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Principal player

Scotsman James McCaughan has turned around Iowa insurer Principal Financial's lackluster asset arm. But some critical chores remain, like going fully global.

Initial public offerings were one tough sell in the weeks after 9/11. So Principal Financial Group scored a coup with its October 23, 2001, IPO. The Des Moines, Iowa­based insurer's shares started the day at $18.50 and closed at $21.

"Given the turbulence in the markets, we were very pleased with our price," recalls J. Barry Griswell, the CEO of Principal, which the market valued at $6.7 billion. Like other demutualizing insurers, Principal wanted greater access to capital, but Griswell also cites the benefits of a heightened corporate profile. "We thought, quite frankly, that there was a branding issue," he says. "As a public company, you're on people's radar screens."

Principal is certainly on those screens now, and much of the credit goes to the man Griswell hired not long after the IPO to revitalize the insurer's sluggish investment arm. The heart of the CEO's strategy for Principal was to build its asset management business into a substantial and truly global operation. The IPO was pivotal to this. But Griswell was sure that no existing Principal executive was right for the job.

So he started interviewing outside candidates for CEO of what would become a new Principal money management group. One prospect impressed him from the start. Scotsman James McCaughan, a 28-year industry veteran, was CEO of Credit Suisse Asset Management's Americas division. While at CSAM, and earlier as a top executive at UBS, the Cambridge University­educated Glaswegian had amply demonstrated that he could lead a big money manager into new markets, execute tough turnarounds and clean up after messy mergers.

No less important, Griswell felt confident that McCaughan's low-key temperament would mesh nicely with Principal's Midwestern culture. "Jim was thoughtful and contemplative," Griswell says, "but not aggressive or opinionated."

McCaughan joined the renamed Principal Global Investors in Des Moines in March 2002 and immediately began to vindicate Griswell's judgment. The PGI chief has dramatically improved portfolio performance, in part simply by freeing Principal's portfolio managers from having to hobnob with clients. Four years ago, 75 percent of PGI's funds ranked in the bottom two quartiles of their peer groups on three-year returns, according to Morningstar; for 2005, 85 percent of PGI's 13 funds placed in the top two quartiles, and equity performance was especially improved. PGI's small-cap value equity fund, for example, returned 10.6 percent last year, versus 4.7 percent for the Russell 2000 value index. Its international core equity fund gained 23.4 percent, versus 13.5 percent for the MSCI Europe, Australasia and Far East benchmark.

"Transforming investment performance was the necessary first step in growing our business," says McCaughan, 53. "We're on our way."

Obviously helped by the good performance numbers, the CEO has built a sizable institutional business virtually from scratch: Pension, endowment and subadvisory assets have more than quintupled, from $8 billion at the end of 2001 to $42 billion at the end of 2005. PGI's total assets grew a solid 18 percent a year, on average, in that span, from $83 billion to close to $160 billion. Though still a small part of Principal's vast insurance empire, PGI chipped in 4.6 percent of revenues and 10.1 percent of pretax earnings last year -- compared with 2.1 percent of sales and 5.4 percent of profits in 2001.

A Scotsman might call that a bonnie job. Yet McCaughan has yet to deliver on a number of critical fronts, as he readily admits. He wants to bolster PGI's commitment to equity -- like most insurer investment arms, PGI is fixed-income slanted -- but the group's asset mix is even more heavily weighted to bonds than it was when he arrived. Stocks make up barely one fifth of PGI's portfolios.

Nor has McCaughan taken the globe by storm. PGI's international presence is minuscule: $8 billion in foreign-owned institutional assets.

What's more, the group's pretax margins of 27.3 percent are well below the average of 39 percent for large global money managers, according to Boston Consulting Group. In 2005, PGI had pretax earnings of $114 million on revenues of $417.3 million. That is a healthy increase from pretax earnings of $54.2 million on revenues of $192.6 million in 2001, but the margin then was slightly higher. One reason for the slim (only by money management standards) PGI margin: a push to win institutional business by offering cut-rate fees.

For comparison's sake, PGI's parent, Principal Financial, reported 2005 pretax earnings of $1.13 billion on revenues of $9.03 billion, for a margin of about 13 percent. It derives the bulk of its sales from life and health insurance and retirement services. Shares traded last month at $48.

Like other middle-bracket money managers, PGI confronts issues of size and scale. It ranks 45th in Institutional Investor's most recent ranking of the 300 largest U.S. asset managers (July 2005); PGI's assets as of year-end 2005 were $158.9 billion. It has 12 offices and 1,036 employees. Amid relentless industry consolidation -- Merrill Lynch & Co.'s $8 billion deal in February to swap its asset management group to BlackRock for a 49 percent stake in the money manager is just the most vivid recent example -- PGI and like-size firms can't help but wonder: Are they too big to get by as boutiques but too small to compete with the megafirms?

"We're confident we have good scale to grow," says McCaughan, shrugging off the idea of a middle-gauge crisis. "I believe that Principal Global Investors already has the clarity of purpose that some recent deals appear to be seeking."

McCaughan's own intense focus is evident in his efforts to turn around performance. To begin with, the CEO increased PGI's analyst corps from 82 to 102. Principal has long been a fundamental manager, and 73 percent of its equity assets and 100 percent of its fixed-income assets are actively managed. (By contrast, T. Rowe Price, with $100 billion more under management, has 92 analysts.)

McCaughan, a onetime portfolio manager, was gratified to discover how talented and effective PGI's portfolio managers were, when they weren't being diverted by client servicing. "I was surprised by the high quality of people here when I arrived," he says. "I thought coming in that I'd have to do more hiring." Notes head of relationship management Dave Reichart: "It was a problem when portfolio managers had multiple duties. Jim quickly solved that issue."

McCaughan doubled PGI's institutional sales force, to 12, and he upped the client service and relationship management staff from 12 to 29. That was liberation day for the portfolio managers, who had frequently been called upon to chat up clients and even do marketing. "Insurers often lack a strong infrastructure for sales and client service," notes Ben Phillips, a managing director and money management analyst at Putnam Lovell. Principal CEO Griswell had no objection: "Jim freed up investment professionals to do what they do best."

Most critically, McCaughan instituted clear performance incentives. Portfolio managers who achieve top quartile performance can earn a bonus that is several times their base salary. But if they fall below the median, they receive no bonus at all. Before McCaughan took charge, an underperformer would have lost some, but not all, of his or her bonus.

"That allows them to concentrate, but it also means there's no place left to hide," the CEO says. He adds that "a lot of naysayers would argue that a company coming from an insurance heritage can't really be successful in institutional asset management. We're proving that to be wrong."

Pat Halter, head of Principal Real Estate Investors and a 21-year company veteran, likes the impact of the new pay regime. "There's a very definite alignment of compensation and performance," he says. "People have a new incentive to succeed."

McCaughan is still working, however, on that stock-bond imbalance. At the end of 2005, bonds represented 59 percent of PGI's assets, equities 21 percent and real estate 20 percent. (PGI has no alternative assets.) By comparison, four years ago bonds made up 49 percent, stocks 28 percent and real estate 23 percent.

The lopsided bond tilt partly reflects the strong demand for fixed-income mandates among PGI's pension fund clients. It also stems from PGI's August 2003 $101 million acquisition of Post Advisory Group, a Los Angeles­based high-yield-bond manager with $6 billion in assets. But the equity underrepresentation also suggests that institutions tend not to think of PGI for its stock-picking talent.

To expand the equity base, McCaughan paid $70 million in October 2004 for a 70 percent stake in Columbus Circle Investors, a New York­based growth-stock manager with $3.5 billion under management. In January 2005, PGI shifted about $1.5 billion in large- and midcap growth stocks from its portfolio to Columbus's. At the end of last year, the subsidiary's assets totaled $6 billion.

In some ways, increasing PGI's foreign assets is a more straightforward proposition than upping the equity contingent. "Growing our international business is a top priority," declares McCaughan.

In part through joint ventures with local firms in emerging markets, PGI has amassed $14.5 billion in foreign retail assets as of the end of last year, up from $3.7 billion at year-end 2001.

McCaughan's goal is to bulk up PGI's non-U.S. institutional assets and strengthen the Principal name in Europe and Asia. One base on which to build: a Dublin-based offshore funds platform with roughly $2 billion in institutional assets. They're the remains of Principal Financial's 1999 acquisition of BT Funds Management -- the bulk of the business was sold in 2002.

During his tenure, McCaughan has increased PGI's non-U.S. staff from 30 to 55 and opened an office in Tokyo to complement those in London, Singapore and Sydney. The CEO has also redeployed portfolio managers and analysts so they work in the same time zones as their investments. The two managers of PGI's global emerging-markets portfolio had to abandon Des Moines, in one case, and Singapore, in the other, for London. Still, PGI's non-U.S. institutional assets, though up almost fourfold in the past three years, are, at $8 billion, still paltry by the standards of major U.S. money managers.

Yet McCaughan has no plans to mount a full-blown foreign expeditionary force. He reasons that the best approach is to begin by selling a few compelling niche products, such as dollar-denominated mortgage-backed securities (popular with German banks), and slowly build PGI's reputation abroad. The 2001 purchase of Stamford, Connecticut­based Spectrum Asset Management (assets at the time: nearly $1 billion) gave PGI expertise in a strategy that is being adopted by more and more European pension funds: preferred securities.

Consultants are aware of McCaughan's revitalization project, but many remain skeptical of PGI. "We've been approached by Principal, but we haven't given them any money," says Michael Rosen, principal and CIO of California consulting firm Angeles Investment Advisors. "They certainly have a decent track record, but there are a handful of organizations that are outstanding top to bottom -- analysts, portfolio managers, IT, client service." Principal, he says, is not yet on that list. "I'm sure a lot of people just don't know them very well," suggests Jeffrey Nipp, director of investment manager research at Watson Wyatt Worldwide. "We don't usually get to Iowa."

To reel in pension clients, McCaughan has in some cases resorted to very aggressive pricing, which wins business but puts pressure on PGI's margins. Last April, for example, PGI won a $1.1 billion fixed-income mandate from the Iowa Public Employees' Retirement System. Donna Mueller, CEO of Ipers, says her fund narrowed the candidates down to two finalists: Principal and Pimco Advisors. Pricing put Principal over the top. "The fees played a big part in our decision," says Mueller, adding that PGI's bid was "noticeably lower." The firm will receive just 5 basis points a year in base compensation. The industry standard, according to Putnam Lovell's Phillips, is about 25 basis points. PGI can earn an additional 11 basis points, but only if it exceeds the Lehman aggregate benchmark.

Griswell is happy to go along with McCaughan's sacrificing of some short-term profits to build PGI's presence in pensions. "I'm certainly willing to give up a little margin to get more scale and to become better known," says the Principal chief. But "we want to make sure the performance is sustainable. The jury is still out on whether it can be. I certainly think we can sustain it. And clearly, we've got a lot of growth potential."

COLLEAGUES AND SUBORDINATES DESCRIBE McCaughan as forceful but fair. Says George Jamgochian, who worked for him at UBS and Credit Suisse and is now director of marketing and client services for London-based Financial Risk Management, a fund of hedge funds: "You could say the stupidest thing in the world, and he'd wait for you to finish. Still, he sets standards, and he tells you if you don't measure up to them. He's a very strong personality."

The son of a civil servant in Scotland's Department of Employment, McCaughan grew up in the small town of Campbeltown, on western Scotland's Kintyre Peninsula, and in Glasgow. He earned his Cambridge degree in mathematics in 1973. His first job was as an actuary with Lane Clark & Peacock; it was at the London accounting firm that he came to understand how revealing -- or misleading -- financial numbers could be. "When it comes to accounting," he says, "I basically don't believe in anything other than market value."

In 1978, McCaughan signed on as a junior analyst at Phillips & Drew, the respected British money manager. When in 1979 the U.K.'s financial regulators allowed pension funds to make foreign investments for the first time, he was thrust into the role of instant internationalist. "As a young analyst working on global equity markets, I was a neophyte, but so were my colleagues with 20 years' experience," McCaughan remembers. In 1980 he was tapped to run a small Japanese stock portfolio, which did well. When Phillips & Drew was acquired by UBS in 1986, McCaughan stayed with the firm.

In early 1987 he won a major promotion, becoming president of UBS Phillips & Drew International Investment. McCaughan took charge of building up the firm's almost nonexistent foreign asset management business. His specific mandate: kick-start growth by signing up U.S. pension funds. He smartly opted to market the firm's expertise in international equities. With support from UBS -- and despite the sting of Black Monday -- McCaughan gathered in some major accounts. Between 1987 and 1994, UBS Phillips & Drew's international assets increased from virtually zero to $7 billion, with most of the growth coming from U.S. pension plans.

For the next two years, McCaughan ran UBS's $200 million-plus global institutional asset management business from Zurich, supervising the European and U.S. operations and working to develop a nascent business in Japan and East Asia.

His success brought him a tough challenge. Named president of UBS Asset Management (New York) in September 1996, McCaughan was tasked with launching a turnaround of the Swiss bank's unprofitable U.S. money management operation, whose assets totaled $35 billion.

"Like many troubled money managers, it was trying to do too much," McCaughan says. He focused on the manager's strengths, which included expertise in core fixed income, oil and gas and private equity. McCaughan streamlined the group, unloading an unprofitable cash management unit and slashing the payroll from 225 to 155 employees. Within about nine months the business was in the black. "It's never easy, but if we hadn't taken this action, the organization would have sunk," he says.

No sooner had McCaughan stabilized the operation than UBS announced its merger with Swiss Bank Corp., in December 1997; the deal closed in June 1998. As a result of the merger, UBS Asset Management combined with SBC Brinson, the product of Swiss Bank's 1995 acquisition of Brinson Partners, the widely admired U.S. asset manager founded by industry legend Gary Brinson. "Brinson was a very good firm, and Brinson was a very good CEO," McCaughan says. "They didn't need me, so I left. It was the graceful thing to do."

Through a headhunter, McCaughan landed the post of president of New York­based Oppenheimer Capital in April 1998. Pacific Investment Management Co. had acquired Oppenheimer five months earlier, and when Allianz Group acquired a majority interest in Pimco in September 1999, McCaughan again found himself out of a job: The German insurer's senior management wanted the chief operating officer of Pimco to run all of the U.S. money managers owned by Allianz-Pimco, including Oppenheimer.

A headhunter introduced McCaughan to Credit Suisse Asset Management CEO Phillip Colebatch, who offered him the job of CSAM CEO for the Americas. McCaughan started in April 2000. His mission: to integrate CSAM acquisition Warburg Pincus Asset Management ($25 billion in assets) with CSAM America ($45 billion).

McCaughan arrived just as the postbubble bear market was beginning to bite. That was not the only complication. In July 2000, three months after McCaughan started, Credit Suisse Group bought Donaldson, Lufkin & Jenrette, which had an asset management arm with $30 billion in assets, most of them low-fee cash management accounts. McCaughan thus had to integrate three businesses at once, amid a "vicious bear market," as he puts it.

He instituted sweeping layoffs and cost cuts. Jamgochian, who worked for McCaughan during this period, says the CEO handled the grim reaper task as well as anyone could. "The process was fair and orderly," Jamgochian says. Adds Rodger Smith, a managing director of consulting firm Greenwich Associates who observed McCaughan's tenure at CSAM: "He walked into an incredibly difficult situation. This was one of the worst times to have to integrate different operations."

Amazingly, though, the turmoil only intensified when in July 2001, Credit Suisse First Boston CEO Allen Wheat was replaced by former Morgan Stanley president (and current CEO) John Mack. Several months later, Colebatch left -- one of many executives who jumped ship or were pushed overboard in the early months of Mack's reign. (In July 2002 he joined Swiss Re.) McCaughan found himself without his chief corporate sponsor. "Losing Phillip was quite a blow to my position in the firm," he says. He was soon out the door, and once again the headhunters came calling.

McCaughan joined Principal in March 2002. At PGI the challenges may not be as dramatic as they were at CSAM, but they are just as real -- and they don't let up.

Take 401(k)s. Principal ranks as the seventh-largest plan provider, a solid position that should allow it to emerge intact as a major industry player from an ugly shakeout that many see looming for the defined contribution business. The insurer's 401(k) assets have surged in four years, from $37.1 billion to $63.1 billion.

Paradoxically, though, PGI funds' share of those assets has slipped from 80 percent at the end of 2001 to 60 percent ($37.9 billion) at the end of 2005 -- despite the funds' enhanced performance. The reason is that Principal has increasingly resorted to open architecture -- offering other asset managers' funds to 401(k) participants alongside its own -- to woo plan sponsors. PGI has captured just $800 million in defined contribution assets from other plan providers. McCaughan aims to amass a good deal more over the next few years.

But elsewhere in the subadvisory market, PGI has scored substantial gains. Says marketing chief Scott Leiberton, "Jim originated the third-party distribution initiative, which is now showing real momentum." At the end of 2001, the firm managed just $1.2 billion in assets for other financial institutions; as of year-end 2005, that coveted category had shot up to $13.2 billion. To cite a couple of examples, PGI manages several closed-end exchange-traded bond funds for Nuveen Investments and preferred securities portfolios for ABN Amro.

McCaughan has been especially aggressive, and fairly successful, in pursuing subadvisory business from insurers; they feel comfortable with PGI's insurance heritage and affiliation.

Scottish Re Group, for instance, a Bermuda-based life insurance reinsurer, hired PGI for fixed income about three years ago and now invests more than $1 billion with it. Gregory Winn, the reinsurer's chief investment officer, says, "We've been very pleased with Principal Global Investors' performance." He is impressed with PGI's analysis of commercial mortgages and private placements. "PGI has the capability to evaluate these specialty offerings, which not everyone does," Winn notes.

Clearly, PGI is starting to thrive. But is it still at risk of getting stuck in the mediocre middle as the money management industry consolidates? Principal Financial has the muscle to make a major acquisition on PGI's behalf -- the insurer has about $1.6 billion in cash and cash equivalents and today boasts a market cap of $13.5 billion -- but McCaughan has been mostly quiet on the takeover front. He did those two small deals, Post Advisory and Columbus Circle, and the $9.5 billion they brought to the PGI party is nothing to sneer at. But neither is it the kind of sum that changes a firm's scale. Should McCaughan orchestrate a major acquisition -- buy an equity manager, say, with lots of assets under its roof?

"Would I rule out a big acquisition? Absolutely not," McCaughan says. "But we don't need to do any acquisition at all. We can continue to grow organically."

PGI can assuredly do that, provided it keeps on delivering solid performance. "We need to keep executing," McCaughan says. "We need to keep producing good returns. I worry about that more than anything." If it's any comfort to him, his Scottish clan motto is "Per Ardua ad Alta," which roughly translates as "Safe be McCaughans through difficulty to the top."