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The education of Eli Broad

This businessman and philanthropist is trying to promote the arts, improve schools and cure disease. And he's counting on a $1 billion investment in hedge funds to get it all done.

Millionaire industrialist Eli Broad believes in taking calculated risks. That belief was the driving principle behind his decision nearly 50 years ago to leave a comfortable job at a major public accounting agency to start his own firm. It later guided Broad as he created two Fortune 500 companies -- homebuilder KB Home (formerly Kaufman and Broad Home Corp.) and financial services provider SunAmerica.

"I don't take risks unless I can get a big reward," says Broad (his name rhymes with "road"). In 1999 he sold SunAmerica to insurance giant American International Group for $18 billion; he stepped down as chairman of that business, now called AIG SunAmerica, in January 2005.

Today the 72-year-old Broad, whose fortune is estimated at $5.5 billion, is looking for a different kind of payoff. He devotes much of his time and money to the Broad foundations, a trio of philanthropic organizations based in his hometown of Los Angeles that are trying to improve education, fund new medical research and promote the arts.

With $1.4 billion in combined assets, the Broad foundations rank among the 40 biggest philanthropies in the U.S. But that is not enough to meet the ambitious goals of Broad, who says he would like to double their assets in the next three years. To that end he plans to donate more of his billions. He is also looking to a far riskier source of capital: hedge funds.

"Hedge funds offer greater returns than index funds or traditional funds," Broad says. "They provide greater reward over time with less risk than stocks and bonds. All of this helps us do more philanthropically."

Broad invests in hedge funds much the same way he built two multibillion-dollar companies: He seeks out executives who are like himself -- smart, focused, driven -- and who know how to take and manage risks. Broad keeps about 20 percent of his assets in hedge funds, says Peter Adamson, chief investment officer for the Broad foundations and family office. Today, Adamson, a former McKinsey & Co. consultant who was hired in 2001, oversees about $5 billion for Broad, including a whopping $1 billion in hedge funds. That makes Broad one of the biggest individual hedge fund investors in the world.

Broad has been putting money into hedge funds since the late 1980s, when he invested with a young ex­Goldman, Sachs & Co. merger arbitrageur in Fort Worth, Texas. That manager was Edward Lampert, who now manages $13 billion at ESL Investments in Greenwich, Connecticut (Broad is still an investor). Broad has money with many of the biggest names in the hedge fund universe, including Lee Ainslie III of Maverick Capital, Richard Perry of Perry Capital Management and William von Mueffling of Cantillon Capital Management. These days he leaves the quotidian responsibilities of investing to Adamson and his team but retains final approval of all investment decisions.

Managers like having Broad in their funds. They consider him to be a knowledgeable, sophisticated and dedicated investor who has demonstrated a willingness to stick around for the long haul. "He understands our business and is a real long-term investor," says Jonathan Kolatch, founder and manager of Redwood Capital, a $1.5 billion hedge fund in Englewood Cliffs, New Jersey, that specializes in investing in distressed securities.

It also helps that Broad writes big checks, is well connected and can offer real insight into a variety of business issues. "I have never met anybody who has as quick a mind and is as inquisitive as he is," says Glenn Dubin, managing partner of New York City­based Highbridge Capital Management, which has more than $8 billion in hedge fund assets and over the years has counted Broad among its investors.

Broad's $1 billion hedge fund portfolio has beaten the Standard & Poor's 500 index by an average of 7 percentage points a year since 2002. But that's not how Broad measures success. He wants to do at least as well as the top university endowments that have invested aggressively in hedge funds. Put simply, he wants to beat the Jack Meyers and David Swensens of the endowment world. Meyer is the outgoing head of Harvard Management Co., which runs Harvard University's endowment; Swensen is chief investment officer for Yale University, whose endowment was one of the first to invest in hedge funds. "That's our target," says Broad.

ELI BROAD WAS BORN IN 1933 TO JEWISH IMMI-grants from Lithuania who had met in New York City. His mother, Rebecca, was a dressmaker; his father, Leon, a housepainter. When Broad was six, he moved with his parents from New York to Detroit, where his father opened a five-and-dime.

The first in his family to attend college, Broad graduated cum laude from Michigan State University in 1954 after just three years, obtaining a degree in accounting. He then talked state regulators into letting him take his certified public accountant exam, even though applicants were required to be 21 and he was 20. When he passed, says Broad, he became the youngest CPA in the history of Michigan. A year later he married his wife, Edythe, also from Detroit; they recently celebrated their 50th wedding anniversary.

Broad recalls earning $67.40 a week, after taxes, his first year as a CPA -- not bad for a newly married 21-year-old in 1954 -- but he quickly grew impatient working for someone else. After two years he started his own accounting firm out of the offices of Donald Kaufman, the husband of one of Edythe's cousins. It was a fortuitous move. In 1957, shortly after he had taken space with Kaufman, a successful real estate developer, the two men decided to go into business together building affordable homes in the Detroit suburbs. Kaufman and Broad Home offered a no-frills house -- no basement, a carport instead of a garage. But their homes sold for significantly less than those built by their competitors.

Broad's career change was the first of many calculated risks he would take. "When I left public accounting, I knew the downside," says Broad, who admits he knew little about homebuilding. "I knew if I failed, I could go back to accounting and not devastate my family."

Broad never went back. Within two years he and Kaufman had sold more than 600 houses in the Detroit area. In 1961, Kaufman and Broad Home became the first U.S. homebuilder to offer shares to the public. A year later the pair moved their company to Phoenix, figuring the Sun Belt offered better growth prospects than Detroit, whose fortunes were too reliant on the auto industry. In 1963, Kaufman retired and Broad continued west, moving the company's headquarters to Los Angeles.

In 1971, Kaufman and Broad Home acquired Sun Life Insurance Co. of America, a traditional insurer founded in 1890. Broad says he looked at the demographics of the post­World War II baby boom and concluded that there was a huge potential market in serving people saving for retirement -- one that such old-line life insurers as Metropolitan Life Insurance Co. hadn't tapped. Through Sun Life, Broad began offering fixed and variable annuities and financial planning services.

In 1989 he split the two businesses. Kaufman and Broad Home returned to its original focus, homebuilding; the annuity and financial planning services business became SunAmerica. Broad stepped aside from the first, relinquishing the role of chief executive the same year and that of chairman in 1993, to concentrate on the second. He continued as chairman and CEO of SunAmerica until the sale to AIG. In early 2000, Broad stepped down as CEO of what became AIG SunAmerica; he retired from the chairmanship last January.

Meanwhile, during the 1970s, thanks to the urgings of his wife, Broad began to build up what has become one of the world's biggest collections of contemporary art. His collection includes works by Jasper Johns, Jeff Koons, Roy Lichtenstein and Andy Warhol. One published report puts the value of the more than 700 paintings and sculptures in his collection at $500 million. Broad makes the collection available to the public through the Broad Art Foundation, which since 1984 has loaned his works of art to more than 400 museums and university galleries worldwide.

"Eli has a keen eye for talent, whether it is identifying a young contemporary artist or investing with an emerging hedge fund manager," says Cantillon Capital founder von Mueffling, himself a collector of 19th- and 20th-century art.

Broad was a driving force behind the creation of the Los Angeles Museum of Contemporary Art in 1979 and served as its founding chairman. He says contemporary art benefits society by asking people to think beyond the limits of conventional wisdom.

That same sensibility has infused his efforts to improve public education. In 1999, Broad and his wife founded the Broad Education Foundation, whose mission is to dramatically improve urban public education through better governance, management and labor relations. In its first six years, the foundation has committed more than $400 million to support various programs benefiting the nation's largest city school systems.

Broad believes that improving schools starts at the top. Like private, for-profit corporations, he says, school districts need top-notch chief executive officers, a role that is played by the superintendents. They also need first-rate principals and teachers. "Our first thrust is to develop a pipeline for high-quality change-management folks," says Kevin Hall, chief operating officer of the education foundation, who oversees its programs.

One key initiative is the Broad Center for the Management of School Systems, which trains leaders from business, education, government and nonprofit organizations and the military. A second is what Broad calls "district transformation." In New York City, for example, Broad supports the Children First program, which gives principals more latitude in how they deploy their budgets. The foundation has also given the city's school system a grant for recruiting and training aspiring principals through its Leadership Academy.

"This is a powerful way to get new ideas and stimulate the community," says Joel Klein, chancellor of the New York City school system. "Eli Broad understands how to change the culture."

The Broad Education Foundation has given about $10 million to New York City education initiatives. "Eli is trying to infuse sophisticated management and entrepreneurial forces into a civil service environment," says Klein, a former assistant attorney general at the U.S. Department of Justice who led the government's antitrust case against Microsoft Corp. "It's not an easy task, but it will happen."

Broad's other philanthropic interest is curing disease. In 2001 he created the Broad Medical Research Program. Daniel Hollander, a professor of gastroenterology at the University of California, Los Angeles School of Medicine, oversees the program, which has awarded about $5 million a year in research grants largely related to bowel disease. "Our objective is to stimulate innovative research and take chances," says Hollander.

In 2003, Broad teamed up with the Massachusetts Institute of Technology, Harvard University and the Whitehead Institute to found a biomedical research center in Cambridge, Massachusetts. He pledged $100 million, which the research center is using to build gene-based tools and applications to study disease at the molecular level.

Broad's ambitious philanthropic agenda depends upon both his willingness to pump more of his own money into the foundations and his ability to maximize the return on those assets. The Broad foundations are required by federal law to disburse at least 5 percent of their assets each year. Add to that an inflation rate of roughly 2.5 percent, and the foundations have to grow their asset base at least 7.5 percent a year just to stay even. Broad, however, isn't satisfied unless his investments return at least twice that.

BROAD BEGAN INVESTING IN ALTERNATIVE INvestments, such as leveraged buyout funds, 25 years ago, first on behalf of his family and then for SunAmerica. He was one of the first limited partners in Theodore Forstmann's Forstmann Little & Co. buyout funds and an early investor with David Bonderman's Texas Pacific Group.

By the late 1980s, Broad had added hedge funds to his alternative-investment mix. He felt that, if carefully selected, they offered greater returns than traditional money managers and index funds and less risk than individual stocks and bonds. "If you pick the smartest people, you are likely to succeed," says Broad. He also likes the fact that, although hedge funds may not offer the highest returns when markets are hot, they offer capital protection when markets are falling.

Broad's first hedge fund investment was with Lampert, who began his career in the merger arbitrage group at Goldman Sachs under future Clinton White House Treasury secretary Robert Rubin. Lampert left Goldman in 1988 to start ESL Investments with the help of legendary investor Richard Rainwater. At the time, Rainwater was managing money for the Bass family, which made its fortune in oil and investments. Much of the $28 million used to launch ESL came from Rainwater, who also provided Lampert with office space. In fact, both Lampert and Bonderman had connections with the Basses. Bonderman, a Harvard-trained lawyer, managed money for Robert Bass from 1983 to 1992 before going off on his own.

"They were stars wherever they were and betting their life with their funds," says Broad. "We wanted to go with them."

Broad never put money with the three most celebrated hedge fund managers of the late-1980s and '90s -- George Soros, Julian Robertson Jr. and Michael Steinhardt. He prefers to invest with managers early on in their careers, when they have a single-minded focus on managing money. By the time he looked at Soros, Robertson and Steinhardt, they were all managing multibillion-dollar funds. Still, says Broad, "we have high regard for them."

In the 1990s, Broad invested with many of today's top managers not long after they put out their first hedge fund shingles. They included Goldman Sachs alum Perry; Ainslie, a former analyst at Robertson's Tiger Management; and Jeffrey Vinik, who had managed Fidelity Investment's Magellan Fund. "They were young, bright, hungry and putting their own skin on the line," says Broad. "They were successful before starting out."

In 2001, two years after selling SunAmerica, Broad decided to set up a family office. Using a headhunter, he hired Adamson to be chief investment officer of the Broad Family Office as well as the foundations. A native Californian with an MBA from Stanford University, Adamson worked for five years as an investment adviser to Lee Bass in Fort Worth, Texas, before being hired by Broad.

Adamson works closely with Katherine McClelland Krieger, a former senior consultant at Cambridge Associates who has served as associate director of investments for the Broad Family Office and foundations since 2001. Between the family office and the foundations, the pair oversee about $5 billion, more than a third of which is invested in alternatives, including hedge funds, buyout funds and venture capital. Roughly $1 billion is invested in hedge funds. That doesn't include Broad's investments with such firms as ESL, which he now considers more of a long-only fund than a true hedge fund. (ESL has just a handful of investments, including major holdings in retailers AutoZone and AutoNation. Its nearly 50 percent stake in the department store chain Sears Holdings Corp. accounted for nearly three quarters of the fund's $13 billion in assets at the end of June.)

When Adamson arrived at Broad's offices on Wilshire Boulevard in Los Angeles in 2001, he inherited four hedge fund positions, including investments in Maverick Capital and St. Francis, Wisconsin­based arbitrage shop Stark Investments. Today, Broad's hedge fund portfolio is invested among 25 or so managers. "We don't want too many funds," says Adamson. "It is difficult to outperform with 40 to 50."

Under Adamson the Broad foundations have outperformed the market, delivering an average annualized return of 15 percent. An important part of that performance has come from Broad's hedge fund investments, which since 2002 have returned about 700 basis points a year more than the S&P 500 index. The hedge fund portfolio trailed the index in 2003, delivering a 16.5 percent return versus the 28 percent gain by the S&P, but Adamson says that is to be expected. "We'll underperform during monster years for the S&P," he says. During the first seven months of this year, Broad's hedge funds were back on track -- up 8.5 percent, while the S&P 500 was up 1.8 percent.

ADAMSON AND HIS TEAM SEEK MANAGERS THEY deem to be among the world's brightest, most focused investors. They draw on a variety of resources to find new talent, including a wide network of family offices and endowments as well as Broad's old buddies at SunAmerica and investment committees on which he sits. Adamson says he even scrutinizes quarterly 13-F forms, which list investment companies' equity holdings as required by the Securities and Exchange Commission. "If some company is an interesting investment, I look at who is invested in it," he says.

Once Adamson identifies a potential hedge fund investment, he talks with the manager, the manager's team and the back office staff -- and also with other investors. "Typically, I know someone in the fund before I talk to the management team," he says.

Adamson began looking at ValueAct Capital Partners, a San Francisco­based fund specializing in activist investing, after he read a story about the firm's investment in Martha Stewart Living Omnimedia. Adamson pulled ValueAct's 13-F, which affirmed what he had read about the firm's strategy of investing in beaten-down companies that are growing well and generating free cash flow. "I called them out of the blue," says Adamson, who invested $25 million in ValueAct.

Although family offices are known for being conservative investors, Adamson stresses that Broad is not overly concerned about a fund's volatility. "Eli is not spooked by short-term negative performance," says George Hamel, co-founder and co­managing partner of ValueAct. "If we do what we say we do, he will stick with us."

Adamson and Broad have a special fondness for former Goldman Sachs proprietary traders. "Goldman is a great firm and a great training ground for hedge fund managers," says Broad. Even though ex­Goldman Sachs traders don't have their own official investment track records when they leave the firm, says Adamson, "most of those guys were managing capital for the partners, so they are good at protecting against big losses."

Broad has invested in seven funds managed by former Goldman Sachs traders, including Perry Capital, Redwood Capital and Silver Point Capital, a multistrategy fund run by Edward Mulé and Robert O'Shea in Greenwich, Connecticut. Silver Point, formed in January 2002, specializes in credit analysis and credit-related investments.

Broad likes former Fidelity Investments mutual fund managers, such as Vinik, for the same reasons he favors ex­Goldman Sachs traders. "They also have a culture of success," he explains. "They know how to take risk and to manage risk. They know how to see opportunities that others don't."

Although Broad doesn't poke his nose into the day-to-day investing process, he still approves all new manager hires. Says Adamson, "Eli's reputation as a very demanding, impatient and accomplished individual is correct."

Krieger says that when she and Adamson are considering a new manager, they must write up a two-page case for making the investment and send it to their boss. Broad usually gets back to them within a day and will occasionally overrule their investment decisions. "He's very quick," says Adamson.

Broad stays on top of the performance results. Adamson estimates that Broad goes through a two-foot-high stack of materials every night. It's not uncommon for him to be able to rattle off a manager's returns compared with the S&P 500 for, say, a specific three- or five-year period.

Broad's real benchmark, though, isn't the S&P 500 but the top university endowments. For the 12 months ended June 30, 2004, their average return was 18 percent, with Harvard leading the way with a 21 percent return, Yale 19 percent, Stanford 18 percent and Princeton 17 percent. The Broad foundations, by comparison, returned 20 percent for that period. "We are looking for investment performance that is among the best," says Broad.

Hedge fund managers consider Broad to be smart money, given that he has built two Fortune 500 companies. "We say to hedge funds, 'You know my history and who we are,'" says Broad, who tells managers they can help others by helping the Broad foundations grow their assets. "They think it is good what we are doing. They want to be part of it."

Krieger says hedge funds like having the foundations' money because, unlike many large institutional investors, the foundations don't demand daily or weekly updates on performance or portfolio holdings. In addition, Broad can commit a large sum of money at one time -- $15 million to $25 million. What's more, his legal team can turn around limited partnership documents in just a few days.

Hedge fund managers like to tap Broad for his extensive business knowledge. They have been especially interested in getting his take on the firestorm swirling around AIG concerning the investigation by New York State Attorney General Eliot Spitzer into how the world's largest insurer may have used finite reinsurance contracts to inflate its earnings. Broad, who served on AIG's board of directors from January 1999 to May 2003, says that many accounting rules are subject to interpretation and some companies are more aggressive in interpreting the rules. Although it's easy to criticize AIG, he says, "the earnings are there." But, he adds, "it's a fine company with a great future that may have pushed the envelope."

Broad and Adamson typically add two or three new hedge funds to the portfolio each year and remove two or three others. They'll bail out of a fund if it suffers massive personnel turnover or persistent underperformance without a clear sign of improving. Last year they gave the boot to three managers, including convertible arbitrage fund Marin Capital Partners, which closed down in June because of "a lack of suitable investment opportunities," according to published reports quoting the fund's investment letter. At the time, the fund was down nearly 4 percent. Adamson says Broad did not lose money on Marin. Meanwhile, Broad says he plans to make his first Asian hedge fund investment soon.

Broad, though, is being very careful these days when selecting new hedge funds. He is concerned that there are too many and that existing ones are raising too much money. "We will have a shakeout," he predicts.

In fact, Broad says that investing in hedge funds may not make sense for the average investor who doesn't have the access to the kinds of superior managers he can tap. "Unless you go with the best and the brightest, I'm not sure you will do better than the best mutual funds," he says.

Invest with the Best
For Eli Broad, the key to successful hedge fund investing is to find the brightest, most focused managers. Since the start of 2004, his portfolio of 25 or so hedge funds, including the eight listed here, has handily beaten the market.

Annualized return* (%)
Portfolio/Benchmark 2004 2005*
Standard & Poor's 500 index 9.00% 1.80%
Broad's hedge fund portfolio 13 8.3
Cantillon World 16 10
Fortress Investment Group 15 7.5
Maverick Capital 14.2 4
Perry Capital Management 19 6
Redwood Capital 22 5
Silver Point Capital Fund 25 5.5
Stark Investments 9.5 3
ValueAct Capital Partners 28.5 7.5
* Returns are net of fees; 2005 figures are through July 31.