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A key woman's leverage

How private equity firm Kohlberg & Co.'s fledgling CDO business nearly came apart when its star portfolio manager left.

On a frigid, overcast afternoon in January, Joyce DeLucca walked into the plush Madison Avenue offices of Katonah Capital, a structured-debt investment firm she had helped build from scratch over the preceding five years. She quickly gathered her 21 staffers and told them she was resigning as managing principal.

When the boss at any Wall Street firm walks out, it usually causes turmoil. But it's particularly disruptive in the rarefied realm of private investment funds, and especially for firms like Katonah that manage collateralized debt obligations -- complex vehicles that issue bonds and preferred stock derived from a diverse portfolio of corporate debt.

DeLucca's departure triggered a little-publicized yet critically important provision in the management agreements of four of the six CDOs she had managed at Katonah, which is owned by New York private equity firm Kohlberg & Co. A "key-man" clause permitted investors in those funds to move their money elsewhere upon the departure of DeLucca, who was deemed critical to the success of the funds -- unless Kohlberg proposed a suitable replacement manager within 60 days. Key-man clauses pertaining to other funds often name a group of critical personnel. But in Katonah's case DeLucca was the sole defined key person, as no one at Kohlberg had any experience managing CDOs

when she was hired from Octagon Credit Investors to launch the firm in December 1999.

Even more disturbing for Kohlberg, DeLucca moved swiftly to establish her own CDO management company with several Katonah employees. Though six months pregnant at the time, DeLucca wasn't about to slow down. She soon received indications from some of Katonah's investors that they would move their assets to her new firm, Kingsland Capital.

Indeed, rather than being a clean break, DeLucca's move set in motion a bitter struggle for control of Katonah's assets that is still wending its way through the New York court system. It also killed a deal that Kohlberg had struck to sell Katonah to Washington-based investment firm Allied Capital, seriously jeopardizing Katonah's future.

The circumstances leading up to the conflict are murky. Each side presents a slightly different version of the facts, and many details remain hotly contested.

What's certain, though, is that DeLucca's defection from Katonah was anything but sudden. A clash of wills between the portfolio manager and her bosses had been escalating for almost two years. Business was fine: In five years running Katonah, DeLucca had amassed $2.25 billion in six CDOs; her portfolios generated impressive internal rates of return in excess of 20 percent, and Kohlberg & Co. collected millions in management and performance fees. But the parent firm was increasingly concerned that the fate of its burgeoning CDO business was too dependent on DeLucca. Kohlberg principal Christopher Lacovara, along with James Kohlberg, who in 1987 had co-founded the private equity shop with his father, leveraged-buyout pioneer Jerome Kohlberg Jr., began pushing DeLucca in the summer of 2003 to hire a second senior portfolio manager. DeLucca chafed at the suggestion, worried about the impact of such a move on her staff, and didn't make the hire. Kohlberg & Co., increasingly frustrated, agreed in November 2004 to sell Katonah to Allied for $40 million.

Allied, spooked by the prospect of Katonah's investors following DeLucca to her new firm, backed out of the deal, leaving Kohlberg to scurry for replacement managers for the Katonah funds and to persuade investors to choose those managers over Kingsland. Kohlberg now shares a portion of the fees for those vehicles with the new managers: Blackstone Group; Sankaty Advisors, a credit-investment affiliate of private equity titan Bain Capital; and Invesco Senior Secured Management, a division of London asset manager Amvescap.

In February, Kohlberg & Co. sued DeLucca, alleging that she solicited staff and planned to form Kingsland while at Katonah, which amounted to a breach of her employment contract, and that she scuttled the Allied sale.

"DeLucca formulated and attempted to implement a scheme to seize control of Katonah's assets for her own benefit," Kohlberg alleges in its complaint, which is pending before the Supreme Court of the State of New York in Manhattan.

DeLucca denies she did anything untoward and has filed a motion in the case for back pay she says Katonah owes her and her team. "There was no plot," she tells Institutional Investor. "In the midst of what I considered to be a productive dialogue about the future of the company, Kohlberg surprised me with a plan to sell." Her attorney, Steven Kayman of Proskauer Rose, adds that Kohlberg "is trying to punish my client for moving on and pursuing her own career goals."

The episode highlights a lurking threat to scores, perhaps hundreds, of firms that manage private funds. Key-man clauses are contained in the agreements governing a variety of private investment vehicles, including most CDOs, as well as private equity, venture capital and hedge funds (see box). The relatively young CDO market, in which about 200 firms manage some $250 billion, relies heavily on the star system embodied by DeLucca. The market continues to grow rapidly, mainly on the backs of small teams of expert managers forming start-ups or being hired by larger organizations.

"In the majority of the cases in the CDO market, investors are relying on one or two people, or maybe a slightly larger group, to make sure that their money is prudently managed," says Drew Dickey, head of the structured-credit team at Babson Capital Management, which manages 43 CDO funds and invests in outside CDOs as well. "That creates the potential for situations like the one you had with Katonah."

DELUCCA IS USED TO FIGHTING FOR WHAT SHE wants. During a career spanning nearly two decades, the native of suburban Babylon Village, about 40 miles east of New York City on the south shore of Long Island, established a reputation as one of the savviest, most successful managers in the macho credit investing world. She joined money manager Bernstein Macaulay as a high-yield and mortgage-backed-securities analyst in 1986, after graduating from Ithaca College in upstate New York. By 1989 she was managing the high-yield portfolio of the real estate and debt investment firm Fisher Brothers. Six years later she co-founded leveraged-debt shop Octagon Credit Investors as a subsidiary of J.P. Morgan & Co.

Bright and charming, DeLucca, 40, can also be firm when the situation calls for it, say people who know her. "Joyce can be as tough as nails," notes one former colleague. "She always felt that she had to prove herself in a man's market."

DeLucca was already a star in the summer of 1999, when Kohlberg decided to diversify its leveraged-buyout portfolio by allocating some cash to CDOs. It was a natural extension of the firm's activities, as CDOs have a capital structure similar to that of leveraged companies. A CDO manager sells bonds, secured by a diversified pool of corporate debt, to its investors. To ensure that the interest rate it pays is lower than what it receives from the debt in the portfolio, the CDO also contains an equity component, which covers the first losses on that underlying debt. The difference between what the manager collects on its debt portfolio and the coupon owed on its own bonds -- minus management fees -- goes to the equity investors. Kohlberg had little experience in the CDO world, but DeLucca had been managing and investing in such vehicles for years.

The firm plucked her away from Octagon, and she began building an investment team. Among her early hires were two senior analysts: Robert Perry, a former Octagon colleague, and Brian Carlson, who had been with Mountain Capital Advisors, the CDO investing unit of Japan's Fuji Bank. DeLucca worked with CIBC World Markets, which had pitched the idea of moving into CDOs to Kohlberg, to line up investors for Katonah. She and her growing team researched and assembled the securities that were bundled together for Katonah's first deal, which had a five-year lockup and closed in May 2000.

Investors in that first fund, however, insisted on protecting their interests with a key-man provision, naming DeLucca in the management agreement. Kohlberg had little choice but to agree.

"Because it was a start-up, we had to really take input from the investors," says Kohlberg principal Lacovara. "They felt they needed to have some protection because Joyce was really the person at the company when we started marketing."

For the next three years, business was great. And so was the relationship between DeLucca and her bosses. Katonah raised four more funds, amassing $1.9 billion on which Kohlberg was collecting a roughly 50-basis-point management fee (about $9.5 million) annually. Kohlberg also earned incentive fees based on the performance of the funds, which were generating internal rates of return in the high teens to low 20s. Katonah's performance stood out as especially strong at a time when many other structured-debt vehicles were suffering huge losses amid a wave of corporate bankruptcies and defaults, particularly in the telecommunications industry, which DeLucca avoided. The debt portions of Katonah's funds were never downgraded, a critical measure of strength for CDOs.

By the summer of 2003, Katonah was about to raise a sixth fund, and Kohlberg & Co. became concerned that the firm's assets were too closely tied to its sole portfolio manager. All but one of the funds were subject to key-man clauses naming DeLucca -- and only DeLucca. Kohlberg had close to $60 million in equity invested in the vehicles and wanted to protect its fee income. The firm was also intent on diversifying into investment-grade and other types of credit vehicles, with which DeLucca was not as experienced, says Lacovara. When the $375 million Katonah VI fund closed that September, Kohlberg for the first time declined to participate as an equity investor.

Kohlberg was aware of potential key-man problems from its experience in private equity. It had taken note, moreover, of the messes the provisions had created for other CDO managers. French investment bank Crédit Agricole Indosuez, for example, became involved in a battle to keep the management contracts of four CDOs following the defection of staff in 2001 to the RBC Capital Markets division of Royal Bank of Canada. It hired a replacement portfolio manager and retained three of the funds, but also lost a $1.4 billion CDO to RBC.

In October 2003, after conferring with James Kohlberg, Lacovara asked DeLucca to hire another portfolio manager, who could serve as an additional key man for the funds. She dug in her heels, arguing that adding another manager would demoralize the investment team she had built, causing employees to worry about succession and compensation issues. Lacovara pressed the issue, however, and DeLucca agreed to retain a search firm, Jamesbeck Global Partners, to find another senior person.

Ten months came and went without a hire. DeLucca contends that Katonah lacked a specific plan for expansion or a defined job description, making it impossible to attract a qualified candidate. At a breakfast meeting in New York in early August 2004, James Kohlberg asked DeLucca to come up with a formal plan for how Katonah could grow its business beyond high-yield CDOs. But he also made clear his frustration at the lack of progress in hiring another manager.

"Either you do this, or we will," he told DeLucca, according to Lacovara, who was briefed on the conversation.

In a memo to DeLucca following the meeting, dated August 4, James Kohlberg reiterated the need for Katonah to hire "a senior management person that can protect our already significant investment, as well as capital required for this next stage of expansion, should anything untoward happen to you." In that same memo, however, he also congratulated DeLucca on the success of the firm to date, signing off "onward and upward."

It was at about that time that DeLucca learned that she was pregnant.

Over the next few months, DeLucca investigated ways to grow Katonah, such as setting up hedge funds and other alternative-investment vehicles. Meanwhile, Allied approached Kohlberg about buying the CDO firm. Kohlberg had ignored similar inquiries before. This time, frustrated with DeLucca, the firm decided to explore a sale.

"We clearly had a deteriorating relationship, and it was not clear how we were going to resolve things with her," says Lacovara. "We were just tired. They caught us at the right moment."

The tension that had been building between the two sides came to a head on November 17, when DeLucca met with James Kohlberg, Lacovara and Kohlberg & Co. principal Samuel Frieder to discuss her strategic plan. She forwarded several ideas, including one that called for Kohlberg to invest as much as $200 million more in the business and direct more of Katonah's earnings to DeLucca and her staff. Before she could get through her pitch, however, the Kohlberg executives broke the news that Allied would be buying Katonah and merging it with its own credit investment firm, Callidus Capital Management. DeLucca and her staff would be offered incentive payments to stay on for at least one year and help with the integration of Katonah into Callidus but would not be guaranteed jobs after that.

DeLucca says she was shocked. And hurt. Though she didn't own Katonah, she had been the face of the firm to investors and employees and regarded herself as primarily responsible for its growth and success. She could be a tough manager but had engendered tremendous loyalty in her staff. In 2004, for instance, she voluntarily took an 8 percent pay cut to increase the compensation pool for subordinates. She was extremely upset that Kohlberg would decide to sell without consulting her.

"I considered it to be as much my company as it was theirs," she says. "My team and I built the culture. It was our track record."

The Kohlberg contingent was annoyed by DeLucca's suggestion that they pour more money into Katonah while ceding a bigger share of the profits to her and her team. Such a proposal, the firm's suit against DeLucca asserts, "could have been offered only by someone who thought she had a gun to the head of the other party, which DeLucca apparently thought she did after well over a year of dissembling with respect to the search for an additional key person. These were lowball offers, the economic equivalent of demanding that Kohlberg surrender Katonah to DeLucca for virtually no consideration."

Over the next few weeks, DeLucca says, she and other Katonah staffers met with Callidus personnel to discuss how the two firms would be integrated. (Allied and Callidus executives decline to comment.) DeLucca also informed her bosses at Kohlberg that she was pregnant. Clearly, in a business in which one person is so critical, an absence due to even a brief maternity leave may be a legitimate source of concern. But both sides emphasize that DeLucca's decision to start a family has nothing to do with the dispute.

By January she and several members of her team say they had become increasingly frustrated by the lack of clarity about their future roles at the firm. On February 2, one week after DeLucca left, Perry and Carlson, along with fellow senior analyst Thomas Liu, who had joined Katonah from Bank of America two years earlier, followed her to Kingsland. Five more team members -- in all, more than a third of Katonah's employees -- would soon join the new firm. Katonah's investors could elect to take their money to Kingsland or to another manager of their choosing.

Kohlberg's immediate option, transferring management of the CDOs to Callidus, was not going to fly with investors. "Callidus is a terrific group, but they are just not very well known in the marketplace," says Lacovara. "It would have been difficult to get investors to agree to that rather than going with a name that perhaps they were already familiar with."

On February 9 the Allied sale was terminated. Five days later Kohlberg sued DeLucca and Kingsland.

LACOVARA WORKED THE PHONES furiously during the rest of February and March, desperate to find established CDO managers to take over the Katonah funds.

Five of the six funds were relatively straightforward transfers. Kohlberg owned all the equity in the first deal and persuaded New York private equity giant Blackstone Group, which also runs a CDO business, to assume its management contract. (The equity investors in a CDO have more say than the noteholders regarding suitable replacements for a key person.) A Japanese investor held the equity in the second fund and had not requested a key-man clause. That vehicle, along with funds III and IV, was transferred to Sankaty Advisors. Katonah V went to Invesco Senior Secured Management.

DeLucca's best remaining shot at retaining some of Katonah's funds came from the $375 million Katonah VI, which she raised just four months before leaving. Kohlberg was not an equity holder. And at least one investor, French insurance company AXA Financial, had indicated a preference for transferring the fund to Kingsland. But AXA did not constitute a majority of the fund's investors. It soon joined other holders in voting to move the CDO to Blackstone -- after a lobbying effort by the private equity firm, to which AXA has long-standing ties. (Blackstone president Hamilton James headed investment banking at Donaldson, Lufkin & Jenrette when AXA was the firm's majority owner; Blackstone and AXA also invest in each other's funds.)

Lacovara had successfully found new homes for all six funds. But the outcome was less than optimal for Kohlberg & Co., which is now sharing with the outside managers the fees it used to keep for itself.

"We get some residual fees from some of the funds," says Lacovara. "It was not a great economic deal for us. It was okay, but it was nowhere near the kind of income the company was enjoying prior to all this trouble."

In April, DeLucca gave birth to a baby girl, Layla. Three months later Kingsland closed its first CDO, a $400 million fund. The most senior portion of the debt for the vehicle cost Kingsland just 25 basis points over LIBOR, one of the lowest-priced deals ever for a CDO, according to several bankers and analysts familiar with the deal.

Even though Kingsland didn't wind up with any of Katonah's assets, Kohlberg is pressing on with its lawsuit, which alleges that DeLucca solicited staff and planned to form Kingsland while at Katonah. DeLucca strongly denies Kohlberg's accusations. She has also filed a claim against Kohlberg asking for back pay for herself and several ex-Katonah employees whose bonuses, she says, were determined before they left but were never paid by Kohlberg, which declines to comment on the claim. The judge in the case, which is now in the discovery stage, has encouraged the parties to submit to mediation.

Kohlberg, for its part, remains committed to Katonah, which it has rechristened as Katonah Debt Advisors. In May the CDO firm hired E.A. Kratzman, a 25-year veteran of the credit market and a founder of Institutional Debt Management, a syndicated loan manager that is now part of Massachusetts Mutual Life Insurance Co. Most recently, Kratzman had been part of the debt securitization group at Rabobank in New York. Katonah is working with Goldman, Sachs & Co. to raise its seventh fund and still plans to diversify into other forms of debt management.

But the firm has also learned a painful lesson.

"Having a single key-person designee in a fund with a five-year lockup is fundamentally destabilizing," says Lacovara, who adds that Katonah will try to avoid having a key-man clause in the new fund. "Our view is that you should either have nobody, or you should have multiples."

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