here you go, a case of traders farming out trades while CEO's and power brokers hire "hedge" funds.... dumb and dumber.
February 1, 2002
PAGE ONE
Chicago Art Institute's Hedge-Fund Loss
Paints Cautionary Portrait for Investors
By IANTHE JEANNE DUGAN, THOMAS M. BURTON, and CARRICK MOLLENKAMP
Staff Reporters of THE WALL STREET JOURNAL
On a summer afternoon in 2000, Conrad Seghers made his pitch to the financial overseers of the Art Institute of Chicago. The biologist-turned-day trader, then 32 years old, told the business luminaries gathered in the museum's boardroom that hedge funds run by his fledgling Dallas investment firm could both expand the venerable museum's wealth and protect it from stock-market swings.
At the long conference table that day was A. Steven Crown, chairman of the museum's finance committee and scion of a billionaire family with big stakes in General Dynamics Corp. and Rockefeller Center. Other members of the committee responsible for evaluating Mr. Seghers's proposal were department store heir Marshall Field, who formerly owned the Chicago Sun-Times; David J. Vitale, chief executive of the Chicago Board of Trade; Arthur M. Wood, former chairman of Sears, Roebuck & Co.; and Andrew Rosenfield, a wealthy Chicago entrepreneur.
Evidently, the trustees were impressed with Mr. Seghers and his business partner, James Dickey. The Art Institute, which had begun to depart from a long history of conservative investing, soon signed on as a limited partner with their firm, Integral Investment Management. By Sept. 1, 2001, the museum had invested more than $43 million, or 6.6% of the $650 million at which its endowment is currently valued.
PLUNGING INTO RISK
Some of the members of the Art Institute of Chicago's board of trustees Finance Committee members
• A. Steven Crown, chairman of finance committee and scion of billionaire family with big stakes in General Dynamics and Rockefeller Center
• Marshall Field, department store heir and former owner of the Chicago Sun-Times
• David J. Vitale, chief executive of the Chicago Board of Trade
• Andrew Rosenfeld, Chicago entrepreneur.
Other board members
• Anne Searle Bent, G.D. Searle heiress
• John H. Bryan, former Sara Lee chairman
• John A. Edwardson, former UAL president
• Arthur Martinez, former Sears, Roebuck chairman
• Thomas J. Pritzker, chairman of Pritzker organization, which controls Hyatt Hotels, among other interests
• Shirley Ryan, wife of Patrick G. Ryan, chairman of Aon
Source: Art Institute
But after earning some initial profits, this pillar of old-money Chicago received an embarrassing lesson in the hazards of nouveau investing. Hedge funds, despite their safe-sounding name, are lightly regulated investment pools known for high risk. The institute's trustees ultimately steered more than half of its money into hedge funds, including those run by Mr. Seghers. Museum officials say that overall, the institute is ahead on its hedge-fund investments, although they won't say by how much.
What they do say is that the museum struck out on its dealings with Integral. One of the firm's funds was essentially wiped out late last year, losing at least $20 million of the museum's money. The museum only then discovered that through Integral, it had unwittingly helped seed an Internet start-up operated by Mr. Dickey and had invested in distressed consumer debt, among other holdings. In December, the institute filed suit in a state court in Dallas, accusing Messrs. Seghers and Dickey and an affiliated Los Angeles fund manager of fraud. The Federal Bureau of Investigation and the Securities and Exchange Commission are investigating the investments.
The money managers deny doing anything wrong. Mr. Seghers argues in a countersuit filed in mid-January that his contract with the museum gave him carte blanche. His attorney, Lawrence J. Friedman, says in an interview that like most hedge-fund managers, Mr. Seghers "could have bet on the Super Bowl if he wanted" with clients' money.
Mushrooming Industry
The Art Institute imbroglio offers a cautionary tale of the mushrooming hedge-fund industry. Once the exclusive province of super-rich individuals, the funds have drawn new investors from the ranks of once-circumspect institutions and novices seeking alternatives to the vertiginous stock market. Last year, hedge funds netted $26 billion in new investments, pushing total industry assets over $500 billion. Overall, hedge funds returned 4.4% last year, according to consultant Tremont Advisers, while stocks dropped about 13%.
But hidden within those attractive numbers are plenty of collapses. As the number of hedge funds grows, the potential dangers do as well. Hedge-fund investors are supposed to be sophisticated enough to see the peril, or at least be able to absorb substantial losses. One of the few government regulations requires most investors in such a fund to have at least $1 million in assets. Hedge funds aren't required to report their results publicly, and most -- including those managed by Integral -- try to keep details of their investments secret.
The museum's leaders say Mr. Seghers told them that Integral's investments would be largely immune to market volatility. "We sought an investment that would be relatively safe in the event the market declined," Mr. Crown said in an affidavit filed in December in the court case in Dallas.
In his countersuit, Mr. Seghers accuses the institute of mounting a "smear campaign" against him and his firm -- an allegation the museum denies. He blames the institute's woes on its "foolhardy" overdependence on hedge funds generally. He pins his firm's troubles on fallout from Sept. 11 and a major broker's computer glitches.
Founded in 1866, the Art Institute has built an imposing collection that features masterpieces by the likes of Seurat, van Gogh and Hopper. Housed in a neoclassical complex near Chicago's lakefront, it is the nation's third-largest art museum in terms of revenue.
In recent years, the museum has felt some financial strain. Partly because of improvements at its prestigious art school, the institute reported a rare loss of $2.6 million on revenue of $191.3 million for the fiscal year ended June 30, 2001, according to its latest annual report. The institute's conventional stock-market holdings had losses of $33.2 million, or 4.5%, during that period, the report said. In contrast, the museum "benefited significantly" from its hedge-fund investments, the report said. One fund had paper gains of $102.1 million for the year. The museum declines to say precisely how its hedge-funds have performed overall. All of these results predated any losses related to Integral.
Scientific Training
The son of a cardiologist, Mr. Seghers moved as a boy with his family from his native Belgium to the central-Texas town of Temple. At first, he appeared headed toward a career in science or medicine. He received an undergraduate degree in zoology and a master's in biomedical engineering from Texas A&M University and a Ph.D. in cell and molecular biology from Southwestern Medical Center, part of the University of Texas.
But he says a desire to make a lot of money quickly drew him away from science. In the early 1990s, he says he began "day trading" stocks, years before widespread attention was paid to the practice of rapidly buying and selling shares and cashing out at day's end. In 1996, he started studying on weekends for an M.B.A. at Baylor University in Waco, Texas. Mr. Dickey, a fellow business student who had worked at financial firms, suggested that year that they start a hedge fund. "I said, 'What's a hedge fund?' " Mr. Seghers recalls.
Once Mr. Dickey had brought his friend up to speed and they had received their business degrees, the duo collected $100,000 from friends and family and opened a partnership initially called Exponential Returns, Mr. Seghers says. John Bruder, a retired Phoenix electrical engineer, remembers being impressed by the young 6-foot-4-inch money manager's scientific credentials when they met at a hedge-fund conference in Bermuda in 1998. Mr. Bruder says he invested $200,000, made a 15% profit and cashed out after a year.
In 1998, after a name change to Integral Investment Management, the firm distributed marketing material saying it had never had a losing month. It boasted "the highest Sharpe ratio in the industry" -- a widely used measure that gives high marks to funds with generous returns and relatively low risk levels. Mr. Seghers says at its peak in 2001, Integral was managing $100 million and had clients in Asia, Europe and the U.S.
In the late 1990s, the Art Institute's board was veering from its historically staid investment strategy. The shift was guided by William Kennedy, an Atlanta consultant who had successfully screened money managers for the institute since the 1970s.
Typically, the commission for consultants advising on traditional stock and mutual-fund investments is a percentage of the assets. Hedge-fund matchmakers can earn more because they often receive a share of profits as well. Theodore Sawicki, a lawyer for Mr. Kennedy, says his client merely followed the museum board's desire to seek out hedge-fund investments.
With Mr. Kennedy's guidance, the museum by mid-1998 made its first hedge-fund investments, putting $57.7 million into pools managed by financial stalwarts American Express Co. and Alliance Capital Management LP. Bonds, mostly relatively conservative U.S. government instruments that had accounted for most of the institute's investments in 1996, were reduced to 20% by mid-2000.
In Atlanta, Mr. Kennedy's son, David, who is a principal at the family firm, Kennedy Capital Advisors, was scouting other hedge funds to broaden the Art Institute's investment mix. David Kennedy says he and a colleague followed Integral for months, reviewing the firm's rosy marketing statements, and then invited Messrs. Seghers and Dickey to make a pitch to Kennedy Capital's biggest client, the Art Institute.
The night before their first presentation, in July 2000, Messrs. Seghers and Dickey dined at the elegant University Club in Chicago with William Kennedy. Mr. Seghers rehearsed his script. Then, he says, he and Mr. Dickey went to an all-night Kinko's to redo their marketing material. Mr. Kennedy had told them the museum trustees "are all old people, so make the font size bigger and the background lighter," Mr. Seghers recalls. David Kennedy confirms that his father suggested making the material more readable.
The next day, Mr. Seghers urged the Art Institute to invest in a fund called Integral Hedging. Both sides concur that he told members of the museum's board that the fund generally combined safe cash holdings with stocks and riskier index options, which are contracts to buy and sell equities at future dates. Mr. Seghers and museum officials recall that he said Integral would combine the investments in such a way that he could guarantee profits of 1% to 2% a month in flat or rising markets. The fund, he said, could lose money only if the stocks to which the options were tied dropped more than 30%, providing a striking degree of investor protection.
Massive Market Turbulence
Mr. Seghers says he also told museum officials that massive market turbulence could endanger their investment. But Mr. Crown said in his December affidavit that "Integral represented to me and the board's financial advisers that the proposed investments would have a high percentage of liquidity and would produce only very limited losses in the event of a severe market downturn."
Most of the museum's 33 trustees decline to comment on the record. But some of them say they relied on Kennedy Capital to warn them about any ill-advised investing risks. Kennedy Capital executives say there were no hints of problems in monthly statements they received from Integral's outside administrator.
Integral and Kennedy Capital stood to gain handsomely from the museum's new strategy. The institute agreed to pay Integral one percent a year of the assets it managed, plus 20% of any profits it made. It couldn't be determined how much Integral actually received. Integral gave Kennedy Capital a 25% cut of the management fee and 3% of the profits, for a total payment of about $60,000, Kennedy executives say.
Mr. Seghers says that he didn't want to "stare at a computer screen all day," so he outsourced trading to others, including Samer El Bizri, who handled all of Integral Hedging's assets. Mr. El Bizri, now 28, is a money manager in southern California. He and his Galileo fund are named as defendants in the Art Institute suit in Dallas. He didn't return phone calls or e-mails seeking comment. His lawyer, Marc X. LoPresti, says Mr. El Bizri did nothing wrong. The attorney wouldn't comment further, except to say that Integral Hedging is currently Mr. El Bizri's only client.
Test Drive
Even by the tight-lipped standards of the hedge-fund business, Integral's principals were "protective of what they were doing" with clients' money, says Alec Petro, a Boston money manager. Mr. Petro says he took the firm for a "test drive" in late 1999, investing $250,000 on the condition he could cash out whenever he wanted. After three months, he concluded Integral's approach was "hocus pocus." He says he got his $250,000 back, with a small profit and no hassles.
The Art Institute was less tentative. In late 2000 and early 2001, it invested a total of $23 million with Integral Hedging, according to the museum's Dallas court papers. Encouraged by positive financial statements from Integral, the institute invested another $20 million on Sept. 1, 2001 -- this time in a sister fund, Integral Arbitrage, the court papers say. The decisions were blessed by the institute's finance committee and the larger board of trustees, which included former Sara Lee Corp. Chairman John H. Bryan, former UAL Corp. President John A. Edwardson and billionaire Thomas J. Pritzker.
Now, the museum is trying to sort out where the money went. Among the Integral funds' investments is that in InsBridge Inc., a Plano, Texas, company that develops software for searching the Internet for insurance rates. The Integral funds invested $2 million last August in InsBridge, Mr. Seghers's attorney, Mr. Friedman, said in a court hearing in Dallas this week. Mr. Seghers is chairman of the company, and Mr. Dickey is co-founder and president.
In an interview, Mr. Friedman says, "InsBridge is a superb company with a very terrific future." As for Messrs. Seghers and Dickey holding top positions with InsBridge, Mr. Friedman says, "It is very common for people who make investments to sit on their board to monitor their investment."
Far beyond Integral, the Art Institute went hedge-happy. As of its June 30, 2001, financial report, the latest such information publicly available, it had $396.5 million invested in hedge funds, nearly double what it had a year earlier.
In October, however, the news from Integral suddenly turned sour. Mr. Dickey called Kennedy Capital to say that Integral Hedging had lost as much as 90% of its value, including about $20 million of the Art Institute's investment. Kennedy Capital broke the news to the Art Institute's chief financial officer, Robert E. Mars. The museum demanded an explanation but was dissatisfied when Integral blamed the loss on its broker, Morgan Stanley, according to museum officials.
In Dallas court papers, Mr. Seghers says his firm's problems began with a glitch in computers at Morgan, which handled trades for Integral and Mr. El Bizri. Integral had borrowed money from Morgan to buy stock, which, in turn, secured the loans, the court papers say.
The papers allege that last year, Morgan's computers miscalculated the ratio of Integral's borrowing to its equity holdings. This triggered a "margin call," or a demand from Morgan for more collateral to back the loans. If stock prices drop, a broker has the right to sell a portion of a client's stock to reduce the principal amount of the loan. Because of Morgan's snafus, Integral saw its holdings liquidated at very low values, Integral's court papers say. Integral's problem was compounded, it says, when stocks plummeted in the wake of the Sept. 11 terrorist attacks.
Morgan spokesman Bret Gallaway denies any such computer problems. "This is a transparent attempt by Integral to shift the blame for their investors' losses," he says.
Alarmed by the Integral loss, Art Institute officials say they looked into other Integral investments. The museum discovered that in mid-October, the firm's hedge funds invested about $17 million in Recovery Partners II, a fund set up by Thornton Capital Advisors in San Diego to buy and sell bad consumer debt, such as past-due credit-card and utility bills.
In his December affidavit, the institute's Mr. Crown says Messrs. Seghers and Dickey never disclosed "that they intended to invest the plaintiff's funds in such high-risk investments as distressed credit-card debt." Mr. Seghers's attorney, Mr. Friedman, says the contract the museum and Integral signed gave his client wide latitude to pick investments and that all of his selections were permissible.
The museum is in the midst of an extensive internal audit of all of its hedge-fund investments. It has fired Kennedy Capital as its financial consultant. Mr. Mars, 62, retired this month, as previously planned, after 26 years as the institute's chief financial officer, most of those quite successful. He was replaced by the former CFO of the University of Chicago. Pretrial hearings in the Dallas court case continue.
Trustee Marshall Field, for one, is philosophical about the experience with Integral. "This is the risk of the game," he says. "And we lost. And so what?"
-- Kortney Stringer in Dallas contributed to this article.
Write to Ianthe Jeanne Dugan at ianthe.dugan@wsj.com1, Thomas M. Burton at tom.burton@wsj.com2, and Carrick Mollenkamp at carrick.mollenkamp@wsj.com3 |
