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Lesson Learned

Lazard lost nearly $3 billion in hedge fund assets after star manager William von Mueffling left. Now that the firm has recouped that money, it is trying to make sure that the same thing never happens again.

In January 2003, Lazard’s $3.8 billion hedge fund business was riding high. Led by star manager William von Mueffling — who had delivered an annualized return of 58 percent from August 1998 through December 2002 running the Lazard European Opportunities fund — the venerable investment bank seemed on the verge of becoming a major player. But behind the scenes Lazard’s hedge fund business was about to collapse.

In a bitter dispute over compensation, von Mueffling, then 34, was threatening to walk. He wanted to be paid in

proportion to his team’s contribution to Lazard Asset Management, the money management arm of the firm. In 2002, von Mueffling’s group had accounted for an estimated 25 percent of LAM’s revenues.

Von Mueffling’s demands required a cultural change that Lazard was unwilling to make. Bruce Wasserstein, the legendary deal maker brought in by Lazard senior partner Michel David-Weill one year earlier to head the firm, was known for paying plenty for the best people, but he couldn’t hold on to von Mueffling.

Lazard wasn’t willing to single out one person for the group’s success. In a statement at the time, the firm said, “Hedge fund management at Lazard is a team effort, and one of the team has resigned.” Von Mueffling wasn’t mentioned.

But his departure proved devastating for Lazard. By the time he resurfaced eight months later as the head of his own firm, New York–based Cantillon Capital Management (see box, page 33), von Mueffling had been joined by several of the people who had helped manage about $3 billion in hedge fund assets at Lazard. Many of Lazard’s hedge fund investors also followed von Mueffling to Cantillon. LAM’s hedge fund assets fell to just $900 million.

The von Mueffling debacle was a public blow that came at a very delicate time for Lazard, a private partnership that Wasserstein was lobbying to take public against opposition from David-Weill, whose great-grandfather co-founded the investment bank in 1848. Wasserstein knew it was crucial to portray the firm as stable, growing and well managed — not the image projected by the problems at the hedge fund business.

After finally securing David-Weill’s consent, Wasserstein took Lazard public in May 2005, a move perfectly timed for the recent boom in investment banking, Lazard’s specialty. As of mid-September its shares were trading at about $40, up 60 percent from its $25 IPO.

Lazard began rebuilding the hedge fund operation well before the IPO. In March 2004, Wasserstein hired longtime confidant Ashish Bhutani as CEO of LAM, which manages about $80 billion in long-only funds for institutions, financial intermediaries and wealthy individuals. Under Bhutani, LAM has launched nine new hedge funds — three by existing portfolio management teams and six by managers who have been recruited from outside the firm. LAM has marketed the funds to a broad group of investors around the world, including pension funds and other institutions, some of which had previously had money in its funds. Now, three and a half years after von Mueffling’s departure, the hedge fund assets are back to $3.8 billion.

“The hedge fund business is an important part of what we do for our clients,” says Bhutani. “It is a fantastic extension of our asset management business.”

But as Lazard was playing catch-up, the hedge fund universe was expanding. In 2003, Lazard was No. 39 on the Hedge Fund 100, a ranking of the world’s biggest hedge fund firms by Institutional Investor’s sister publication, Alpha, with year-end 2002 assets of $3.3 billion. This year, based on its year-end 2005 assets of $3.5 billion, Lazard narrowly failed to make the list.

That doesn’t seem to faze Bhutani. “We could easily be significantly larger,” he says. “But we are selective because we don’t want to dilute the power of the brand. We are not looking to be the biggest. We’re looking to be the best.”

For Lazard, as with most asset management firms, the hedge fund business is a potent moneymaker. Though just about 4.5 percent of total assets, hedge funds accounted for about 20 percent of LAM’s $466 million in revenue in 2005. Lazard’s long-only funds charge, on average, a management fee of 65 basis points; its hedge funds charge a management fee of 150 basis points and an incentive fee of 20 percent of performance.

Incentive fees can be a huge profit driver for hedge fund firms, but the recent performance of some LAM funds has been mediocre. Bhutani and other top LAM executives say that they judge the success of a fund over three to five years. Most of their new funds have been around for less than two.

The biggest long-term challenge for Lazard may be retaining top-performing hedge fund managers. Balancing the interests and the compensation requirements of its hedge fund business with those of its traditional asset management business remains difficult.

“We believe we provide a very competitive and fair compensation package for our professionals,” says Bhutani, who seems determined never to provoke a showdown with a star fund manager who proposes to leave and take important clients with him. He contends that Lazard has created meaningful incentives for skilled professionals to run hedge funds and make substantial sums of money.

Asset management firms customarily pay their hedge fund managers at least half of the incentive fee. Although LAM won’t give specific details, John Reinsberg, deputy chairman for international and global investments, says: “Investment teams receive a generous portion of the management and performance fee. It’s very much a pay-for-performance business.” At the same time, the firm has crafted a set of contractual terms, including deferred compensation clauses, that provide strong disincentives for its managers to leave.

Ashish BHUTANI HAS KNOWN Bruce Wasserstein since 1989, when he was recruited from Salomon Brothers to Wasserstein Perella Group to work with the investment banking boutique’s most important high-yield-debt clients. The Indian-born Bhutani, who has an MBA in finance and international business from New York’s Pace University, went on to become deputy chairman of Wasserstein Perella and later co-CEO for North America of Dresdner Kleinwort Wasserstein after Dresdner Bank bought Wasserstein’s firm in 2001.

Not long after Bhutani took over as head of LAM, he sent the firm down two tracks to rebuild its hedge fund business. One was to launch hedge fund products using in-house investment teams that were already running strategies for the firm’s institutional funds. LAM has created three funds this way: Lazard Emerging Income, Lazard European Discovery and Lazard World Alternative Value (see box, page 34).

Co-managers Ardra Belitz and Ganesh Ramachandran run the Emerging Income fund, which was launched in March 2004. The fund invests in very-short-term financial instruments, looking for opportunities in countries such as Tanzania and Egypt.

In October 2005, Lazard launched the European Discovery fund, which invests in as many as 40 equity securities of European companies that have a market capitalization of E1 billion ($1.27 billion) or less. The fund, managed by Brian Pessin and Edward Rosenfeld, follows a long-only strategy.

Earlier this year Lazard launched the World Alternative Value fund to invest in equity securities whose share prices trade at a discount to their underlying net asset value. Manager Kun Deng trolls for buying opportunities among closed-end funds, investment trusts and corporate restructurings. He hedges by shorting closed-end funds trading at a premium to net asset value, exchange-traded funds and various indexes.

Lazard’s second approach for developing new funds is to lure managers or entire teams from other firms, looking for people thinking of starting their own hedge funds but not interested in dealing with the noninvestment tasks that come with running a business. Lazard has hired three such groups so far. In December 2003 the firm recruited Robert Rowland from New York–based Soros Funds, where he had managed European equities for the Quantum Endowment Fund. Rowland, who spent seven years at Soros, manages LAM’s European Explorer fund, which began investing in March 2004.

Also in 2004, Lazard brought in Matthew Bills and his Japanese long-short team from Deutsche Asset Management to start the Japan Alternative Investment Series. Bills, a onetime Fidelity Investments analyst and portfolio manager, is based in Japan. The four funds, which pursue different strategies, were launched between October 2005 and June of this year.

Lazard also grabbed a team of six people from Deutsche Bank’s Scudder group. They run the Lazard Korea Corporate Governance fund. Launched in April, the fund is led by John Lee, who previously had run the Korea Fund, a closed-end mutual fund, since 1991. The new hedge fund invests in small- and midcap South Korean equities that are expected to benefit from improving corporate governance.

Bhutani would like to grow LAM’s hedge fund business to a dozen or so teams. But to avoid tarnishing the Lazard name, which is still powerful, especially in Europe, he is being picky. The three teams Lazard has recruited were chosen from roughly 250 groups that the firm interviewed. Rowland and his team, for example, met with Lazard several times before signing their deal.

Lazard’s selectivity is comforting to some of the firm’s longtime investors. “We’re happy that Lazard doesn’t have a high profile,” says Clayton Young, assistant treasurer at White Plains, New York–based engineering and manufacturing company ITT Corp. “They are not asset gatherers.” ITT, which has had money in Lazard’s long-only offerings since the mid-1990s, recently invested in the World Alternative Value fund.

Lazard looks for managers whose investment processes are coherent, explainable and, most important, repeatable. Potential managers must have a good track record running money using their strategy.

Like other big asset management firms, Lazard tries to lure talent by providing the infrastructure that managers need to run their businesses, including sales, marketing, trading, back office, compliance, accounting and client service. “The great thing Lazard has to offer is, it allows managers to do what they should do — manage money — and not focus on operations,” acknowledges von Mueffling.

In addition, Lazard touts the advantages that come from being part of a big, successful asset management shop: access to corporate management and to LAM’s network of about 60 analysts, as well as the firm’s huge asset base and investment clout.

The analysts are an integral part of the investment process. Lazard sets aside a bonus pool from the hedge funds’ performance fees that the analysts share based on their contributions to the funds’ returns. Sharing the performance fees with analysts helps Lazard recruit and retain top people.

Essentially, Lazard is challenging managers to choose between making more money for themselves and presiding over a potentially bigger business within LAM’s supportive organization. However, von Mueffling’s solo performance makes this recruitment pitch a tough sell. He is a paradigm of the benefits of being entrepreneurial. He has made more than $100 million in 2004 and at least $200 million in 2005.

Bhutani admits that successful managers could make more money on their own. But he stresses that Lazard offers significant advantages. Japan Alternative Investment Series manager Bills considered going independent, but he joined Lazard so he could spend all his time on investing and have access to the firm’s intelligence. Rowland agrees: “Lazard Asset Management has a powerful intellectual pool to bounce ideas off.”

The challenge of attracting and retaining talented hedge fund managers is not unique to Lazard. Jes Staley, New York–based global head of asset and wealth management at JPMorgan Chase & Co., which manages $900 billion, including $25 billion in hedge funds, says every firm has to deal with this issue when developing and growing a hedge fund business within a big asset management operation.

“The most important thing is for the traditional investment management people to agree that growth in the [hedge fund business] makes sense,” he says. “It’s not easy.”

Staley says he asks people to grant him the premise that the amount of money customers are willing to pay for a service is a fair measure of how much value they attribute to it. Investors “will pay 200 basis points and 25 percent [of performance] for a hedge fund manager they have confidence in,” Staley explains. “They are voting with their wallets and by the fees they are paying.”

FOR ALL OF ITS SELECTIVITY, Lazard has yet to establish its newer funds as top performers — and some of its older ones are faltering. The Emerging Income fund, for example, was up 2.44 percent in 2005 and 2.77 percent through the first six months of this year. That compares with 10.82 percent and 4.69 percent returns for the Eurekahedge emerging-markets fixed-income hedge fund index during the same periods.

LAM’s European Explorer fund’s performance has been inconsistent. The $700 million fund was up 10 percent last year. “For a European fund, that is not great,” says Antoine Bernheim, a consultant to European investors. Indeed, the average European fund rose nearly 13 percent last year, while von Mueffling’s Cantillon Europe fund was up about 26 percent. Although European Explorer lagged the comparable Eurekahedge European index in 2005 (up 10.1 percent versus 12.7 percent), it has been beating its benchmark for the first six months of this year (up 8.5 percent versus 5.43 percent).

Meanwhile, Lazard’s $800 million Global Opportunities, a global long-short equity fund launched in 1993 and run by Michael Rome, has faded from its past glory. According to an April 2001 interview published on Bernheim’s Web site, hedgefundnews.com, during the preceding eight years, Global Opportunities had an average annualized return of 22.4 percent. In four of the past five years, however, its returns have ranged from –1 percent to 6 percent. Even in 2003, when the fund was up 22 percent, it underperformed the broader market; the MSCI world index was up a net 33.1 percent that year. For the first six months of this year, the the fund rose 2.64 percent, compared with 5.49 percent for the Eurekahedge global hedge fund index.

Despite its less-than-stellar investment performance, Lazard has attracted a wider array of investors than it had a few years ago. When von Mueffling was the star, the bulk of the firm’s assets were European, including a large chunk from private Swiss banks and their wealthy clients. These days Lazard has a more diverse client base, including endowments, foundations, high-net-worth individuals and funds of hedge funds. It has also attracted more clients in the U.S. and Asia.

“It has a solid institutional base of business,” says Bernheim. Indeed, many investors say Lazard’s name still has a fair amount of cachet.

Although investors were disappointed to see von Mueffling leave, Barclay Leib, a portfolio manager at Weston Capital Asset Management in Westport, Connecticut, defends Lazard’s decision to let him get away. “There comes a point in the relationship between a larger institution and a talented individual where it is very difficult to make the economics work,” says Leib, whose firm manages $1.7 billion.

Lazard has also made some critical changes to its compensation agreements to ensure that the departure of someone with von Mueffling’s clout doesn’t recur. The manager contracts call for substantial deferred payments over several years. Lazard won’t elaborate further. And the firm has added restrictive covenants that prevent managers from working with other investment firms and from signing up Lazard clients for a specified period of time after they leave.

“Firm arrangements make firm friends,” says Rowland. “I like the clarity of my contract. I have a very good deal.”

Notes Bhutani: “We believe we provide a very competitive and fair compensation package for all of our professionals. They are generously compensated in years in which they perform well, and can still receive a reasonable compensation in the years when performance is not as strong. This structure better aligns the interests of our clients, portfolio managers and the firm. I believe that, if we had this in place in years past, managers would have had a stronger incentive to stay.”

That hoped-for staff stability can only help Lazard and its investors. So far the firm has recouped all the hedge fund assets it lost following the departure of von Mueffling, thanks to its ability to create and market new strategies and its brand-name appeal. Although Lazard has struggled to put up outstanding investment returns, even as its former star is thriving, Bhutani is confident that his current group of hedge fund managers will be able to turn around their performance.