The founder of a hugely successful hedge fund firm — Paloma Partners Management Co. — S. Donald Sussman is aware of how remunerative owning a hedge fund can be. So over the years he has liberally seeded hedge fund start-ups, backing now-flourishing firms such as D.E. Shaw & Co.
Ten years ago Sussman saw another such opportunity in a fund of hedge funds, Pacific Alternative Asset Management Co. Based in Irvine, California, Paamco was launched by James Berens, Jane Buchan, William Knight and Judith Posnikoff, all of whom had been portfolio managers at the Newport Beach, California, fund of hedge funds Collins Associates (founded by onetime pension consultant Budge Collins).
In 2000 Sussman loaned Paamco $1.3 million to help get the firm going, and not long afterward he agreed to up the loan cap to $2 million. The credit was for ten years and was in exchange for 10 percent annual interest or, alternatively, 40 percent of the profits, whichever was greater. The deal was nominally structured as a loan so that Paamco’s founders could retain control. However, Sussman insisted upon the right to convert the loan into an equity stake at some point.
Paamco, whose four founders boast Ph.D.s in economics, finance or management, prospered, chiefly by persuading big pension funds that they were expert at selecting just the right mix of hedge funds. Today the firm oversees almost $10 billion .
To date, Sussman’s return on what was ostensibly a $2 million investment in a start-up firm may turn out to be worth more than $60 million.
Yet this seeming success story has left a sour taste for everyone, and underscored the risks of seeding arrangements for all the parties involved.
To establish his claim to a 40 percent stake, Sussman had to take Paamco to court. In August a Manhattan District Court judge found in his favor, and recently Paamco’s founders decided not to appeal, explaining that although there were “strong grounds,” it would not be in the best interests of clients or employees.
The whole episode is a bit of a legal head-scratcher. At the crudest level, it consists of a classic “he said, she said” dispute over the original terms of the seed contract. Sussman contended that he had the right to convert his loan to a 40 percent equity stake in Paamco at any time before 2010. Paamco CEO Buchan and the other founders contended that he could convert his loan into equity only if Paamco were to be sold or the loan prepaid.
An attorney representing Paamco says the case turned on revisions made to the original credit document and approved by both parties in 2003 when Buchan et al. formed Paamco Founders to separate their partnership interests from those of the firm for business and legal reasons. Apparently, those reviewing the contract for Paamco missed critical language — although that, too, is a matter of dispute.
Still, all seemed hunky-dory until 2008 when Paamco Founders told Sussman’s holding company, Franklin Realty Holdings, that it wanted to wind down the loan (only $1.4 million of which Paamco had used). Thereupon, Sussman sought to trigger what he presumed to be an equity-conversion right. Paamco Founders, however, countered that the claim was false and stopped paying interest on the loan. Sussman filed suit. Paamco Founders counter-charged that a rate of 10 percent on a loan of between $1.5 million and $2 million constiututes usury in New York State.
Judge Richard Sullivan ordered Paamco Founders to pay the back interest and issue Franklin Holdings a “membership interest certificate” effectively entitling Sussman to 40 percent of Paamco Founders.
Paamco, meanwhile, has entered damage-control mode. Buchan has been calling clients to reassure them that the firm’s operations remain unaffected. “The original charge only collectively affects the four founders,” she points out. “Paamco was never party to any lawsuit. We are pleased to have put this behind us.”
Nonetheless, some clients are plainly worried that the fallout will hamper Paamco’s performance. Already, the Los Angeles Water and Power Employees’ Retirement Plan has withdrawn its $35 million investment and the Kansas City School Retirement System its taking out its $18 million. (Buchan points out that the two accounts represent just 2 percent of Paamco assets.)
Other investors are playing wait-and-see. The Pennsylvania State Employees’ Retirement System, which hired Paamco in 2002, has put the firm on its watch list. But in an e-mail, the fund told II, “Paamco has been one of the top-performing managers in our absolute return program and has exceeded our expectations, achieving an annualized return of 5.5 percent after fees.”
Paamco’s troubles don’t end with resolution of the lawsuit, though. Judge Sullivan speculated that Paamco’s peculiar ownership structure “may have been designed to mislead” investors into thinking the firm was majority-owned by women and thus eligible for investments intended exclusively for such firms. The Securities and Exchange Commission has begun a probe. Paamco wrote its investors that a full review of the record will show that there is “no basis to conclude that we acted improperly in any way.” Although Paamco says it never officially went after so-called minority-content mandates, some observers say the firm did not discourage the view that it was women-owned. Many investors were thus caught off guard when they heard of the Paloma founder’s sizable stake.
The SEC will have to decide if Sussman’s equity-conversion rights were such that he should have been included on Paamco’s annual ADV form, in which investment advisers must list their owners and their stakes. (He appears for the first time on the 2010 form.) As it was, Jane Buchan and Judith Posnikoff appeared to hold 51 percent of Paamco.
One longtime hedge fund seeder, Hugh Lamle of M.D. Sass, says that even when seed agreements run to more than 1,000 pages, he reviews every page himself. That may not be such a bad idea.