Can anybody fix Goldman's brokerage?

On Jan. 2, Jim Clark, a founder of such technology icons as Netscape Communications Corp. and Silicon Graphics Inc., was at home in Palm Beach, Florida, when he got an e-mail from an executive at Goldman Sachs Group Inc.'s private wealth management division. Goldman was offering Clark a chance to invest in the closely held social-networking company Facebook Inc. The deal -- through a fund overseen by Goldman Sachs Asset Management -- was being offered to other Goldman investors at the same time, Bloomberg Markets magazine reports in its March issue. The firm would levy a 4 percent placement fee on clients, plus a half percent “expense reserve” fee. It would also require investors to surrender 5 percent of any profits, known as “carried interest,” according to a Goldman Sachs document. Clark turned Goldman down. In June, 2009, he had yanked most of the roughly $400 million he had invested with the firm due to what he considered bad advice and poor performance, including a big hit from GSAM's Global Alpha hedge fund. This offer, he says, just irked him further. A few months earlier, he had purchased a stake in Facebook through another firm for a lower price, he says, and without the onerous carried interest. “I don't think it's reasonable,” Clark says. “It's just another way for them to make money from their clients.” $840 Billion Clark isn't the only investor unhappy with Goldman Sachs Asset Management. GSAM (often pronounced gee-sam) managed most of the $840 billion in assets Goldman oversaw in December, a figure that dwarfs the money managed by brand-name firms such as Legg Mason Inc. and Franklin Resources Inc. Yet the evidence shows that the behemoth inside the 141-year-old investment bank is generating subpar returns for investors and is a persistent headache for Chairman and Chief Executive Officer Lloyd Blankfein. The CEO has dispatched a series of lieutenants on missions to fix the listless asset manager, which last year saw pension funds in California and Nevada withdraw a total of more than $900 million because they were unhappy with its performance and concerned about turnover in the investment management division's ranks. At the same time, GSAM has become increasingly important to Goldman, as the firm's trading powerhouse has idled. Revenue from Goldman's Fixed Income, Currency and Commodities (FICC) trading division dropped 37 percent in 2010 from a year earlier, and the firm's investing for its own accounts could further suffer when new rules, including strict limits on proprietary trading by banks, kick in. Turnover at the Top Goldman declined to make Blankfein or any other executives available for comment on this story. In March 2008, Peter Kraus, co-head of the investment division that oversaw GSAM, resigned after incentive fees -- the 20 percent that hedge and other funds slice off profits -- plunged 81 percent in fiscal 2007 and Global Alpha lost 40 percent, according to investors. Co-head Ed Forst took over. He was one of a cadre of Blankfein confidantes known as Lloyd's Boys, according to former employees. Forst, now 50, left after three months to take a job at Harvard University, and investment management became the job of Marc Spilker, a former co-head of U.S. equities, and Timothy O'Neill, a former senior strategist. They were the seventh and eighth Goldman investment heads in eight years. Separate Accounts Lag O'Neill and Spilker didn't do much better than Kraus, now 58. The division's 2009 net revenue of $3.97 billion accounted for about 8.8 percent of Goldman's total revenue and was down 12.8 percent from fiscal 2008 as both management and incentive fees declined. A big chunk of GSAM's assets are its separate accounts -- pools of money invested for institutions and wealthy individuals. EVestment Alliance LLC, an Atlanta-based research firm, tracks about $300 billion held in the accounts and finds that Goldman trailed its peers in 73.8 percent of the categories EVestment looked at during the five years ended on Sept. 30. Chicago-based financial publisher Morningstar Inc. tracks Goldman mutual funds and found that the 338 fund share classes it looks at trailed the average return of their respective peers in every broad category, including U.S. diversified equity, non- U.S. stock and taxable bonds, over the 3-, 5- and 10-year periods ended on Dec. 31. Yet investors have not only stuck with GSAM; they've added tens of billions of dollars to its assets since 2000. ‘Marketing Muscle' “Given the golden reputation of Goldman, it's amazing,” says Anton Schutz, founder of Rochester, New York-based Mendon Capital Advisors Corp., an asset management firm that specializes in financial stocks and doesn't own Goldman Sachs shares. “What we thought was investing acumen has turned out to be a tribute to the firm's marketing muscle.” The sales prowess of the Goldman franchise lost some of its luster in the deal for Facebook, run by 26-year-old Mark Zuckerberg. Goldman had planned to sell as much as $1.5 billion of the Palo Alto-based company's stock to clients through a GSAM-affiliated fund known as a special-purpose vehicle. Instead, Goldman on Jan. 17 halted its offering to U.S. investors due to the copious press the deal garnered. “Goldman Sachs concluded that the level of media attention might not be consistent with the proper completion of a U.S. private placement under U.S. law,” the firm said. Securities laws forbid investment firms from advertising such offerings to the general public. 2012 Facebook IPO Analyst Josh Bernoff of Forrester Research Inc. in Cambridge, Massachusetts, expects a Facebook initial public offering in 2012. Bundling Facebook shares into a GSAM special-purpose vehicle might have helped Facebook avoid a U.S. Securities and Exchange Commission requirement that any company with more than 499 investors meet SEC financial reporting requirements. Such moves are a common practice in the venture capital industry. Goldman and the funds it manages, including GSAM hedge fund Goldman Sachs Investment Partners, invested $450 million in Facebook before the bank began recruiting investors. Digital Sky Technologies, a Russian investment firm, bought $50 million. On Jan. 21, Facebook announced that Goldman had completed an over-subscribed offering to its non-U.S. clients for a fund that invested $1 billion in Facebook Class A shares. Goldman is still dealing with the fallout from its last run-in with the SEC. In April 2010, the commission filed a civil suit accusing Goldman of fraud for selling a mortgage-related security called Abacus 2007-AC1 to clients without disclosing that bearish hedge fund Paulson & Co. helped pick some of the securities linked to it -- with the intention of selling the security short. Abacus Settlement Goldman settled the suit in July, agreeing to pay $550 million, a record for a Wall Street firm, without admitting or denying wrongdoing. And Blankfein, 56, still hasn't put behind him the criticism of Goldman's controversial role in the collapse of American International Group Inc. in 2008 -- particularly its aggressive collateral calls on the credit-default swaps it had bought from AIG on subprime-packed mortgage securities, many of which it underwrote. In April, the Senate Permanent Subcommittee on Investigations held an 11-hour hearing on Goldman Sachs's role in the financial crisis, grilling Blankfein, Chief Financial Officer David Viniar and others about Goldman's business practices. “Goldman repeatedly put its own interests and profits ahead of the interests of its clients and our communities,” said Senator Carl Levin, the Michigan Democrat who chaired the subcommittee. Market Maker Blankfein told the Levin hearing that as a market maker Goldman had no obligation to tell clients about Goldman's own positions in the securities it was selling. Clients “are buying an exposure,” Blankfein told the committee. “The thing we are selling to them is supposed to give them the risk they want.” Clark was particularly irked by the disclosures surrounding Abacus. He had met with Paulson & Co. founder John Paulson in August, 2006 and been impressed by the hedge fund manager's plans to bet against the subprime-mortgage market. His Goldman brokers talked him out of investing with Paulson, describing him as a bit player, Clark says. Paulson generated a 590 percent return in his flagship credit fund in 2007. ‘These Jerks' “When it came out that Paulson had the biggest payday in history, I got angry,” Clark says. The fact that Goldman Sachs had such a close relationship with Paulson incensed Clark further. “They just butter their own bread and charge huge fees, these jerks,” Clark says. Goldman spokeswoman Andrea Raphael says the firm has no comment on Clark's complaint. The conflict between what Goldman does for itself versus what it does for its customers was addressed by Blankfein & Co. in a 63-page internal document released in mid-January. The Report of the Business Standards Committee probed a raft of issues, including conflicts of interest, transparency and disclosure, as well as the firm's responsibilities to its clients. The report recommended the creation of a simplified balance sheet that would make transparent the division between the deals it does for its own profit and those it carries out for its customers. As the report recommended, the firm's operations are now divided into four reporting segments: investment banking, investing and lending, investment management and institutional client services. A Matter of Reputation “It is important to articulate clearly both to our people and to clients the specific roles we assume in each case,” Goldman said in the report. Protecting the firm's image was a high priority of the 21- member committee, led by managing director E. Gerald Corrigan and Goldman Sachs Asia Chairman J. Michael Evans. “Goldman Sachs has one reputation,” the report says. “It can be affected by any number of decisions and activities across the firm.” GSAM's performance puts the firm's reputation as a savvy investor under pressure. “The results are, No. 1, surprising and, No. 2, disappointing,” says Richard Bove, an analyst at Stamford, Connecticut-based Rochdale Securities LLC. “First, Goldman has sold this business as one they can grow and grow very strongly. Second, they pride themselves on being able to deliver results for high-net-worth people.” Sickly Mutual Funds The numbers tell the tale. According to Morningstar, just 44.9 percent of Goldman's U.S. diversified stock funds managed to beat their peer average over the three years ended on Dec. 31. Just 34.7 percent of such funds beat their peer average over 5 years and 28.3 percent over 10 years. Only 11.5 percent of Goldman's foreign stock funds beat their peer average over 3 years, 6.7 percent over 5 years and zero percent over 10 years. Similar stories play out in both the taxable and municipal bond categories. Morningstar's calculations were done on funds holding a total of $59 billion in assets and exclude money markets. The funds are sold by brokerages, including Merrill Lynch and Edward Jones, and by regional banks. “With just a few exceptions, these funds are chronic underperformers,” Morningstar mutual fund analyst Karin Anderson says. Fund Missteps Spokeswoman Raphael says the firm's own research using Morningstar data shows Goldman mutual funds performing substantially better in certain categories, though still trailing their peers. As for Goldman separate accounts, EVestment looked at narrower categories -- such as U.S. core high-quality fixed income and Japan small-cap equity -- and found Goldman Sachs trailing more than two-thirds of its rivals over the 3-, 5- and 10-year periods. Missteps large and small have contributed to the poor performance. The Class A shares of Goldman Sachs Concentrated International Equity Fund, for example, were dragged down by a position in Renault SA during the three years ended on Dec. 31, according to a Morningstar performance analysis. The stock lost more than half its value, and the fund trailed its category average by more than two percentage points for the period. Bad Health Care Bet The international fund's U.S. sibling, the Goldman Sachs Concentrated Growth Fund, was hurt by its overweighting in health-care stocks, a Morningstar analysis concluded. Such shares fell because of concern over the Obama administration's health-care law. Another possible culprit in GSAM's underperformance is expenses. Goldman's diversified U.S. equity funds sport an asset-weighted average expense ratio of 1.02 percent versus an average of 0.79 percent for the U.S. diversified mutual fund universe as a whole. Bove says GSAM may also be putting an undue emphasis on marketing. “It could be that the focus of an asset manager within a brokerage is more sales oriented than performance oriented,” he says. So why do investors keep their accounts at the New York firm? The prestige of the Goldman Sachs name is a big factor. The Power of a Name “A lot of wealthy clients like to say, ‘I have my account at Goldman, blah, blah, blah,'” says Michelle Clayman, founder of New Amsterdam Partners LLC, an investment manager that owned 267,235 Goldman shares as of Sept. 30. Even GSAM's once-vaunted hedge funds have lost their sizzle. Hedge-fund assets totaled $19.5 billion as of September, making Goldman the 16th-largest hedge-fund firm, according to Bloomberg Markets' annual ranking of hedge funds. That amount was down 34 percent from Goldman's year-end peak of $29.5 billion in 2006, when GSAM was the world's largest hedge-fund manager. Goldman's incentive fees -- the 20 percent of profits that hedge funds and some other investment vehicles generate -- totaled just $65 million for the first nine months of 2010. That's down from a peak of $962 million for fiscal 2006. In reporting its financial results for year-end 2010, Goldman added performance payments from funds run by its merchant banking business, which had been included in trading division results, to its incentive fee totals. With such payments included, total incentive fees rose to $527 million for 2010 from $180 million in 2009. Hedge Fund Flagship GSAM's flagship hedge fund today is Goldman Sachs Investment Partners, or GSIP, an $8.5 billion fund that uses fundamental research to buy and bet against stocks. It's co- headed by Raanan Agus and Kenneth Eberts, who both moved to GSAM in 2007 from the firm's proprietary trading desk. GSIP's performance has been competitive. The offshore version lost 18.9 percent in 2008 and gained 24 percent in 2009 net of fees. That compares with a 19 percent loss for the HFR Composite Index in 2008 and a 20 percent gain in 2009. Through October, the GSIP fund returned 4.6 percent, according to Bloomberg data, a return too low to make Bloomberg Markets ranking of the world's top 100 large funds. That compares with a 6.8 percent gain in the HFR index. As for Global Alpha, it now manages less than $2 billion, according to an investor, down from a peak of $11 billion in 2007. The fund, which uses trading algorithms and computerized models to buy and sell everything from Polish zlotys to wheat futures, returned 3 percent in 2008, 30 percent in 2009 and was basically flat in 2010. Quant Mayhem In 2007, many quant hedge funds suffered because their computer models told all of them to buy, or bet against, the same instruments. As many quant funds tried to unwind their positions at once, mayhem ensued, and Global Alpha lost 40 percent. It's the strength of Goldman's larger franchise that helps it hold on to investors' money despite GSAM's performance. On Jan. 19, Goldman reported $8.35 billion in earnings for 2010, down 38 percent from 2009 on net revenues of $39.16 billion, which were down 13 percent. The culprit was a steep fall in client trading, with FICC trading revenue down 37 percent to $13.71 billion. Investment management revenues rose 9 percent to $5.01 billion. Since 2000, Goldman's assets under management have risen at an annualized rate of 11.8 percent -- with three years of decline, in the bear market years of 2002 and 2008 and in 2010. The Goldman Brand “Goldman is a brand,” Bank of America Merrill Lynch analyst Guy Moszkowski says. “Brands tend to be able to retain customers in situations where performance suggests they shouldn't.” GSAM clients benefit from Goldman Sachs's extensive network of business relations and its dealmaking, with the Facebook investment just the latest example. Mendon Capital's Schutz says that if investors get early access to the latest hot investment, it makes it easier to stomach poor returns elsewhere in their portfolios. “If you get in on the next Google IPO, you're not going to be whining too much,” he says. Still, as the Goldman image has suffered in Congress and the popular press, its star power may be dimming. In July, CFO Viniar, responding to a question on a conference call, said that the 2010 SEC suit had had some impact on GSAM's ability to raise money. In 2010, assets under management fell 3.6 percent as investors pulled cash from low-yielding money market and equity accounts. $71 Billion in Outflows All told, flows out of asset management totaled $71 billion in 2010. In March, the $22.7 billion Nevada Public Employees' Retirement System fired GSAM because the $600 million it had invested with the firm was trailing the Morgan Stanley EAFE index it was supposed to track by an annualized one percentage point. “We have to take action on performance,” Investment Officer Ken Lambert said at the time. “That's what my members are expecting.” He also cited Goldman asset management personnel changes. In June, California's $2.8 billion Kern County Employees' Retirement Association pulled $347 million from two GSAM accounts. Executive director Anne Holdren cited both performance and turnover at Goldman as reasons. Goldman has been working to get money management right for 80 years. The firm's first foray into the field was in 1928, when it started up a partnership called Goldman Sachs Trading Corp., which invested in the then-booming stocks of banks, insurers, utilities and industrial companies. Eddie Cantor Blues The trust collapsed in the 1929 stock market crash, eventually losing more than 98 percent of its value. One big loser was comedian Eddie Cantor, who spent years afterward skewering Goldman Sachs in his vaudeville act. “They told me to buy the stock for my old age, and it worked perfectly,” Cantor quipped, according to “The Partnership” by Charles Ellis (Penguin Press, 2008). “Within six months, I felt like a very old man.” Cantor sued Goldman Sachs for $100 million and, according to the New York Times, settled for an undisclosed sum in 1936. Leon Cooperman, Goldman's longtime research chief, lobbied for years to expand Goldman's money management efforts. When GSAM was created in 1988, he served as its first CEO, leaving Goldman in 1991 to found hedge fund Omega Advisors Inc. The Gang at Old Slip Asset management remained a small part of Goldman until the mid-1990s, when Chairman Jon Corzine and President Henry Paulson decided to build it out after taking note of the profits being generated in asset management by rival Wall Street firms. GSAM set up offices at 32 Old Slip, several blocks away from the parent firm's 85 Broad St. headquarters, and formed a separate culture -- academic, collegial, less cutthroat, according to former employees. In 1994, Corzine and Paulson tapped David Ford to run GSAM, and in 1996 he was joined as co- head by John McNulty, a visionary broker in the wealth management department. It was McNulty's idea to organize the firm into 10 boutiques, each with a different investment strategy, independent of each other and of the front office. The bankers and traders at 85 Broad and 1 New York Plaza looked down on the money managers, say former GSAM employees. “GSAM has always been the stepchild at Goldman Sachs,” says author William Cohan, who's writing a book about Goldman, scheduled to be published later this year. “It's never been as sexy as investment banking, trading and private equity.” Bulking Up The firm had just $52 billion in assets under management in 1995. The next year, Goldman bought CIN Management, the pension plan of British Coal Corp., for an undisclosed amount, to gather assets and increase its visibility in Europe. A year later, it purchased Liberty Investment Management, a growth-oriented mutual fund firm in Tampa, Florida. Then it snapped up Commodities Corp., the Princeton, New Jersey-based firm co-founded by Paul Samuelson, a Nobel Prize winner and author of the best-selling college textbook on economics. Commodities Corp. had been a launching pad for such hedge-fund stars as Tudor Investment Corp.'s Paul Tudor Jones and Moore Capital Management LLC's Louis Moore Bacon. It became the base for what is now the firm's fund of funds business. In 1994, a University of Chicago Ph.D. named Clifford Asness joined Goldman Sachs to build a quantitative research department. Asness soon began managing money and started Global Alpha in 1995. Global Alpha Soars In 1996, the fund scored a 111 percent return, and in 1997, a 42 percent gain. Investors clamored to give Global Alpha their money. In 1998, Asness and three colleagues went on to found AQR Capital Management LLC. McNulty retired from Goldman Sachs in 2001, the year the firm's assets under management hit $351 billion. Since 2007, Goldman has played musical chairs with the division's management. In September of that year, Forst, who had been Goldman's chief administrative officer, was named co-head of investment management with Kraus, who had run the business, with other co- heads, since 2001. Forst, now 50, took over as sole head when Kraus left in March 2008. Forst resigned from Goldman just three months after Kraus's departure, taking a newly created administrative position at Harvard University reporting to President Drew Faust. In the fall of 2008, he briefly worked with Neel Kashkari at the Treasury Department in creating the new Office of Financial Stability. To Harvard and Back In May 2009, Forst abruptly resigned from Harvard, returning to Goldman in September, first as head of strategy and then, once more, as co-head of the investment management division, which oversees both GSAM and private wealth management. In that capacity, he replaced Spilker, a 20-year Goldman veteran who had been tapped for the post in June 2008, only to resign after a run of less than two years. He's now president of private-equity firm Apollo Global Management LLC. Forst's co-head today is Tim O'Neill, another former head of strategy. One recurring element in the constant turnover: none of the new investment heads had spent their careers in asset management. “It was demotivating,” says a former GSAM employee. Last year, Goldman named Jim O'Neill (no relation to Tim), who was head of global economics, as chairman of GSAM. He works out of London and reports to Forst and O'Neill. One of his assignments is to keep a watch on the so-called BRIC countries -- an acronym for Brazil, Russia, India and China that O'Neill himself coined. Reining in GSAM The executive shake-ups are a reflection of Blankfein's determination to crush any independent tendencies at GSAM that might be left over from the days of McNulty and Kraus, former Goldman employees say. Blankfein and his charges have pushed efforts to “Goldmanize” GSAM, according to a former GSAM executive. Among other things, that means assessing performance on short-term, rather than long-term, results. Senior level turnover generates tensions, Merrill Lynch's Moszkowski says, especially in investment management, where clients yank accounts with little cause. “Investment management organizations are delicate organisms; it's all about human capital and intellectual property,” he says. Management continuity should be priority No. 1, money manager Schutz says. A People Business “The key at any asset manager is to avoid the kind of turnover GSAM has seen,” he says. “You need a history of keeping people in the same positions.” Blankfein & Co. periodically remind investors of the firm's commitment to expanding GSAM. In a February 2010 letter to shareholders, Blankfein and President Gary Cohn said the firm would be looking for money management clients at home and in developing markets, including Brazil, China and the Middle East. In a January investor call, Viniar said GSAM was primed for new hiring. “There is more focus on the investment management business than on other areas,” he said. Less publicly, Blankfein and Cohn have been overhauling GSAM in moves designed to tether it more closely to its parent, former employees say. GSAM has moved into Goldman's new offices at 200 West St. And the head office has consolidated McNulty's 10 investment boutiques into four broad groups: quantitative, fundamental equity, fixed income and alternative. Compensation Overhaul Compensation of GSAM investment professionals, which under Kraus was tied directly to performance and revenues, is now largely determined subjectively at the discretion of management, according to two former GSAM portfolio managers. A risk manager from Goldman can demand that portfolio managers cut holdings or reduce leverage, something that didn't happen under McNulty and Kraus. At one point, two former employees say, Goldman's top management was demanding hourly profit and loss statements from certain teams, reflecting their short-term, trading mind-set. Their independence gone, a parade of portfolio managers have left for rival firms or to start their own. Many newcomers come from the banking or trading side of Goldman. None of the changes Blankfein has ushered in will matter much if the lifeblood of any asset manager -- performance -- doesn't rebound soon. Investors can be an impatient lot. Jim Clark, for one, didn't wait. “I concluded that I don't need these hedge funds and I don't want these Goldman Sachs managers,” he says. In 2009, Clark moved almost all of his money to Morgan Stanley. --Bloomberg News--