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Allianz’s Gross Problem: More Than Just the Bond King

The German insurer is scrambling to repair the damage left by Bill Gross’s departure from PIMCO, but it still faces big questions about its strategy in asset management.

The early-afternoon air was crisp and clear in Munich on the last Friday in September. The Oktoberfest fair, the city’s annual salute to beer, bratwurst and Bavarian culture, was in full swing, and employees of Allianz Asset Management (AAM), the €1.8 trillion ($2.3 trillion) investment arm of the giant German insurer, were returning from lunch at nearby beer halls with less than their usual haste. Many were already turning their thoughts to the weekend ahead.

Then at 2:30 p.m. the office suddenly turned into an “angry beehive,” as one employee put it. News reports landed on executives’ screens announcing that Bill Gross, the legendary bond king at Pacific Investment Management Co., Allianz’s big, California-based asset manager, had been hired away by a much smaller rival, Janus Capital Group. AAM chairman Jay Ralph and his assistants frantically tried to confirm the news with PIMCO executives. It wasn’t even dawn yet nine time zones away in Newport Beach, where PIMCO’s 20-story office tower overlooks a marina on palm-lined Newport Bay. By the time that PIMCO chief executive Douglas Hodge was able to confirm Gross’s departure, some 40 minutes later, Allianz’s share price was plummeting. By day’s end it would drop 6.2 percent, wiping €3.8 billion off the group’s market cap, to €58.2 billion. The shares have continued to fall since then, losing an additional 6.5 percent to close at €119.85 on October 20.

For Europe’s largest insurance company by premiums and market valuation, the setback was devastating. Allianz is widely reputed to be one of the world’s premier risk insurers, yet the company had somehow failed to manage one of its biggest single risks — namely, a chaotic exit by its bond market superstar. The uproar also called into question the Allianz model of combining insurance and asset management in one financial services group.

Gross’s departure wasn’t exactly a surprise. Speculation about his future had swirled around PIMCO ever since the firm’s CEO and co-CIO, Mohamed El-Erian, abruptly announced his resignation in January. In the weeks that followed, reports surfaced describing heated clashes over management style between Gross and El-Erian that led to the latter’s departure. Meanwhile, poor performance at PIMCO’s flagship Total Return Fund, which Gross had built into the world’s largest bond fund, had driven a steady stream of redemptions, totaling a whopping $68 billion over the 16 months to the end of August. Gross’s eccentric antics, including wearing dark sunglasses at the start of a keynote address at a Morningstar investment conference in June, added more fuel to the fire. Investors around the world began asking themselves whether giving a fixed-income allocation to PIMCO — for decades the safest decision a pension fund manager could make — was still a good idea.

“At all times, we had succession plans in place,” Ralph told Institutional Investor in an interview a few days after Gross quit. The company had hoped to resolve the concerns about Gross and stem the outflows at PIMCO by staging an orderly change in leadership, executives tell II. On the last Saturday of September, the 70-year-old Gross would be informed that his reign was over as chief investment officer of the investment company he’d co-founded 43 years ago, although he would be asked to stay on for a transition period while a younger team took the helm. Then on Sunday, Allianz and PIMCO — and, ideally, Gross — would release a soothing statement for the markets before their Monday opening.

But as every investor knows, timing is critical to good execution. Allianz botched it in this case. Getting wind of the plot, Gross jumped ship rather than walk the plank. By quitting PIMCO on Friday, preempting the planned announcement, he ensured maximum impact on the markets before the weekend and minimal time for his former employers to restore a semblance of control. Rather than stemming the tide of redemptions, his sudden departure accelerated the flow, with $23.5 billion pouring out of PIMCO in September, reducing total assets to $1.87 trillion.

“I am competitive as ever, and I expect to win for my clients,” Gross wrote in an introductory letter to clients at his new firm. “I look forward to serving you from my new seat at Janus.”

The incident revived long-standing questions about the wisdom of Allianz’s owning an asset manager like PIMCO and whether the German parent could exercise any effective control over its California subsidiary. Executives in Munich insist their strategy is sound. On a conference call with financial analysts three days after the Gross resignation, Allianz chief executive Michael Diekmann asserted that the insurer would maintain full ownership of PIMCO. “The asset management business fits in extremely well with Allianz’s insurance business,” Ralph told II. “It is just as much a core business as our property/casualty or life insurance segments.” Executives at PIMCO, meanwhile, have been working overtime to reassure investors and persuade them that their new team-oriented approach to managing money will deliver strong returns while avoiding the pitfalls that can befall a star manager. (See “Ivascyn and Company Try to Calm PIMCO Clients with Team Approach”)

Last year asset management — encompassing both PIMCO and €373 billion Allianz Global Investors (AGI), primarily an equity shop — accounted for 30.3 percent of Allianz’s €6.4 billion in net income. But partly as a result of PIMCO’s net outflows, asset management dropped to 22.9 percent of €3.6 billion in net income in the first half of this year. The results would have looked worse if AGI hadn’t delivered net inflows of €5.1 billion. Allianz seems more involved with management at AGI than with PIMCO; the subsidiary serves mainly the European market and is run by lesser egos than Gross.

Insurers differ on the merits of owning asset managers as opposed to outsourcing the investment of their assets. Zurich Insurance Group, Europe’s fifth-largest insurer by premiums, sold most of its asset management business to Deutsche Bank a dozen years ago. Italy’s Assicurazioni Generali, Europe’s No. 3 insurer, manages most of its assets but has managed to attract only a small amount of money from outside clients. France’s AXA, Europe’s second-biggest insurer, follows Allianz’s model most closely: It owns two asset managers — AllianceBernstein and AXA Investment Managers — that manage a large percentage of the group’s assets and attract business from a wide range of outside parties.

Allianz executives insist that today’s low-interest-rate environment and the more onerous capital requirements of Europe’s Solvency II directive have strengthened the link between insurance and asset management. This is especially true for life insurance policies in Germany and Italy, the group’s two largest markets, where guaranteed-income products predominate. Such guarantees are becoming more difficult to finance because the underlying bonds carry such puny interest rates today while Solvency II demands that insurers hold more risk capital for those guarantees. As a result, clients nowadays are often sold life insurance policies along with asset management products that carry more risk for higher returns. For Allianz this is more than enough reason to own asset managers.

“Why not have service providers under our full control to ensure quality and performance?” asks Maximilian Zimmerer, who as head of Allianz Investment Management must allocate assets to match the insurer’s liabilities and invest a portion of the firm’s insurance profits. “Max is my favorite board member because he is our largest client,” quips Ralph.

At the end of June, Allianz had entrusted €306 billion of its €601 billion in assets to PIMCO and €135 billion to AGI. External firms manage the remaining €160 billion.

Analysts point out that insurers generally prefer to contract the services of outside asset managers to cover the asset-liability management of their insurance business and to invest their profits. Some also assert that because Allianz owns asset managers, its stock suffers from a conglomerate discount. A report issued in September 2013 by Sanford C. Bernstein & Co. estimated that Allianz could have raised €10 billion by floating PIMCO through an initial public offering. “That would have created enormous shareholder value,” says Thomas Seidl, the London-based lead analyst for the report. “But now, of course, after what has happened at PIMCO, it’s too late.”

CONCERNS ABOUT PIMCO had been brewing for months, ever since El-Erian’s stormy departure. In late January, Allianz named Hodge to replace El-Erian as CEO and approved the appointment by PIMCO of six deputy CIOs under Gross. Those deputies included Daniel Ivascyn, a 44-year-old manager of the firm’s credit hedge fund, who took over as group CIO after Gross’s exit. Yet redemptions continued at the Total Return Fund, and shareholders fumed at Allianz.

At the insurer’s annual shareholder meeting, held in May in Munich, dissidents skewered CEO Diekmann for not involving himself more with PIMCO’s management. Daniela Bergdolt, spokeswoman for DSW, Germany’s largest private shareholder association, likened the tiff between Gross and El-Erian to “a male catfight” and told Diekmann, “I would have wished that you had interfered earlier.” Diekmann rejected the suggestions and reminded shareholders that the bond manager had performed admirably over many years without heavy supervision from Munich. “There is really no reason to be hard on us,” he said at the meeting.

Ralph says the amount of contact between his office and executives at PIMCO remains unchanged. A lack of urgency reigns higher up as well. Diekmann ignored requests by major Allianz shareholders, including Frankfurt-based Union Investment Group, to stay on as chief executive for two more years to ensure that PIMCO’s problems were fully resolved. Instead, just six days after Gross’s departure, Diekmann announced that he would step down in May, abiding by the Allianz tradition that its chief executives retire at age 60. As expected, his successor will be Oliver Bäte, 49, head of the p/c business. The desire to project Allianz’s image of a steady, well-oiled business group takes precedence over any hint of panicky concern for a flailing subsidiary.

The hands-off approach toward PIMCO may also reflect the fact that the top echelon of Allianz lacks anybody with a strong background in asset management. “Michael Diekmann and Jay Ralph have impressive insurance track records, but asset management and insurance are just fundamentally different business models,” Bernstein’s Seidl says.

In his dozen years as chief executive, Diekmann has strengthened Allianz’s standing as one of the world’s most profitable insurers. Yet the group has lost billions on noncore investments under his leadership, most notably in investment banking. Ralph, a 55-year-old Milwaukee native and certified public accountant, has spent three decades in insurance, including the past 17 years at Allianz. He was head of the firm’s risk transfer operations in Zurich, then led its reinsurance business out of Munich before becoming chairman of AAM in 2012.

The notion that asset management and insurance belong under the same roof became popular among large insurers during the years of heady growth in financial services before the global crisis. Stand-alone insurers were viewed as boring firms with low returns on capital that discouraged shareholders. The smart insurance money chased after brand-name asset managers and investment banks.

Allianz was one of the most active players. In the late 1990s and early 2000s, it acquired nine boutique asset managers, each with expertise in individual asset classes. Besides PIMCO, which Allianz purchased in 2000, some of the more prominent acquisitions were Nicholas-Applegate Capital Management, a growth-oriented equity shop based in San Diego; Oppenheimer Capital, a New York–based firm that manages money for pension funds and high-net-worth individuals; and RCM Capital Management, a San Francisco–based manager of mutual funds and hedge funds for institutional clients. Getting those outfits to work together smoothly for Allianz clients was a struggle, though.

The task was initially entrusted to Dresdner Kleinwort Wasserstein, the investment bank that Allianz bought in 2001 for €24 billion and renamed Dresdner Bank, harking back to that entity’s roots as Germany’s No. 2 commercial bank. The deal was supposed to create Germany’s leading financial services provider, but Dresdner was caught in a no-man’s-land: too small to compete with global investment banks and too big to be a focused German player. It racked up multibillion-euro losses on nonperforming loans and plunging trading revenue. Dresdner executives were too distracted to help Allianz integrate its boutique asset managers. In 2008, Allianz finally sold Dresdner to Commerzbank for €9.8 billion — 60 percent less than it had paid for it. Allianz took a €6.4 billion write-down on the sale, causing it to post a loss of €2.4 billion for the year.

“Allianz’s multiboutique approach to asset management went more smoothly only after it got rid of Dresdner,” says Marc Thiele, a London-based equity analyst for Mediobanca Securities. But that was true for only a brief period. Specialist investment boutiques were the rage in the early 2000s, but after the global financial crisis erupted in 2008, clients began to favor large asset managers that could offer multiasset, multistrategy products.

Allianz’s boutiques found themselves at a distinct disadvantage. Whereas BlackRock could propose a single, comprehensive investment solution to a client, Allianz had to pitch equity funds from one of its boutiques, fixed-income securities from another and mutual funds from a third. “A client might only have 30 minutes, of which we spent too much time explaining how it would work,” recalls Elizabeth Corley, chief executive of Allianz Global Investors. “Clients were telling us they just didn’t like our corporate structure.”

So in 2012, Allianz abandoned the multiboutique approach. It left PIMCO alone to handle fixed-income securities, mainly for U.S. investors. AGI, which was created as an in-house investment arm in the late ’90s, absorbed the other boutiques, dealing primarily with equities. Ralph calls the PIMCO-AGI setup the two-pillar model.

They are two very unequal pillars, however. PIMCO was managing nearly four times as much money as AGI at the end of June. It also runs more external money: Third-party mandates accounted for 78 percent of PIMCO’s assets at the end of June, compared with 64 percent for AGI. PIMCO is more institutional (67 percent of assets) and gets 69 percent of its assets from the Americas, with Europe and Asia chipping in 21 percent and 10 percent, respectively. AGI’s third-party assets are evenly balanced between institutional and retail clients; the firm gets 61 percent of its assets from Europe, 30 percent from the Americas and 9 percent from Asia.

UNTIL ITS RECENT TROUBLES PIMCO delivered stellar financial results, giving Allianz a much-needed boost after the Dresdner debacle. Allianz bought a 70 percent stake in the firm for $3.3 billion in 2000, when PIMCO was managing $256 billion. The firm grew spectacularly over the following decade, benefiting from a boom in fixed-income markets and extraordinary performance. Under Gross, PIMCO outperformed 90 percent of its benchmarks for almost four decades. He pioneered active fixed-income investing in the 1970s and was prescient enough to foresee the housing collapse in 2008 and avoid subprime-mortgage-backed securities.

But PIMCO’s soaring success didn’t impress many Allianz shareholders. For a decade after PIMCO’s acquisition by Allianz, its original fund managers held so-called B shares that entitled them to 30 percent of operating earnings. “PIMCO’s headline numbers looked terrific all those years: great inflows, revenues through the roof,” says Mediobanca analyst Thiele. “But ordinary shareholders didn’t benefit that much.” Over the past four years, Allianz has bought back the B shares and now fully owns PIMCO. But Gross’s annual salary — reportedly $200 million last year, compared with Diekmann’s $9.2 million compensation package — rankled shareholders.

Their complaints increased when Gross began to slip. In March 2011 the bond king wrote in his widely followed “Investment Outlook,” posted on the firm’s website, that U.S. interest rates “may have to go higher, maybe even much higher to attract buying interest” when the Federal Reserve ended its bond-buying program known as quantitative easing. He then sold all the U.S. Treasury holdings in his Total Return Fund. Talk about bad timing. Far from heading for the exits, the Fed moved from its second stint of QE to Operation Twist, which shifted purchases to long-dated Treasuries, to yet a third round of QE in 2012. (The central bank’s Federal Open Market Committee was expected to finally pull the plug on QE at its meeting on October 28–29.) Rates didn’t soar; they plumbed record lows, taking the yield on the Treasury’s benchmark ten-year note from 3.41 percent at the start of March 2011 to just 1.43 percent in July 2012. Total Return’s 4.15 percent return for 2011 ranked in the bottom 13 percent of similar bond funds, according to Morningstar.

Gross never recovered his footing. He scrambled with risky bets in emerging markets, the periphery of the euro zone and inflation-indexed Treasury bonds. But in three of the past four years, Total Return underperformed the majority of its rivals.

The poor performance fueled tensions between Gross and his heir apparent, El-Erian, 56, who was both CEO and co-CIO. They sat next to each other on PIMCO’s cavernous trading floor, and their quarrels were overheard by many of the firm’s portfolio managers. “Bill could get really nasty if he didn’t agree with your investment ideas,” recalls one younger portfolio manager, who joined PIMCO because of his admiration for Gross and spoke on condition of anonymity. “He would point out that he had a far longer and better track record.”

El-Erian’s resignation in January stoked more client outflows, largely from Total Return. PIMCO, with Allianz’s backing, insisted that Gross agree to the naming of six deputy CIOs, all of them experienced portfolio managers, from whose ranks his eventual successor would emerge. The appointment of the deputies was “a recognition of the depth of talent that PIMCO has,” Ralph said in an interview before Gross quit.

The front-runner among the six was Ivascyn, Morningstar’s fixed-income manager of the year in 2013. The publicity given to these appointments, as well as others in less senior positions, surprised longtime Gross watchers. “It’s as if Allianz was letting the investment community know that the old days of the bond king were over and that they were surrounding him with lots of high-level talent,” Erik Gordon, professor at the University of Michigan’s Ross School of Business, said in an interview with II in August.

At first, Gross reacted amiably to the changes and praised the new atmosphere of give-and-take in investment meetings. But the continued redemptions at Total Return soon soured relations. In early September, after bitter confrontations with Gross, several senior executives — including the new heir apparent, Ivascyn — reportedly threatened to quit. Allianz could ill afford the departure of another likely successor. In consultations that excluded Gross, PIMCO’s executive committee, with Allianz’s approval, decided that the bond king had to go. The game plan was to inform Gross on the last Saturday of September and, with his acquiescence, make an official announcement on Sunday.

Gross learned of it even earlier. On September 16 he contacted Jeffrey Gundlach, head of DoubleLine Capital, a $52 billion bond specialist based in Los Angeles, and sounded him out about joining his firm. Nothing came of that. Gross next approached Janus CEO Richard Weil, who had worked under him as COO at PIMCO for a decade. The $178 billion-in-assets Denver-based firm has long been mainly an equities house, but Weil jumped at the opportunity. Early in the morning on Friday, September 26, Janus announced that Gross was coming on board and would manage the Janus Global Unconstrained Bond Fund, beginning October 6.

PIMCO and Allianz were badly caught off guard. By the end of September, Total Return had shrunk to $202 billion in assets from an April 2013 peak of $293 billion, according to Morningstar.

PIMCO’s TROUBLES HAVE pushed AGI into the limelight, but the equity-­oriented manager doesn’t yet have the critical mass to rival the California firm as an engine of growth for Allianz.

CEO Corley, 58, spends her nights and weekends writing fiction; she has published five well-received detective novels set in West Sussex, England, where she grew up. Her accomplishments in her day job have been just as noteworthy. In less than three years at the helm, she has seen AGI’s assets swell by a third. Most of that growth has come from third-party mandates — chiefly pension funds but also retail clients.

Though largely known for its German clientele, AGI has extended itself elsewhere in Europe and sought to expand in the U.S. and Asia. AGI still has a reputation for being largely an in-house asset manager for Allianz, but Corley uses this as a selling point to third-party clients. She tries to impress upon them that there are few asset managers with AGI’s experience in providing the range of products and geographic coverage that an investor like Allianz demands. “We are attracting more external clients in part because they recognize our credibility in servicing Allianz,” she says.

Under Corley, AGI has balanced its reputation as an equity specialist by bolstering its offerings in fixed income (now about 40 percent of its total portfolio) and alternatives, such as infrastructure financing. AGI has plunged into multistrategy, multiasset products that combine both fixed-income securities and equities and are aimed at creating alpha in today’s volatile, low-rate environment. “They have made very good progress over the past year with what looks like the right sort of product offerings for this market,” says Andrew Broadfield, a London-based equity analyst for Barclays Capital.

Some of the most successful offerings for retail clients were designed by AGI in collaboration with Allianz insurance specialists. They involve annuities and life insurance products that protect policyholders if the value of their investment mix of bonds, equities and alternatives declines, while allowing them to participate in the upside. These products are marketed to individual policyholders through their pension funds or financial advisers.

Allianz Invest4Life, for example, combines a lifelong guaranteed minimum annuity with returns on the capital market through an Allianz fund. One attraction of such a product is that when a client dies, the remaining account value is passed on to beneficiaries. Developed in Germany, Invest4Life has been introduced over the past two years in France and Italy, and has drawn a total €1.5 billion of inflows.

With other products, however, AGI still struggles with distribution. RiskMaster is a case in point. Offered in the U.K., the product is tailored to the individual risk profiles of clients, who are placed in four categories ranging from aggressive to defensive. The most risk-averse receive products with strong downside protection but limited upside potential. Since the products’ launch in May 2012, the return for the lowest-risk Allianz RiskMaster Defensive Fund has been a pedestrian 8.41 percent, while the highest-risk portfolio has outperformed its benchmarks with an 18.43 percent return. Total investment in all four portfolios has barely reached $50 million, though.

For other products AGI has ranged far beyond the European market. Using its investment team in San Diego, the former Nicholas-Applegate outfit, now named Allianz US High-Yield, AGI developed a high-yield bond product with foreign currency hedges for the high-end Hong Kong retail market. From its inception in January 2012 through the first half of this year, the product has drawn more than €9 billion in net inflows. More recently, AGI created a European stock fund that pulled in more than €1 billion from Hong Kong clients in the first half of 2014. “Who would have thought that Asian investors wanted to buy a European dividend product?” asks AGI’s chief investment officer, Andreas Utermann.

AGI has also expanded into alternative investments aimed at insurers and pension funds that want to coinvest in projects with Allianz. In the wake of the financial crisis, banks reduced their lending to certain sectors, including public works construction. Deep-pocketed insurers like Allianz have stepped into the void. “And they are asking us to innovate for them in these types of spaces,” Utermann says.

In Europe, AGI has become the market leader in infrastructure debt products, which started to draw asset managers at the beginning of 2012. In the 18 months through June 30 of this year, AGI completed ten deals — mainly road construction projects — in seven European countries worth a total of €2 billion. Legal and regulatory complexities can be bigger obstacles than financing. “Every time we make a deal, we have to structure it to fit the Solvency II requirements for a French, German or Italian insurance company involved in the project,” Corley says.

AGI’s largest client — and PIMCO’s — is Allianz itself. In Germany, most life insurance has traditionally been sold with a guaranteed rate of return for policyholders. “But with very low interest rates, guarantee products are getting more difficult to finance, and Solvency II requires more risk capital to underlie those guarantees,” says Allianz investments chief Zimmerer. “That pushes us closer to the asset management business.”

An Allianz product called IndexSelect, marketed in Germany, invests part of a client’s yearly fixed-income returns in an equity index. The insurer buys an option on the equity market so that the client risks losing no more than one year’s return. For a similar product in the U.S., where the main Allianz life business involves variable annuities, the insurer relies on daily hedging and derivatives.

In matching assets to liabilities, Allianz depends heavily on PIMCO for bonds and on AGI for the bulk of its equity portfolio. “There are also third-party providers because you always need competition for your own companies,” Zimmerer says. “It is our own money, so we have to be demanding with both PIMCO and AGI. If the performance isn’t there, we will do something.”

Allianz insists it is not pushing AGI to accelerate its growth and provide more of a balance to PIMCO. “We don’t feel a need for both companies to be the same size,” chairman Ralph says. But a bigger footprint for AGI would help reduce longer-term concerns over PIMCO.

For now, PIMCO is working to overcome third-party client skepticism. “At some point, you have to determine whether this is the right place to keep your money when there are lots of other choices to consider,” says Todd Rosenbluth, director of mutual fund research at S&P Capital IQ, a unit of the Standard & Poor’s rating agency that provides financial data and analytics; the outfit is advising its retail and institutional clients to look for alternatives to PIMCO.

If and when PIMCO recovers its allure, the debate will resume over whether Allianz should sell it or at least reduce its stake through an IPO. “This is the worst possible moment to sell PIMCO,” says the Ross School’s Gordon. “If Allianz does eventually decide to do so, they will wait until they can show that it’s an asset that doesn’t depend upon Bill Gross.”

But what would Allianz do with a multibillion-dollar windfall from the sale of a healthier PIMCO? “The challenge would be to find another opportunity — say, a large insurance target in the emerging markets with a good risk-return profile,” says Mediobanca analyst Thiele. But there are no obvious targets in Asia or Latin America. Many big insurers in those regions aren’t listed. And when they are, they tend to be government-owned, as in China, for example. Besides, Allianz is already gaining market share organically thanks to its strong balance sheet. Why take on the risk of a large acquisition?

Many Allianz shareholders would no doubt welcome proceeds from a PIMCO sale or IPO. Even if that doesn’t happen, management is under pressure to raise its current 40 percent earnings payout ratio to shareholders, who have seen Allianz’s stock price tumble because of the PIMCO turmoil. Many analysts believe the insurer may announce an increase in the payout ratio to 45 percent of profits by the end of the year, but the company says it has no plans to change its dividend policy.

“Certainly, they could do more for shareholders, but I don’t think they will,” says Bernstein’s Seidl. “The good thing about Allianz is the reliability of their policy announcements. They stick to what they say.”

And taking Allianz at its word, shareholders should not expect further changes at PIMCO now that Gross is gone. “It is business as usual,” insists Ralph, pointing out that the management changes and investment policies at the asset manager are sufficient.

Mission accomplished? • •

See also PIMCO’s Global Market Thought Leaders blog.

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