A SPINOFF STUDY
A SPINOFF STUDY
by Chris Mayer
You may have heard the old story about a plumber who comes to a man's house to fix a problem with the plumbing. He comes in, bangs on the pipes once and is done.
"That'll be a hundred dollars," the plumber says.
"A hundred dollars!" the man says. "All you did was bang on the pipes once."
"Banging on the pipes is only five dollars," responds the plumber. "Knowing where to bang - that's ninety-five dollars."
Investing is often about knowing where to bang. The money to be made in investing can often come simply from knowing where to look for bargains. Fortune swims not in the busy waterways, but in the quiet shallows, where people are not usually looking for it.
Examples include small-capitalization stocks, obscure or illiquid securities and uniquesituations - such as spinoffs, divestitures, merger securities, rights offerings, restructurings and a host of other lesser known and underfollowed situations. If you don't know what these things are - don't worry. I'm going to explain one of the best places for individual investors to look for bargains.
Though these special situations, as they are often called, are not usually thought of when one thinks of value investing, the fact is that these activities have traditionally been the province of some of the greatest value investors. These were the kind of rich veins that the young Warren Buffett routinely mined. During his time running the Buffett Partnership (1957-69), before Berkshire Hathaway, there were some years in which special situations made up more than half of his profits.
Of course, Buffett was not the only one dining off the tasty menu in the bistro of special situations. Other sharp-eyed value investors saw the same thing and made it a regular part of their investing diets, and they also enjoyed brilliant success.
Here's the story of one of them: In 1985, a man named Joel Greenblatt started the private investment partnership Gotham Capital. Greenblatt made it his bread and butter to work in the special situations arena. He writes about his experiences in his book, You Can Be a Stock Market Genius, which, despite its moronic title, is a serious treatment of investing and contains a lot of good advice.
Much of the book consists of case studies in which Greenblatt shows you how various spinoffs unfolded - Host Marriott from Marriott Intl., STRATTEC SECURITY from Briggs & Stratton, American Express from Lehman Brothers, Liberty Media from Tele-Communications Inc. (this last one netted investors ten times their initial investment in less than two years) and many others. Each of these experiences teaches us something about investing, in particular about the nature of special situations.
Greenblatt enjoyed tremendous success at Gotham Capital.Every dollar invested in the partnership when it was started in 1985 returned $51.97 by the end of 1994, for an annualized return of 50%. Just think, $1,000 invested in Gotham in 1985 returned $51,970 only ten years later. In January 1995, all capital was returned to the outside limited partners.
While Greenblatt invested in a host of special situations, spinoffs were his favorite play. Why were spinoffs so appealing to Greenblatt and his merry band at Gotham? A little research shows that they had found a crack in the sidewalk of Wall Street, which market-beating investments often slipped through. Greenblatt points to a Penn State study published in 1993 that found spinoffs beat their industry peers and outperformed the S&P 500 Index by about 10% per year in their first three years of existence. That is a large margin of outperformance, but is no anomaly. A McKinsey & Company study also found that spinoffs produced returns in the first two years of independence of more than 27% annualized.
Far from being only a U.S. phenomenon, the same outperformance occurs in other markets. A UBS study of European equities found spinoffs substantially outperformed in their first few years of independence. These studies looked at all spinoffs available in the market.
The individual investor has the advantage of selectivity. We don't have to buy every spinoff, nor do we have to pick them randomly. Assuming the investor can cherry-pick the lot and avoid the dogs, there is a good chance to do even better. You would think that the market would adjust and chip away at those outsized returns. They are a well-known phenomenon, documented and studied. Investors should bid up the shares of spinoffs, and the outperformance should disappear over time. But as Greenblatt and others have pointed out, there are good reasons why the well of promising spinoff opportunities will continue to be refreshed on a regular basis.
But before I tackle the reasons why this apparent inefficiency exists, let us consider the various reasons why companies engage in spinoffs at all:
1. To spinoff an unrelated business. Big unwieldy conglomerates that are involved in everything from insurance to restaurants may decide to separate an unrelated business to unlock the value in that business.
2. To separate a "bad business" from a "good business." Sometimes a company with a profitable core of operations will spin off a laggard that is draining resources and management attention from the main group. Once separated, each of the businesses can stand on their own merits, often to the benefit of both.
3. To unload debt and/or other liabilities. Sometimes a spinoff will be loaded up with debt, freeing the parent company but leaving an overleveraged business in its wake. The spinoffs that have failed have often been of this kind. However, this maneuver can be lucrative for the parent company, as you might imagine.
4. To take advantage of tax benefits. A spinoff can qualify as a tax-free event and may be the most efficient way to pass value on to shareholders. If the company were sold outright, for example, the cash distributed to shareholders would be taxable. There are sound economic reasons for spinoffs, and this may explain their initial outperformance.
Think about it: You have a new company with a new, dedicated management team that is likely to be highly motivated. As Greenblatt writes, "Pent-up entrepreneurial forces are unleashed. The combination of accountability, responsibility and more direct incentives take their natural course."
Curiously enough, as Greenblatt points out, the biggest gains from spinoffs often came in the second year, not the first. This indicates that perhaps it takes some time for the changes to kick in and deliver tangible results.
Okay, so we've seen some evidence on spinoff outperformance, and we know the motivation behind spinoffs and why they happen. All of this makes good sense. Now why does Wall Street continue to ignore this apparent low-hanging fruit? There are good reasons for that too.
The first reason is simply that Wall Street and the big institutions don't want them. They are often too small to make a difference. If you own shares in a big company and you are getting some small distribution of shares in a spinoff, it's easier for you just to sell the shares rather than dedicate any resources to try to figure it out. Again, it is too small to worry about.
Plus, if you invested in an insurance company, and suddenly, this insurance company is spinning off its smaller credit card operation, do you get excited? You're not interested in credit cards - you're interested in the insurance company. As Greenblatt notes, "Generally, the new spinoff stock isn't sold, it's given to shareholders who, for the most part, were investing in the parent company's business. Therefore, once the spinoff shares are distributed to the parent company's shareholders, they are typically sold immediately without regard to price or fundamental value."
This usually creates selling pressure on new spinoff shares as institutions unload their stock. Since many spinoffs are small, they have little, if any, analyst coverage. And a freshly minted spinoff is not likely to be an immediate user of Wall Street's services. In other words, it doesn't have investment banking needs, so Wall Street is not likely to be interested in promoting the stock. There is little or no hype surrounding their shares. In fact, management may have an incentive to "talk down" the spinoff, since their incentive stock options are priced at the initial market price of the spinoff shares. In this case, it is in their best interest to start at a low price. Then talk it up and promote it later, sometimes months later.
As Greenblatt says, the inefficiencies in the spinoff market are "practically built in the system" and should continue. Knowing this, how can we take advantage of spinoffs? Greenblatt points to three characteristics of a winning spinoff:
1. Institutions don't want it (for reasons such as those discussed above). Sometimes, very large companies spin off companies that are still quite large and attract a lot of attention. Investors are likely to find the buried treasure in smaller companies.
2. Insiders want it.
3. A previously hidden investment opportunity is uncovered by the spinoff transaction. If you can capture a couple of these, or even one of them, you stand a good chance of having found a potential spinoff winner - and outperforming the market by 10% or more.
The investment idea for this month is a classic spinoff situation that holds all the promise of being a great spinoff - it's too small for the institutions to care about, and its independence uncovers an asset that was previously buried in a huge conglomerate.
Regards,
Chris Mayer
for The Daily Reckoning
America's first listed hedgefund
Citadel Returns 26 Percent, Breaks Hedge Fund Mold, Sees IPO
(Published in Bloomberg Markets magazine.)
By Katherine Burton and Adam Levy
April 29 (Bloomberg) -- It's a midwinter afternoon in
Chicago, and Citadel Investment Group LLC, with $12 billion in
assets under management, is wrapping up a typical day -- trading
almost 2 percent of the daily volume on the Tokyo and New York
stock exchanges, or about 70 million shares. Removed from the
trading floor's din in a 36th-floor corner office, Citadel
founder and Chief Executive Officer Kenneth Griffin sits at an L-
shaped desk devoid of paper.
On his computer screen: an in-box full of messages, not the
prices of stocks or bonds. Griffin, 36, no longer trades. ``They
are better at it than I am,'' he says, gesturing toward the
traders outside his office.
Griffin says he has more to think about than the next big
trade. He says he wants to build something greater than a simple
hedge fund firm: a diversified company that's No. 1 or No. 2 in
every investment arena it tackles and that manages tens of
billions of dollars. He says he may sell shares in the expanding
company to the public, which would make Citadel the first U.S.
hedge fund firm listed on a stock exchange.
Whatever he does, Griffin will create ripples in the hedge
fund industry. He began in 1987 by trading convertible bonds as a
sophomore from his Cabot House dorm room at Harvard University,
in Cambridge, Massachusetts, with $265,000 from his mother,
grandmother and two other investors.
Seven Global Businesses
He opened Citadel with $4.6 million in November 1990. Now,
he's involved in seven global businesses, trading everything from
natural gas to stocks and bonds to currencies.
Citadel has recorded a 26 percent annualized rate of return;
1994 was the sole money-losing year for its flagship Citadel
Wellington LLC fund. A $100,000 investment at the firm's
inception is now valued at about $2.6 million, making Citadel one
of the world's best-performing hedge fund companies.
Hedge funds are largely unregulated investment portfolios
designed for people and institutions with more than $1 million to
invest.
``They've taken a different approach,'' says Richard Fuld,
chief executive officer of Lehman Brothers Holdings Inc., who
says Citadel is one of his investment bank's most-important
clients. ``Ken is trying to find a way to institutionalize the
firm, to create something that will stand the test of time.''
Griffin, like his investors, has prospered. He lives in a
penthouse in Chicago that he bought for $6.9 million in 2000.
$60.5 Million Cezanne
He held his second wedding in the garden of Versailles in
2003 and, in 1999, bought Paul Cezanne's ``Curtain, Jug and Fruit
Bowl'' for $60.5 million, the most ever paid for one of the
French Impressionist artist's paintings.
Griffin's Citadel now has 970 employees, and he says he
plans to add as many as 150 this year. He began 2004 with 750.
Citadel's clients include such institutions as Morgan Stanley and
the University of North Carolina.
``Ken has built an outstanding firm that has broken the mold
from traditional hedge funds,'' says Paul Tudor Jones, who runs
Tudor Investment Corp., a hedge fund firm that manages $11.8
billion. ``Citadel will be a legacy firm in our industry.''
Citadel employs 72 Ph.D.s, including former mathematics
professors and astrophysicists. They are the heart of the firm's
Quantitative Research Group, which develops proprietary
mathematical models to support traders. They staff so-called
Ph.D. Row, the south side of the 36th floor, an area dominated by
erasable floor-to-ceiling white boards full of complex math
formulas.
Math Genius Biography
The area resembles a scene from the 2001 movie ``A Beautiful
Mind,'' a biography of math genius John Nash. There's so little
empty space on these giant boards that some group members write
equations on their office windows.
Even Griffin, who can write computer code and pricing models
for convertible bonds and mortgage-backed securities, has one of
those boards in his office -- and it's often filled with lines of
complex formulas.
``In many ways, we are a tech firm first and foremost that
happens to trade,'' says Thomas Miglis, 50, who had top
information technology jobs at Bankers Trust New York Corp. and
Salomon Inc. before joining Citadel as chief information officer
in 2001. ``Technology isn't thought of as a cost center.''
After almost 15 years at the helm of Citadel, the only job
he's ever held, Griffin faces some challenges if he's to realize
his goals.
Pressure on Returns
The first hurdle is increased competition, which is putting
pressure on returns. There are about 7,900 hedge funds today
compared with 1,945 in 1994, and assets have climbed to $1.01
trillion from $186 billion in 1995, according to Hedge Fund
Research in Chicago.
As more money pours into the industry, performance has
dropped, and Citadel is no exception. While Citadel's annual
returns, which have averaged 15 percent net of fees since the
beginning of 2001, are among the best compared with his firm's
peers, they're half the 31 percent Griffin produced from 1991 to
2000. His offshore fund returned about 2 percent in the first
quarter.
Citadel takes 20 percent of any profit it makes and charges
all expenses to investors.
``His returns are good, not spectacular, but he's managed
the volatility well,'' says James Simons, 67, president of New
York-based hedge fund firm Renaissance Technologies Corp. and a
Citadel investor.
Simons' $5.7 billion hedge fund returned 25.5 percent in
2004 compared with Citadel's 11.6 percent.
Less-Crowded Strategies
With top performance tougher to produce, Griffin needs to
find less-crowded strategies to exploit before other managers
pile in. Emblazoned on its promotional material, Citadel's motto
-- ``Stay ahead of the curve'' -- attests to the need to outpace
competitors and identify new places to invest.
To that end, Griffin pushed into energy trading in 2001 when
Enron Corp. imploded and other energy traders were leaving the
business. Today, Citadel employs a 70-member team, including four
meteorologists, who trade natural gas and power. Later this year,
Citadel will start buying and selling crude oil and refined
products.
Griffin is looking to emerging markets as well, mulling over
plans to set up teams of analysts and traders in Brazil, China,
Hungary and India.
Griffin also needs to disprove the industry's conventional
wisdom that hedge funds can't survive if they get too large.
60 Hedge Funds
``A risk factor of any fund is its size,'' says Simons, who
invests $1.5 billion of Renaissance's money in 60 hedge funds and
has invested in Citadel for seven years. ``If you're very large,
you can't be as nimble, and returns will probably not be as
good.''
No hedge fund firm has ever surpassed $23 billion in assets.
The two largest in history, George Soros's Soros Fund Management
LLC and Julian Robertson's Tiger Management LLC, both reached $22
billion in 1998 before large losses and withdrawals pared the
value of their holdings.
Today, neither firm manages money for outside clients.
Griffin bristles when asked about the risks of having too
much money under management.
``That's a trite question,'' says the Citadel CEO, who's 6
feet tall, has blue eyes that rarely blink when he speaks and a
buzz cut speckled with gray. ``We are 1 percent of the industry.
That's irrelevant.''
Harsh Environment
Griffin points out that San Francisco-based hedge fund firm
Farallon Capital Management LLC, which oversees $12.5 billion, is
bigger than Citadel and invests almost exclusively in companies
going through a reorganization or merger.
OrbiMed Advisors LLC, a New York-based firm that manages $5
billion, invests only in the health-care industry. It's easy to
see how a multistrategy firm such as Citadel could run at least
$40 billion, Griffin says.
Citadel must also deal with its reputation for being a harsh
place to work -- a company where at least a half-dozen former
employees say talented professionals haven't stayed for the long
haul because the firm has grown too quickly and the biggest
compensation years are behind it.
``When the markets change, we don't accept lower returns,''
says Mike Pyles, Citadel's head of human resources. ``We aren't
that kind of firm. We expect the manager to go and figure out how
to make money in the new market. We make no apology for it.''
Griffin says turnover at Citadel is no higher than at any
Wall Street firm.
12 Senior Managers
Since 2002, Citadel has lost at least 12 senior managers,
including Reade Griffith, 40, the founder and CEO of Citadel's
European office, who now runs U.K. hedge fund firm Polygon
Investment Partners LLP.
His departure was followed by those of Alec Litowitz, 38,
who ran merger arbitrage, and David Bunning, 39, who headed the
global credit team.
Defections in the past six months include Ken Simpler, 37,
the head of Citadel's private negotiated transactions unit; David
Snyderman, 34, who took over the global credit team after Bunning
left; and Peter Labon, 39, one of Citadel's first stock managers.
The exodus began right after traders began collecting
deferred compensation in October 2002 from the firm's most-
profitable years: 1999, when the Citadel Wellington fund returned
45.2 percent, and 2000, when it returned 52.6 percent.
``The glue that holds the place together is money,'' says
one former employee, who asked not to be identified.
Assets Doubled
As assets doubled from $6 billion in 2001 and the number of
employees ballooned, strategic decisions fell increasingly to
Griffin, former employees say.
``Ken is involved in the details of running the
organization,'' says Blaine Tomlinson, president of Financial
Risk Management, a London-based firm that farms out $13.5 billion
to hedge funds including Citadel. ``Perhaps this frustrated some
of the executives who left, but this attention to detail has been
a key factor in Citadel's success.''
David Zezza, 43, who sits on Citadel's management committee
and oversees fixed-income and foreign-exchange trading at
Citadel, agrees.
``Ken has seeded the place with his DNA, his energy and his
drive,'' he says. Zezza, formerly global head of emerging markets
at Deutsche Bank AG, joined Citadel at the end of 2004.
When asked about departures, Griffin says nothing and hands
over a glass desk ornament given to him by an investor whose name
he won't disclose.
Machiavelli's The Prince
Etched on the surface is a quote from Niccolo Machiavelli's
The Prince that reads in part: ``There is nothing more difficult
to arrange, more doubtful of success, more dangerous to carry
through than initiating changes.''
Griffin doesn't shy away from talking about how tough a boss
he is. ``We're here to win, not to go through the motions,'' he
says. ``Each of the business leaders here know they have to drive
their business to be No. 1 or No. 2.''
It's hard for a hedge fund firm to maintain that momentum,
says Jeffrey Tarrant, a partner in New York-based Prot‚g‚
Partners LLC, which invests in hedge funds.
``Sustaining an edge in the hedge fund business is
grueling,'' he says. ``Few hedge funds have been able to capture
the founding hedge fund manager's judgment into an
institutionalized process.''
For all of the challenges Griffin faces, he's been beating
the odds since he started Citadel less than three weeks after his
22nd birthday.
First Backer
``If you had asked me whether I would ever consider giving
money to a student straight out of college and introducing him to
all my investors, I would have said, `No way,' but with Ken, you
break the rules,'' says Frank Meyer, Griffin's first backer and
the former head of Glenwood Capital Investments LLC, a fund of
funds company now owned by London-based Man Group Plc.
Born in Daytona Beach, Florida, Griffin grew up 223 miles
(359 kilometers) south, in Boca Raton, where his father was a
businessman in the building supplies industry. Griffin debugged
computers for International Business Machines Corp. while at Boca
Raton Community High School.
As an 18-year-old Harvard student, he first got involved in
the stock market after reading a Forbes magazine article that
claimed shares of Home Shopping Network Inc. were too expensive.
Griffin bought put options on the stock, betting correctly it
would tumble, and then saw his profit eroded by commission and
transaction costs.
Convertible Bonds
Unhappy with that result, he read up on financial markets
and stumbled across information about convertible bonds. He says
he didn't think the value of the bonds and the prices at which
they converted into stock made sense, so he began writing his own
software to rationalize the prices.
In the summer between his freshman and sophomore years,
Griffin raised $265,000 from relatives and friends. He set up
shop in his dorm room when he returned to Harvard that autumn. A
month later, the market crashed and Griffin, who had shorted
stocks -- borrowing them from shareholders in the hope of
profiting by repurchasing the securities later at a lower price -
- made money.
``Most of us had trouble understanding these things, and Ken
was up in his dorm room trading them,'' says Alexander Slusky,
managing partner of Vector Capital Corp., a San Francisco-based
private equity firm that invests $600 million, and a friend of
Griffin's from Harvard. ``He would run from classes to downtown
brokerage firms to get quotes on his positions because he
couldn't afford to have pricing services piped into his room.''
Hedge Fund Pioneer
Griffin graduated a year early with an honors degree in
economics and then, through a bond trader in South Florida, met
hedge fund pioneer Meyer.
``Ken showed he was good at a lot of things: programming,
trading, even compliance,'' says Meyer, 61, now retired. ``It's
rare to find all those skills together.''
Meyer says he was especially impressed that Griffin had
taken his fund's tiny size and his lack of experience and
exploited it. When trading a company's convertible bonds, for
example, money managers borrow that company's shares from Wall
Street firms to sell them as a way to hedge their bond bets.
Small players often have a hard time getting firms to lend
them stock. ``He went to see syndicate managers and introduced
himself and ingratiated himself,'' Meyer says.
Meyer gave the recent graduate $1 million and an office at
Glenwood's Chicago headquarters.
Dorm Room Program
Griffin began trading with a convertible arbitrage strategy
based on his dorm room computer program and returned 70 percent
that year, which convinced Meyer that he was ready to start his
own fund.
Few investors would place money with someone barely out of
college, so Meyer introduced Griffin to traders familiar with
convertible bonds, a relatively small market then.
Griffin opened his fund on Nov. 1, 1990, with $4.2 million,
naming it Citadel to suggest it would serve as a stronghold in
volatile markets. His first three years of business were
prosperous: The fund returned 43 percent and 40.7 percent in its
first two years and 23.5 percent in 1993.
Investors piled in. In 1994, the convertible market tanked
as bonds recorded their worst year since 1969. Citadel lost 4.3
percent, and assets tumbled by a third to $120 million as
investors fled the fund.
``It was like a clarion call,'' Meyer recalls. ``Ken told
me, `We're not going to let this happen again.'''
Strict Lockups
Citadel instituted strict lockups, mandating that clients
couldn't take their money out of the firm for three years. The
last of Citadel's funds adopted the new policy on July 31, 1998,
less than three weeks before Russia defaulted on some debt and
Greenwich, Connecticut-based hedge fund firm Long-Term Capital
Management LP lost $4 billion, or more than 90 percent of its
capital.
Citadel was a rare buyer, able to snatch bonds as funds sold
their inventories. Citadel's flagship fund ended the year up 30.5
percent, one of the best performances among hedge funds that
year.
Slowly, Citadel began adding other strategies, beginning
with Japanese and then European convertible bonds. Statistical
arbitrage, betting on historical relationships between
securities; merger arbitrage, wagering on the stocks of merging
companies; and fixed-income arbitrage, buying and selling related
bonds, followed.
In 2001, the firm hired two seasoned stock managers from
large hedge funds to start trading equities: Carson Levit, 39,
who had previously worked at Pequot Capital Management Inc., and
Labon, from Bowman Capital Management LP.
New Strategies
Asset growth picked up speed as Citadel added new
strategies. In Citadel's first eight years, the firm's assets
jumped to $2 billion. By 2001, they had topped $6 billion.
A hallmark of Citadel's success has been its ability to
diversify into new investment areas at the right moment.
``What makes Citadel a worthwhile investment is its uncanny
ability to go where other people are not -- and make a lot of
money there,'' says Mark Yusko, former chief investment officer
at the University of North Carolina's endowment fund.
He now runs Chapel Hill, North Carolina-based Morgan Creek
Asset Management LLC, a $1 billion firm that invests in hedge
funds. ``I've looked at investing in literally hundreds of funds,
and I'll say Citadel is a little smarter than the rest,'' adds
Yusko, an early Citadel investor.
Griffin says he had long thought about expanding into energy
trading and waited until 2001, in the wake of Enron's collapse,
to make its aggressive push into the business.
Recruiting Energy Traders
Days after Enron failed, Griffin hopped on a plane with
Miglis, the head of technology, and a few other executives and
began recruiting energy traders in Atlanta; Kansas City,
Missouri; Houston and Tulsa, the hometowns for energy companies
including Aquila Inc., Mirant Corp. and Enron.
They interviewed hundreds of potential employees and hired
only a dozen, including Ruth Sotak, who left Aquila to become
head of Citadel's energy operations team.
While Griffin was out recruiting, a team of Citadel
employees -- computer programmers, options traders,
mathematicians working on pricing models and lawyers in charge of
getting necessary regulatory approval to trade -- was building up
the staff and equipment necessary to compete in the business.
``We can organize resources when there's been a dislocation
of incumbents,'' Griffin says.
Energy supply
Weather is key to figuring out energy supply, demand and
transportation issues, ``so we went out and set up a team of
meteorologists,'' says Scott Rose, the managing director in
charge of Citadel's energy business.
Citadel's four meteorologists sit in front of imaging and
mapping computers in an alcove off the trading floor. On a
typical day, they might analyze snowpack and rainfall density in
the U.S. Northwest to see how a recent increase in precipitation
in the region will provide a boost to hydropower producers and,
in turn, cut demand for other types of electricity producers.
Citadel has also started dabbling in pollution rights and
catastrophe, or ``cat,'' bonds. Reinsurers, such as Swiss
Reinsurance, issue these securities to hedge some of the risk of
paying claims in catastrophic losses. The bonds pay high interest
rates, though investors may lose their principal and interest
payments if a storm generates losses at or above a set amount.
Griffin isn't afraid to go into areas untested by other
hedge funds. The firm now has a 100-person team that makes
markets in equity options for retail brokers such as Ameritrade
Holding Corp. and E*Trade Financial Corp.
As a so-called specialist, Citadel agrees to stand ready to
buy and sell options, which give the buyer the right, but not the
obligation, to buy or sell a security at a set price by a certain
date.
Largest Specialist
Citadel does business on all six options exchanges,
including the New York-based International Securities Exchange,
the biggest U.S. stock-options market, where the firm is the
largest specialist.
Citadel plans to start making markets in equities in the
next few months, says Matthew Andresen, former CEO of electronic
trading network Island ECN Inc., who was hired last year to head
up the market-making business.
Griffin refuses to disclose any returns for the firm's
various investment strategies. He says only that Citadel made
substantial profits last year from betting on equities, which
isn't surprising given that it's an area where most of the
largest firms put capital to work.
Long $19.6 Billion
Citadel was long $19.6 billion of U.S. stocks, options and
convertible bonds as of Dec. 31, according to a filing with the
U.S. Securities and Exchange Commission.
Investors say Citadel's first years of trading equities were
disappointing as it made the transition to buying and selling
shares based on fundamental research rather than computer models.
Griffin will say only that the stocks team has made money every
year since it was started.
Citadel uses proprietary mathematical models and advanced
computer systems to help make all of its investment decisions,
from pricing convertible bonds to computing energy transactions
to calculating the risk of its stock holdings.
Other hedge funds restrict so-called quantitative trading to
select areas -- such as derivatives, where mathematical equations
help value financial obligations derived from debt and equity
securities.
``Each and every one of our strategies is backed by
technology,'' Miglis says. Citadel has 400 information technology
employees who support the firm's 270 investment professionals.
Crash Proof
Computer systems are so central to Citadel's business that
the firm has its own generator on the roof and its own fuel tank
in the basement. Pipes and filtration systems in the main
computer room will suck out oxygen in case of fire, and the firm
runs a 200-workstation office with a redundant computer system in
an undisclosed location 30 miles from headquarters.
Investors bear the entire cost of running the company. Most
hedge funds charge investors management fees of 1-2 percent of
assets and 20 percent of profits.
Citadel takes its cut of profits like the others and then
deducts all operating expenses from its fund performance before
paying investors, saddling them with a bill that historically has
equaled 3-6 percent of assets for the computer systems and larger-
than-average staff.
David Shaw's D.E. Shaw & Co., which has $14.7 billion in
assets under management, and Tudor Investment both have less than
half as many employees as Citadel does.
``Their expense structure is high compared with others,''
Morgan Creek's Yusko says. ``Ultimately, we overlooked it because
their returns were so high.''
Bump in the Road
Some hedge fund investors say they don't like Citadel's
unusual rule that doesn't allow them, without prior written
permission, to invest with -- or even talk to -- any trader who
leaves Citadel until two years after they have taken all their
money out of Griffin's fund or the ex-employee has been away from
the firm.
Other money managers have balked at investing in Citadel
because they say they're not sure how the firm will handle the
inevitable bump in the road.
``I always like to ask managers to discuss their failures
and how they have overcome that adversity,'' says Philip Halpern,
a private investor who formerly ran the University of Chicago's
$4 billion endowment fund.
`Tremendous Success'
``In the case of Ken and the tremendous success of his
business, I am not sure he personally ever has been stress-
tested,'' says Halpern. ``For this reason, I might be a little
cautious.''
Griffin says he's seen his share of difficulties.
``Certainly, like everyone in the money management business,
Citadel has experienced challenging market conditions over the
past 15 years,'' he says. ``Our approach, however, has been to
view these times as opportunities to grow, to learn and to
profit.''
To maintain his track record, Griffin is looking to take his
company far beyond the U.S. Citadel already has offices in Tokyo
and London, and that's just the start of a big international
push.
``We're focused on what is the right geographical
opportunities,'' Griffin says. ``Capital markets reward you for
what you learn that other people have yet to ascertain.''
Griffin traveled to Saudi Arabia last year to learn more
about the oil business and, early in 2005, spent three weeks in
Asia, meeting with Morris Chang, founder of Taiwan Semiconductor
Manufacturing Co., the world's largest supplier of made-to-order
computer chips, as well as with Chinese political and business
leaders.
`Economic Phenomenon'
He talks about the trip with a boyish enthusiasm. ``China is
clearly an economic phenomenon,'' he says. ``They built New York
City in a Shanghai rice field.''
Griffin shares an office with his assistant, Jodi
Deichmiller; she says she e-mails him, even though they sit 5
feet apart, so as not to disturb his concentration.
He keeps a row of management-theory books on a credenza
behind his desk, and he says he tries to emulate one of America's
most celebrated business leaders, former General Electric Co. CEO
Jack Welch.
``I admire Jack Welch and his conviction of the role of the
individual in the firm,'' Griffin says. ``To earn `A' results,
you have to have an `A' team.''
Like Welch, Griffin meets with small groups of employees
every few weeks for lunch, during which he encourages them to
make suggestions or voice complaints. He also encourages his team
leaders to set out specific goals for their people, another
Welchlike touch.
Arduous Process
``We have metrics for success, and we discuss where we will
be on Jan. 1 next year,'' says Anand Parekh, 32, who heads
Citadel's global equity team. Griffin says he interviews
potential employees almost every day.
In Citadel's early days, the hiring process was arduous.
Charlie Winkler says that when he was told he was one of five
finalists for the job of chief operating officer, he was given an
eight-part exam that included questions on investment accounting
and critiquing a letter Citadel sent to its investors.
The exam, delivered to him on a Friday and picked up the
following Monday, took 12 hours to complete.
On Tuesday, Winkler met with Griffin and two other Citadel
executives. He was grilled for four hours.
``It was like I'd had my written exam and then my orals,''
says Winkler, who says he prefers to work at startup companies
and left Citadel when it grew too large for him.
Early Blood
These days, candidates coming out of college go through a
training program that includes 18 weeks of classes. At the end of
the classes, four-member teams, supervised by a trader, are given
a few million dollars to manage.
``Ken likes them to have the early taste of blood,'' says
human resources chief Mike Pyles.
Griffin says it's more about focus. ``Markets are
humbling,'' he says of the exercise. ``Now that they are humbled,
they are so much more focused.''
Griffin also gives new hires two management books:
``Hardball: Are You Playing to Play or Playing to Win?'' by
George Stalk and Rob Lachenauer (Harvard Business School Press,
2004) and ``Good to Great,'' by Jim Collins (HarperBusiness,
2001).
Well-worn copies of both books can be seen on credit
analysts' desks next to foot-high piles of SEC filings.
``By giving people rules of the road, it makes them more
engaged,'' Griffin says.
Mania for Management
Griffin's mania for management theory doesn't mean he's
stopped keeping track of what happens on the trading floor. He
looks at the firm's profit-and-loss statement daily, and he's
informed as soon as there's a $50 million move, especially if
it's a loss.
``Failure comes with the territory,'' he says. ``I have to
make sure we're always in a position to compete tomorrow. I can
absorb a $50 million loss. Our denominator is $12 billion. It is
what it is.''
Griffin strictly values his own privacy and that of his
company. He makes employees sign non-compete agreements. Even
after these expire, some former employees are loath to talk.
``Even though my non-compete wore off a while ago, I think
he still would try and make my life miserable,'' says a former
employee who now works for another hedge fund.
PlayStation Sports Games
Griffin's friends decline to comment on his hobbies --
including fast cars -- and even his taste in music. One pal does
say Griffin likes PlayStation sports games.
Griffin reveals little. Lehman CEO Fuld tells about his
calling up Griffin and inviting him to a client conference at a
ski resort. ``I can't,'' Griffin said.
Fuld kept trying to persuade him. ``Can't you drop business
for one day?'' Fuld asked. ``I can't,'' Griffin responded several
more times as Fuld tried to cajole him into attending. Finally,
more times as Fuld tried to cajole him into attending. Finally,
he let out the whole story. ``I can't. My leg's in a cast,'' he
said.
Griffin has had five operations on his knee in the past
seven years, forcing him to shelve his hobby of playing in two
soccer leagues.
Griffin does manage to get away from the office, his friends
say. ``He is very focused and very determined, but by no means is
he all business all the time,'' says Slusky, who traveled this
past winter to Chile for a vacation with Griffin.
Easter Island
A month later, Griffin took a trip to one of the most-
isolated places on Earth: Easter Island, located in the South
Pacific about 2,000 miles from the nearest population centers in
Chile and Tahiti.
Lately, Griffin has become increasingly interested in art, a
passion he credits to his wife, Anne Dias, 34, who runs her own
hedge fund firm, Chicago-based Aragon Global.
Last year, ARTnews magazine listed the couple among the top
10 most-active collectors in the world. Griffin says he purchased
the Cezanne at a Sotheby Holdings Inc. auction because he admires
how the painter pulled off drawing three inanimate objects.
``The still life is an impossibility, and he made it a
reality,'' he says.
Griffin also bought Edgar Degas's ``Young 14-Year-Old
Dancer,'' a bronze sculpture. ``She's not going to let the world
put her in her place,'' Griffin says about what that piece means
to him.
The Cezanne and the Degas are on display in the Art
Institute of Chicago. The donor's name, for both works, is kept
anonymous.
``It's funny, he cloaks himself in secrecy, but everyone in
the financial world from London to Tokyo to New York knows who he
is,'' Yusko says.
And those same people will be watching closely as Griffin
attempts to transform his company into an ever more powerful
financial institution.
