Before his ouster, Pandit was among Wall Street CEOs grappling with the approaching Volcker rule. The proposed regulation, named after former Fed Chairman Paul Volcker, bans deposit-taking banks from owning more than 3 percent of a hedge fund’s assets or investing more than 3 percent of Tier 1 capital in the funds.
While the rule doesn’t go into effect until 2014, Wall Street firms have begun to comply. Goldman Sachs Group Inc., the fifth-biggest U.S. bank, pulled about $800 million from hedge funds this year through September, reducing the fair value of its total investments to $2.45 billion, according to regulatory filings. Morgan Stanley’s investments in hedge funds have dropped 61 percent since the end of 2009 to $939 million, filings show.
Bank of America Corp., the second-biggest U.S. bank, doesn’t operate in-house hedge funds, according to Jackie Fine, a spokeswoman for the Charlotte, North Carolina-based lender. Investments with outside managers are a “small portion” of the bank’s $1.45 billion “strategic capital portfolio,” Fine said in a phone interview.
Pandit may have had few choices as he considered CCA’s future, according to Charles Whitehead, a law professor at Cornell University who’s written about the Volcker rule. Shutting the funds and quickly withdrawing Citigroup’s cash could result in losses because the money may be tied up in complicated bets, while granting managers a stake in the new firm could provide incentive to improve returns and maximize the bank’s stake, he said in a phone interview.
“Giving them 75 percent to divide up among themselves -- that’s a pretty strong incentive,” said Whitehead, a former Citigroup executive who has no knowledge of the bank’s hedge- fund strategy.
The new firm’s structure was based in part on Overland Advisors LLC, a hedge fund that traces its roots to Wells Fargo & Co., according to a person with knowledge of the matter. The San Francisco-based bank spun off the fund in 2010 before selling a majority stake to a company controlled by managers in February. The lender didn’t disclose how much the managers paid for Overland.
Citigroup hasn’t disclosed how much it intends to pay the CCA executives in fees for managing its assets. That makes it difficult to accurately value the firm, said Elizabeth Nesvold, managing partner with Silver Lane Advisors LLC, an investment bank that specializes in mergers and acquisitions of asset- management companies.
Hedge-fund managers typically earn 2 percent of assets they oversee and 20 percent of the profits. Citigroup may have secured a “sweetheart” deal on management fees because it was the early-stage investor in many CCA funds, which could reduce the new firm’s initial value, Nesvold said.
“The spinoff can still be highly lucrative for the managers and Citigroup, if fund performance is compelling,” Nesvold said.
That prospect wasn’t enough for Rajesh Kumar, head of the unit’s mortgage hedge fund, who’s leaving in a dispute over the new firm’s pay structure, the people said. Rather than receive regular management fees, portfolio managers will instead get a bigger slice of their funds’ profit, the people said. Kumar thought this policy was unsustainable and would encourage managers to take too many risks, one of the people said.
Kumar declined to comment on his plans when reached by telephone. Romero-Apsilos also declined to comment.
Kumar was one of CCA’s best performers after he set up the Mortgage/Credit Opportunity Fund in May 2008 with $200 million of the bank’s money. His team returned 17 percent for the rest of that year, as delinquent mortgages soared in the U.S. and lenders including Citigroup teetered on collapse.
The fund invests in securities tied to mortgages, including bonds backed by risky home loans and shares in real estate investment trusts, or REITs. Kumar’s team gained 24 percent this year through Nov. 8, the third-best performance among CCA strategies, internal data show. The fund, which has about $460 million, most of which belongs to Citigroup, will still be part of the new firm, the people said.
Kumar’s departure could harm the new entity’s efforts to attract money from outside clients, said Don Steinbrugge, managing partner of Agecroft Partners LLC, a Richmond, Virginia- based advisory firm. Investors tend to associate a fund’s historical performance with its managers and that credibility can suffer if the person leaves, he said.