Inside Citi, a Hedge-Fund Push Blows Up

Inside Citi, a Hedge-Fund Push Blows Up
Brokers' Pitch to Investors Was One of Low Risk; Now, a Suit and a Move to Compensate for Big Losses
By DAVID ENRICHApril 29, 2008; Page C1
When Citigroup Inc. was launching a pair of hedge funds last year, it didn't have to look far for investors. Brokers at the firm's Smith Barney unit drummed up hundreds of millions of dollars from retail clients, including some who were told the fixed-income funds were a safe place to stash money.
Since then, the hedge funds, devastated by the credit crunch, have plunged by 75% or more in value. After weeks of internal debate involving Sallie Krawcheck, the global wealth-management head, Citigroup is offering to cover some of the losses. An investor who put $500,000 into one of the hedge funds filed a federal lawsuit against Citigroup earlier this month.
The mess is another black eye for the New York financial conglomerate, which has taken lumps during the past few years for falling short of its potential to cross-sell products to its huge customer base. This time, though, the sales machine shifted into overdrive. The Smith Barney brokers had little trouble attracting retail customers to the funds. Their pitch: The funds were ideal investments for conservative retirees.
At Citigroup's annual shareholder meeting in New York last week, Paul R. Koch, a Smith Barney broker from Wayzata, Minn., complained to Chief Executive Vikram Pandit that the bank seems to be compensating clients "just enough so they don't sue us." At least a few top-producing brokers have quit in frustration, according to Citigroup officials and brokerage recruiters.
Citigroup defends its handling of the hedge funds, saying they were offered only to clients with large, diversified portfolios. "Our disclosure and marketing material sufficiently outlined the inherent risk in the funds and their leveraged strategies," a Citigroup spokesman said in a statement. "These funds suffered from unprecedented market dislocations and Citi made the business decision to support the funds and their investors."
The losses by the two hedge funds at issue, called Falcon and ASTA/MAT, are the latest examples of the credit crunch hammering retail, or individual, investors who believed they were holding low-risk securities.
It is the latest hedge-fund headache for Citigroup. Earlier this year, Citigroup had to inject capital into another hedge fund, hobbled by its purchase of a big book of corporate loans. The company's flagship Old Lane fund, co-founded by Mr. Pandit, has been struggling with weak returns and investor redemptions, prompting Citigroup this month to write down the fund's value by $202 million.
Falcon invested in municipal bonds, mortgage-backed securities, bank loans and other debt instruments, while ASTA/MAT emphasized municipal bonds. Each was composed of different funds that were launched periodically. Until turmoil rocked financial markets last summer, the funds racked up strong returns, boosted by heavy doses of leverage.
Last year, as Citigroup was gearing up to launch new Falcon and ASTA/MAT funds, it encouraged brokers at Smith Barney and in Citigroup's private bank to pitch the funds to their best customers. One reason for the push: Initial market tremors caused the Falcon family to decline by more than 10%, and Citigroup hoped to stabilize it with an infusion of cash.
By September, the new Falcon fund had raised about $71 million. A new ASTA/MAT fund raised about $800 million. Both new funds were heavily comprised of retail investors.
Citigroup brokers and fund managers assured prospective investors that the new hedge funds were low-risk, with Falcon likely to post losses of no more than 5% a year in the worst-case scenario, according to people familiar with the situation.
"That's why they bought it," says a Smith Barney broker whose clients, many of them wealthy retirees, invested in the Falcon fund. "These kinds of clients weren't looking for a home run."
Robert Zeff, a retired lawyer in Boca Raton, Fla., invested $500,000 in Falcon at the advice of his Smith Barney broker. "He was a very conservative investor whose main issue was capital preservation," says Joe Osborne, who is representing Mr. Zeff in a lawsuit accusing Citigroup of fraud in its marketing of Falcon. Some individuals invested millions of dollars, according to lawyers and brokers.
As of March 31, the new Falcon fund was worth just 25% of its initial value, according to internal documents. The ASTA/MAT fund had shriveled by Feb. 29 to less than 10% of its original value, the documents show. Even as their performances deteriorated, Reaz Islam, the 41-year-old manager of the funds, reassured uncertain brokers and clients that the funds were likely to rebound, according to people familiar with the matter. Mr. Islam declined to comment.
Ms. Krawcheck lobbied to help investors recover at least some losses, arguing that they were among Smith Barney's best clients. Some executives resisted on the grounds that investors understood the risks they were taking. A "battle royale" raged for several weeks, according to a person involved.
Under a compromise, Citigroup's wealth-management unit has agreed to spend $250 million to allow Falcon investors to exit from their positions without absorbing the fund's full losses, if investors agree to forfeit all legal claims against the funds. Some ASTA/MAT investors will get a similar offer.
In the future, Citigroup will scale back its marketing of hedge funds to retail customers, according to people familiar with the situation. In 4 p.m. New York Stock Exchange composite trading, Citigroup shares rose 21 cents, or 0.8%, to $26.81.