover expenses, four times the industry average. He moved into offices in what is now the Citadel Center with views of a statue of Ceres, the goddess of grains, atop the Chicago Board of Trade’s art deco headquarters. He spent $80 million on a Jasper Johns painting, donated $19 million for a new wing at the Art Institute of Chicago, married French-born hedge fund manager Anne Dias in the garden of the Palace of Versailles near Paris and bought a Bombardier Global Express private jet — worth about $50 million today, according to the aircraft maker — which he had outfitted with a crib for his 2-year-old son. Convertible Bonds As of May 2008, before the worst of the credit crisis, Griffin’s two main funds, which invest in everything from stocks to currencies to oil, had borrowed $8 for every $1 of investor capital, Citadel says. That was about four times the industry average, according to JPMorgan. Griffin was loaded up on high-yield and investment-grade bonds hedged with credit-default swaps, which protect buyers in the event of a default, as well as convertible bonds, which can be converted into shares at a preset price. The funds tumbled 55 percent in 2008 as credit markets froze, and Griffin suspended redemptions that December, angering some clients who sought to take their money out. ‘On the Floor’ “In retrospect, I wish I had had less leverage,” Griffin says, adding that his earlier success had “engendered confidence” that Citadel could survive the storm. “Sure the carpet had been ripped out from under us, and some days we were on the floor,” Griffin says of his losses. “But we got back on our feet. The challenges came at us quickly, they came at us hard, but they were just business challenges.” Griffin’s weight gain was his only sign of stress, says Ian Bremmer , president of Eurasia Group, a New York-based political- risk consulting firm, who has known Griffin for a decade and plays racquetball with him once or twice a week. Griffin, who also bikes for exercise, sometimes with his son in tow, never lost confidence that he was doing all he could to save his firm, Bremmer says. “After the crisis, he is sweating the small stuff less,” says Bremmer, who has traveled with Griffin to China and the Middle East. “I see him relaxing more, maybe being a little less hard driven, and looking at the bigger picture.” Aspen Home If Griffin is more relaxed — in July, he spent $13.25 million on a 16,500-square-foot (1,500-square-meter) vacation home in Aspen, Colorado — he’s no less ambitious. His latest enterprise may well be his most audacious, at least since starting his own hedge fund. Citadel Securities is Griffin’s first major foray into a customer service-oriented business for institutional clients rather than one that seeks to profit from rising and falling financial markets. Grafting an investment bank onto a hedge fund firm won’t be easy. Unlike large banks, Citadel doesn’t have a big balance sheet, so it can’t offer loans to clients to purchase companies or make investments. Some hedge funds or investors may be suspicious of dealing with a competitor or concerned that the firm might use its insight into markets to trade on its own behalf, a conflict of interest. Others say the perception that hedge funds have shorter time horizons may run counter to the slower pace of investment-banking deals. ‘Hard Sell’ “It’s going to be a hard sell,” says Richard Jenrette , 80, who co-founded investment bank Donaldson, Lufkin & Jenrette Inc. in 1959. “Ask corporate executives what their views of hedge funds are, they roll their eyes and think that they’re too short-term in their nature, trading in and out of positions to make a quick buck.” Griffin’s detractors, including rivals and former employees, say he’s overreaching. They say Citadel’s history of being a Ken-centric organization, with frequent turnover of senior executives, and Griffin’s reputation as a business partner who charges clients more than most funds, means he’ll never become a head-to-head competitor with investment banks such as Goldman Sachs Group Inc. or Morgan Stanley. It took Goldman Sachs more than a century to become the most profitable firm in Wall Street history, they point out. Griffin’s supporters say it’s unwise to bet against him. From his earliest days as a trader, he has looked to seize opportunities when others were in distress and has prospered. Enron, Amaranth He started making fixed-income arbitrage trades — profiting from the price differences between related bonds — in 1999, after hedge fund firm Long-Term Capital Management LP lost more than $4 billion and was bailed out by its lenders, who also pulled back from that type of investing. Three years later, after the bankruptcy of Enron Corp., then the world’s largest energy trader, Griffin hired a dozen investment professionals and a team of meteorologists and started buying and selling oil, gas and electricity contracts. In 2006, he bought natural gas positions from hedge fund firm Amaranth Advisors LLC after it lost $6.6 billion. He pumped $2.6 billion into E*Trade Financial Corp. , the New York-based online broker, after its shares sank almost 80 percent in 2007 and customers withdrew cash. The E*Trade investment included a 17 percent stake in the company, senior unsecured notes and an $800 million purchase of asset-backed securities tied to subprime mortgages, which Citadel bought for 27 cents on the dollar. Those securities and the debt have jumped in price since the purchase, making the hedge fund a profit of about $1 billion, according to a person familiar with the deal. Options Market Griffin also built an options-market-making business starting in 2002, stepping in as a buyer or seller for retail brokers to ensure they could get trades done when needed. He added an options-routing system in 2005, which chooses among 20 U.S. exchanges to ensure clients get the best price, and an equities-trading business. Today, Citadel has about 175 retail brokerage clients, including Charles Schwab Corp. and TD Ameritrade Holding Corp. It handles 9 percent of daily U.S. stock trades and 30 percent of trades in U.S. equity options, which grant the right but not the obligation to buy or sell a stock at a set price on or before expiration. Citadel Securities executives say the decision to start an investment bank is based on the belief they can provide better customer service than larger firms. While most Wall Street banks have several salespeople calling on the same institution to sell stocks, bonds or currencies, Citadel will offer clients the option of having one person dedicated to fulfilling all of their needs. ‘Chance to Build’ “The chance to build, to fill the need created in 2007 and 2008, was a once-in-a-lifetime opportunity,” Griffin says. Some brokers failed their customers in the fourth quarter of 2008 by not providing bids for those who wanted to sell securities or by low-balling them on prices, he says. Wresting market share from Wall Street’s largest firms will be a challenge, according to Roy Smith , a professor of finance at New York University’s Stern School of Business. “I don’t think Citadel has any clue of how difficult it’s going to be to build a bank,” says Smith, who was a partner at Goldman Sachs. “The large firms are well entrenched in this business. They’re getting stronger and won’t give up any market share. I doubt that they’re going to bed worrying about what Citadel is doing.” Rift With Thain To oversee the banking venture, Griffin has turned to executives who have spent their careers focused on technology and trading, fitting for a firm that prides itself on using computers for everything from conducting split-second trades based on tiny price anomalies to being able to track real-time changes in the value of its roughly $100 billion in positions. D’Souza , who arrived in the U.S. from India at the age of 19, attended 550-student Bethany College in Lindsborg, Kansas, where he received a bachelor’s degree in computer science. Friends say he’s more likely to chit-chat about computers and technology than sports or expensive cars. He worked at Morgan Stanley for eight years before joining Merrill Lynch in 2004 to run its global equity-trading business, where he oversaw the modernization of the firm’s automated- trading systems. In 2007, his division was the biggest revenue generator within Merrill’s investment bank, with a record $8.29 billion. He left after a rift with CEO John Thain , who planned to install another senior trading executive over him. Impatient Boss Former colleagues say D’Souza is methodical and doesn’t make snap decisions. Those traits may lead to friction with Griffin, who can be an impatient boss and quickly lose confidence in individuals he once thought integral to the firm , according to people who know the men. The two were said to be in talks about D’Souza’s role at the firm as of mid-October, according to people familiar with the matter. D’Souza hired another former Merrill banker, Todd Kaplan , 45, in March to head the business that advises companies on reorganizations, mergers and acquisitions. Kaplan worked at Merrill for 22 years until it was sold to Bank of America Corp. in January. He spent much of his career in Chicago and counted Sam Zell , chairman of Tribune Co., among his clients. As global head of leveraged finance at Merrill, starting in 2003, Kaplan oversaw the group that arranged junk bonds and loans to finance the $33 billion takeover in 2006 of U.S. hospital operator HCA Inc., the biggest leveraged buyout at the time, and helped underwrite the $20.9 billion purchase of Houston-based Lyondell Chemical Co. by Basell AF in 2007. Lyondell filed for bankruptcy a year after the merger was completed. The five banks that financed the deal say they have lost at least $3.7 billion, and people with knowledge of the deal say total lender losses could surpass $8 billion, making it one of the costliest leveraged buyouts in history. Cumulus, Fontainebleau “Ken will appreciate having people like Rohit and Todd, who may have a different approach in terms of how and when they implement things but whom he can count on to get the right answers,” says Gregory Fleming , a former Merrill president and now a senior research scholar at Yale University Law School in New Haven, Connecticut. Since June, Kaplan and his team at Citadel have helped Cumulus and Fontainebleau restructure their debt. The Cumulus deal involved getting the radio broadcaster’s bond covenants changed, which the sponsor, Bank of America, didn’t think possible, according to Lew Dickey , the company’s CEO. “Citadel was very thoughtful in terms of developing strategy and very aggressive in helping us to execute it,” Dickey says. He wouldn’t disclose how much he paid Citadel, saying only that the market rate for such advice was between $500,000 and $1 million. Cutting Leverage Citadel started buying and selling high-yield and distressed debt on behalf of institutional clients in late September and added bank loans in October. By 2010, the sales and trading group will move into convertible bonds, equity derivatives and stocks, executives say. Griffin says his job has been to ensure that his funds have reduced their borrowing — they’ve cut their gross leverage in half since the 2008 peak — and that they’re generating enough cash to meet redemptions. He says he plans to focus more on strategies that are based on fundamental research, rather than price differences, and that don’t require as much borrowed money. Citadel in September released $250 million of the $1.5 billion that clients were seeking to withdraw, and Griffin says it will release at least that much more in the fourth quarter. More than 20 percent of the $11 billion in Citadel’s biggest funds belongs to Griffin and employees. Single-Strategy Funds While most of Griffin’s time has been spent in New York and Chicago, he’s also traveled to the Middle East and Europe to meet with clients and help market Citadel’s three new single- strategy funds focused on macroeconomic trends, equities and convertible bonds. The funds have raised about $500 million from new and current investors since the second quarter, according to a person familiar with the matter. “My partners have been running their businesses, moving Citadel forward without as much of my day-to-day involvement as they might have had two years ago,” Griffin says, adding that the key-man risk associated with Citadel in the early part of the decade is no longer valid. “There are just too many strong people here for that to be.” Convertible Bonds Griffin has a history of getting involved in his top lieutenants’ business, and some ex-employees say he doesn’t always listen to their advice. After Bear Stearns collapsed, Griffin told Brad Begle , Citadel’s head of convertible bonds, to buy more because they were cheap, according to people familiar with the matter. The bonds, as measured by an index published by Merrill Lynch, had fallen about 5 percent in the first three months of the year. Begle, who declined to comment, protested because he feared the market would drop further, according to the people. The two were of one mind, Griffin says. “There was no disagreement about the increase,” he says. “There might have been a disagreement about the pace of the increase.” Convertible bonds dropped another 29 percent from the end of August to the end of 2008. 5,000 Meetings Griffin says he believes in process — breaking down how employees make their investment decisions and how they go about executing them. The goal is to let computers handle as much of the work as possible and to help ensure that any investment successes can be replicated. If a trader follows a process and loses money, it’s pardonable, at least for a time, investors and former employees say. Citadel would never try to sell the strength of its stock- picking team on one or two great calls, as some firms do, Griffin says. “What blows investors away is when we talk about the discipline we use around our equity business,” he says. Citadel had more than 5,000 meetings with executives at 2,500 companies in 2008, according to Griffin. Analysts’ coverage includes showing up at most public forums at which company executives speak. Griffin’s attention to detail can be hard on underlings. One former employee says that when he had to take a car ride with Griffin, he would prepare 10 minutes of conversation for every minute of travel, just to ensure he’d be on top of every fact Griffin might want to know. When D’Souza told visitors to Citadel’s New York office in September that the sales and trading businesses had more than 100 customers, Griffin quickly jumped in: “It’s 150,” he said. ‘Big Picture’ Some Citadel employees say Griffin doesn’t micromanage and only gets involved in strategic issues or when a business isn’t performing. When investment teams lose money, as most did in 2008, Griffin will spend time with managers on their floors, former employees say. “Ken understands the big picture,” says Andrew Kolinsky , president of the market-making and options group. “He counts on us to run the day-to-day business.” Having an intelligent boss can be tough, says Mark Yusko , head of Morgan Creek Capital Management LLC in Chapel Hill, North Carolina, which farms out $9 billion to money managers and is a Citadel investor. “I always joke that Ken is a better trader than his traders, a better lawyer than his general counsel and a better accountant than his accountants,” Yusko says. “When you are very smart, people don’t always like you.” Executive Turnover Nine senior executives have left Citadel in the past three years. Out of five money management chiefs listed in a December 2006 prospectus for Citadel’s $500 million bond offering, only two — James Yeh , who runs high-frequency trading, and Mark Stainton , head of energy trading — are still at the firm. Griffin says Citadel’s turnover is on par with other Wall Street companies and that plenty of employees, including Chief Operating Officer Gerald Beeson , have been with him for at least 16 years. The average tenure of executives on the management committee is 6.5 years. Citadel has strict employment contracts, employees and headhunters say. When a trader walks out of the firm, he can’t open his own fund or join one involved in any of Citadel’s trading strategies or businesses for as long as 18 months. He’s also barred from approaching Citadel’s employees or investors and must agree to a non-disparagement clause. Several former employees refused to speak about Citadel, even anonymously, citing their fear of being sued or losing their deferred compensation. One who agreed to talk told reporters to be careful they weren’t followed to a meeting with him. Teza Lawsuit “There’s a common concern among former employees that Citadel will take legal action against them should they discuss their experiences at the firm with outsiders,” says Jason Kennedy , CEO of Kennedy Associates, a London-based executive search firm, whose clients include hedge funds. “Most other employers are more relaxed.” Citadel says its employment contracts are standard for the securities industry. The firm sued high-frequency traders Mikhail Malyshev and Jace Kohlmeier , who left Citadel in February, claiming they set up a competing hedge fund, Teza Technologies LLC, before their nine-month agreement had elapsed. Citadel also filed for arbitration against both men, seeking $300 million in damages from each. Lawyers for the two men, who managed a Citadel fund that generated $1 billion last year, argued in Cook County Circuit Court that their clients weren’t in violation of the contracts because they were only preparing to do business as Teza and weren’t trading for investors. Non-Compete Agreement A judge in October barred the former employees from starting their firm until mid-November, when the non-compete agreement expires. Citadel appealed the ruling on the grounds that the nine months should start from the date of the judge’s opinion. The arbitration is still pending. Citadel says it learned of Teza’s existence only after an employee, Sergey Aleynikov , was arrested by Federal Bureau of Investigation agents in July on allegations he had stolen proprietary computer code from Goldman Sachs. Aleynikov, who has since been fired from Teza, denies the charges. Investors are also subject to restrictions. If an investor wants to put money with a portfolio manager who has left the firm, he must get permission from Citadel and continue to do so for up to a year after he has withdrawn his money. Few funds have similar stipulations. Charging Expenses Griffin is one of a handful of managers who charge expenses to clients, generally 4 percent to 6 percent of assets, rather than the standard 2 percent management fee. “We’re not comfortable with that arrangement,” says Michael Rosen , chief investment officer of Angeles Investment Advisors LLC, a Santa Monica, California-based firm that advises clients on hedge fund investments. “We look to develop long- term partnerships with funds we invest in, and it’s not equitable to treat partners by charging them open-ended fees that are many multiples of the industry standard and not provide transparency on how exactly that money is being spent.” Griffin didn’t charge expenses in 2008 and covered the costs himself. While Citadel’s new funds have management fees that range from 1.75 percent to 2.5 percent, there are no plans to lower the rate for Kensington and Wellington. Trading With Citadel Some hedge fund managers say they wouldn’t trade with Citadel because they don’t want to enrich a competitor or because they’re worried about letting a rival see what they’re doing. “Money managers always have to ascertain whether their interests are aligned with their trading counterparties,” says Brad Balter , head of Boston-based Balter Capital Management LLC, which farms out money to hedge funds. “In Citadel’s case, it remains to be seen if they are,” adds Balter, who was previously responsible for sales and trading relationships with hedge fund clients at Citigroup Inc. Scott Krase , a senior partner at New York-based Oak Hill Advisors, who has traded both bank debt and high-yield bonds through Citadel, calls it a foolish concern. “If that were the case, you wouldn’t trade with anybody,” Krase says, since most investment banks have proprietary trading desks. Citadel may have a higher burden of proof than other brokers since its bread-and-butter business is making bets in the markets. ‘Extra Mile’ “The perception of a conflict of interest is a hurdle that they’re going to have to go the extra mile to manage,” says Andrew Lo , a professor of finance at Massachusetts Institute of Technology’s Sloan School of Management in Cambridge. Citadel executives say they’re taking the concern seriously and have created a separate legal entity with its own servers and key-card access. “We have established the same safeguards as other financial institutions,” says Brennan Warble , who co-heads the investment bank’s sales and trading group with Peter Santoro . “It’s an issue we are comfortable managing.” At least one trader recruited for a position at Citadel says he decided not to join the firm because he feared his clients wouldn’t follow him to what they perceive to be a hedge fund in broker’s clothing. “People will trade where they get the best execution and order flow and data flow,” Morgan Creek’s Yusko says. “Can Ken Griffin build an organization of the same quality as Goldman Sachs? I think he can, because he is one of the best opportunistic business builders we will ever see.” Whether Griffin can deliver on that promise depends on his ability to convince money managers and companies he can serve them as well as he has served Citadel and its investors over the past two decades. To contact the reporters on this story: Katherine Burton in New York at kburton@bloomberg.net ; Saijel Kishan in New York at skishan@bloomberg.net .