This content is from: Home

Dog Days of Alpha

Goldman injects cash to shore up a big fund but faces a major drop in performance fees.

Goldman, Sachs & Co. got a black eye in August when some of its highest-profile hedge funds plunged in value, but the blow may be worse than it first seemed.

Market turmoil slammed the firm’s $6 billion-in-assets Global Equity Opportunities hedge fund, which fell 40 percent between June 30 and August 10, prompting Goldman to bail the fund out in dramatic fashion. The bigger Global Alpha fund, which held $12.5 billion at the start of the year, lost more than 14 percent in a week.

Having two star hedge funds take big hits is bad enough for Goldman’s reputation; being deep underwater means returns have to improve dramatically before performance fees kick in again. Goldman Sachs Asset Management, the subsidiary that manages $758 billion, generated nearly one quarter of its $4.29 billion in revenues last year from such fees.

And the problems extend beyond Goldman’s marquee hedge funds to other areas of its quantitative division, which manages $250 billion of the total, using many of the same methodologies as the hedge funds. The firm’s long-only quant funds investing in U.S. stocks have been underperforming for the past 12 months, as have its global tactical-asset-allocation portfolios.

The Global Equity Opportunities hedge fund, or GEO, was up 6.4 percent in the first half of this year, compared with an 8.0 percent rise in the MSCI World index, according to a knowledgeable source. Then came August. The fund plunged by more than 30 percent in just one week, chief financial officer David Viniar said in a conference call with analysts. Because investors could withdraw their funds on a monthly basis with just 15 days’ notice, rumors spread of big redemptions by European investors. With returns suffering, the fund’s assets plunged from just over $6 billion at the end of June to about $3.6 billion before Goldman stepped in, according to the knowledgeable source.

Investors in Global Alpha can withdraw funds only on a quarterly basis with 45 days’ notice, making the fund less vulnerable to sudden redemptions. The next opportunity for investors to exit is at the end of this month.

Virginia Reynolds Parker, chief investment officer of Parker Global Strategies, a $500 million fund-of-hedge-funds manager in Stamford, Connecticut, predicts redemptions from Global Alpha. “Many investors have lost confidence,” she says. “I wouldn’t be surprised if it were the end of the program.”

Goldman took the unprecedented move of injecting $2 billion of its own capital into GEO. It also persuaded outside investors, including Los Angeles entrepreneur Eli Broad, to stump up a further $1 billion.

Goldman adopted a confident stance. “This is not a rescue,” Viniar told analysts. “Given the dislocation in the markets, we believe that this is a good investment opportunity for us and the other investors that we have brought in.” GEO in fact rebounded the following week. Still, the fund was down 23 percent year-to-date at the end of August, according to the source; Global Alpha was down 30 percent.

But there was a good bit of PR at work too. As Broad tells II, Goldman “said they put in $2 billion and wanted additional money so the world would not think of it as a bailout.”

Apart from institutions, existing investors in the fund include wealthy individuals and Goldman’s own executives, raising eyebrows in some quarters about the wisdom — and propriety — of using shareholders’ money for a bailout. Goldman won’t specify how much of GEO’s capital belongs to its own partners; a spokeswoman would say only that the amount is “minimal.” But when asked whether top executives, including CEO Lloyd Blankfein and asset management chief Peter Kraus, had any money invested in GEO, the spokeswoman declined to comment. As for whether Goldman took any special measures to ensure proper use of shareholder money before the GEO investment, the spokeswoman replied by e-mail that “the investment was board-approved.”

GEO’s old inves-tors may be suffering, but new investors are getting one sweet deal. They are locked in for six months; until January 1, 2010, they will pay no management fee and only a 10 percent performance fee once the fund has appreciated by 10 percent. Existing investors pay a 2 percent management fee and a 20 percent performance fee. The latter fee, however, will kick back in only when GEO rebounds above its highest level of last year, its so-called high-water mark.

Goldman was not alone in suffering from the stock market ructions. Other big names, like AQR Capital Management and Barclays Global Investors, also stumbled. Quantitative funds, though, have been one of the growth engines of GSAM, which accounted for 11 percent of Goldman’s total revenues in 2006.

But the engine has been sputtering. Much of Goldman’s $962 million in performance fees last year came from Global Alpha, which rose 39.9 percent in 2005 before losing 6 percent in 2006. GSAM’s performance fees fell 87 percent, to $110 million, in the six months to May 2007, versus the same period in the previous year. GSAM reported zero inflows into alternatives in the second quarter, after inflows of $2 billion in the first quarter and $32 billion in all of 2006.

The full impact may not become clear until next year because most incentive fees are paid in December. Goldman’s shares have fallen 19 percent since the middle of July.

New investors like Broad agreed that GEO suffered from unusual events and that its long-term strategy was sound. “It was an easy decision,” he says. GEO has returned 13.6 percent annually between its inception in May 2003 and June 2007.

Some existing investors are less confident. “We’re liquidating our investment,” says one fund-of-hedge-funds manager who invested about $5 million in GEO two years ago. He had put the fund on a watch list back in January following months of “flat or slightly negative” returns.

Goldman says that GEO reduced leverage to 3.5 times following the capital injection, from about 6 times before. That will make it harder for the firm to post the high returns it needs to start collecting lucrative performance fees again. Goldman “is trying to work together to find the best solution” says a person familiar with the matter.

Top executives at other investment banks have taken the fall for hedge fund losses in recent months, from former UBS CEO Peter Wuffli to former Bear Stearns president Warren Spector. It’s unclear whether executives at Goldman will suffer similar fates, but some kind of restructuring looks likely. Goldman must act fast to restore its luster.