(con't)
Two years later Griffin had solid returns in the high teens and enough credits to graduate early. He considered taking a job with the Palm Beach III fund but eventually decided to stay partly independent. III's Adams, who was using the same attorney as the 20-year-old, introduced him to Meyer, a hedge fund pioneer who ran a Chicago-based alternative investment operation called Glenwood Investment Corp.
In September 1990 Griffin began trading a convertible arb strategy as a separate account for Glenwood. One year later, duly impressed with Griffin's maturity - and his 70 percent returns - Meyer introduced him to Glenwood's clients, enabling him to raise a then-significant $18 million fund called Wellington Partners. Griffin leased 3,000 square feet of space in an office building in Chicago's historic Loop district and launched the five-person fund.
At first, Wellington traded only U.S. convertibles, Japanese convertibles and warrants - lucrative trading arenas in the early 1990s. Markets were significantly more inefficient in those days, and the firm, using computer models built by Griffin, earned profits of 43 percent in 1991 and 40 percent in 1992. "In the early 1990s, if you knew how to model a bond, you could make a lot of money," says convertible bond chief David Bunning, a onetime Harvard wrestler who joined Citadel as its sixth employee in 1991. Griffin hired inexperienced college graduates and even interns as he gradually expanded. "It was a global arbitrage shop run by a 22-year-old," says Bunning.
Griffin's youth showed. Former employees recall Griffin, in the early years, as a difficult and abrasive manager impatient with small mistakes. He was forever challenging Citadel traders to defend every nuance of their positions and personally running them through pointed grillings at regular trading meetings. "He was in your face," says one former employee. "He was a micromanager. He would dig. He was always challenging people to do things better. He loves looking at everything from different perspectives." Some people don't. Turnover was high.
"Ken has a remarkable ability to remember a vast amount of detail," says the former Citadel staffer. "He can be talking to 20 traders and practically know their books better than they do." Griffin says he has learned more over time about the best way to run a "functioning team." Friends and associates say he has mellowed since the firm's early days.
By 1994 Griffin and 60 employees were running nearly $200 million. Then the convertible market tanked, as bonds recorded their worst year ever. Stocks, too, fell across the board. And David Askin's Granite funds, a prominent hedge fund, blew up - losing $400 million. Concerned investors withdrew about one third of Citadel's capital, and the firm suffered its only losing year, dropping 4.3 percent, in part because the capital shortage crimped its ability to navigate the markets. Griffin, notes Meyer, was incensed that the firm's unstable capital base made it impossible for it to profit from the general convertible bond market panic. "He realized that to lose money in that sort of market was criminal," says Meyer.
It is a steamy mid-July morning in downtown Chicago, and Griffin, natty in a dark blue shirt and striped tie, is spooning up his daily bowl of raisin bran with bananas and raspberries at a small, round conference table in his neat, modest office where he eats breakfast each day. There are few distractions. An inexpensive print of Harvard Yard, celebrating the school's 350th anniversary, hangs beside his desk - he's a donor and active fundraiser. A soccer ball sits on a credenza, and a small rubber lizard is perched on a computer screen, but that's it for whimsy.
Griffin's desk and shelves are full of business plans, consulting reports and stacks of books, including the Long-Term Capital Management exposŽ When Genius Failed and the political-scientific treatise Meaning of It All by Nobel Prize-winning physicist Richard Feynman. The most prominent decoration in Griffin's office is a giant erasable whiteboard where he likes to scribble ideas during staff meetings.
Griffin loves grinding through analyses with managers from all parts of the firm, whether it's a takeover deal the firm is betting on or a new computer system it's investigating. "What makes it fun is I like solving problems," he says. "I simply like having the opportunity to compete. You grow. You become a better person."
Though Griffin no longer trades, his office is placed prominently beside Citadel's L-shaped trading floor. Having handed off direct trading control years ago, he professes not to know how his traders are doing on most days, even though market data screens are perched on his desk. If a big position goes bad, he says, his trading managers will let him know. "I try very hard to minimize the time I spend looking at the daily P&L," he says. "You end up fixating on a lot of noise."
The markets are opening for business in New York, and Citadel's 70 or so young traders, dressed hedge fund casual in shirtsleeves, are stirring. Quietly hunched over their computer screens, they punch buttons and talk into their phones. Unlike many trading shops, few trophies or decorations adorn the walls. Similarly, few personal touches occupy the trading desks, except for the occasional baby pictures and bumper stickers that bear the legend "Hubris Kills." These were handed out by chief convert trader Bunning at a traders' off-site meeting in May.
A Japanese flag hangs over some empty desks against one wall. Their usual occupants are home sleeping; beginning at 4:00 p.m. they'll be filled by a dozen traders, who work Citadel's giant positions in Japanese equity and bond markets overnight. Citadel operates smaller but significant offices in London, San Francisco, Tokyo and Greenwich, Connecticut.
Like their boss, the vast number of Citadel employees don't actually trade. The 350-person staff - heavy on young Ivy League and University of Chicago graduates - divide into several areas: portfolio financing, technology, quantitative research, administration and trading. Quantitative research, for example, develops the firm's new trading strategy and updates the old models.
Citadel goes to great lengths to ensure that these different groups work together. Except for the most junior employees, trader compensation - which is divided into salary, discretionary bonus and performance bonus - is based more on the firm's overall returns than on the trader's profit-and-loss statement. Technologists take classes taught by firm officials on trading strategies, and traders take classes on technology or portfolio financing issues. Turnover is now low.
These days Griffin spends much of his time as CEO thinking about how to manage a financial services firm, an admittedly rare art form. Every Citadel unit operates according to detailed, regularly updated business plans, which are stacked all around Griffin's office.
Such planning certainly has helped Citadel's financial structure. After the 1994 troubles, Griffin set out to create a more stable capital structure and more reliable financing to allow Citadel to survive and profit the next time panic hit the markets.
"If you're Avis, and the lights suddenly go off at Hertz, you had better be in a position to make a lot of money," says Griffin.
Most hedge funds outsource their financing and stock lending to one of Wall Street's "prime brokers." Griffin concluded that was dangerous and expensive; instead, in 1998 he hired John DiRocco, a veteran Wall Street stock loan and repurchase specialist from rival hedge fund Paloma Securities, to create his own securities lending operation and expand his lending and counterparty arrangements. The Greenwich-based unit has its own Depository Trust and Clearing Corp. account, borrows stock directly from large institutional investors such as Vanguard Group and has floated small bond issues to get rated by S&P and Fitch. "All financial institutions live and die by their liquidity," says Griffin. "We are a financial institution. The fact that many people don't think about it is beyond me. It is the essence of what we do."
Obsessed with risk, Citadel meticulously tracks all its dealings with more than 60 financial counterparties and Wall Street brokers, constantly grading them on 20 factors - from the cost of borrowing hard-to-find securities to the range of securities they'll finance - on a scale from 20 to 200. "We have the information stored on every deal we've done," says CFO DiRocco.
All this attention to financials has paid off. In 1998 Griffin decided to risk alienating investors by significantly restricting their ability to withdraw their capital. They had to agree to the new lockup terms or face the possibility of having their investment returned. The firm had already been reducing its positions as converts chief Bunning grew alarmed at the cheap pricing of credit in the bond market. Through the summer DiRocco strengthened Citadel's counterparty arrangements, and the capital lockups went into effect August 1.
Russia soon defaulted on its debt, and Long-Term Capital Management nearly collapsed, along with the rest of the financial world. Citadel, with locked-in capital and a de-levered portfolio, enjoyed one of the best performances among hedge funds, earning returns of 30.5 percent. The firm was a rare buyer, as desperate hedge funds unloaded bond inventory.
"Ken hired me to expand his funding capabilities in June of 1998, and he locked up his capital 60 days before the biggest hedge fund blowup ever," says DiRocco. "When you're liquid with locked-up investors in that kind of environment, you can be very selective about when and what you're buying."
Whether it's building a capital structure or refining an investment approach, "process" is the guiding philosophy at Citadel. The firm focuses not just on coming up with better pricing models but on applying to money management the type of analysis that a Japanese car company would use to improve its assembly lines. "We are process-driven beyond the quantitative, and we blend the quantitative and the fundamental," says Daniel LeVine, a Brown University Ph.D. in math who runs Citadel's quantitative research group. "The things to which we apply quantitative techniques might surprise some people. I think that is what distinguishes us."
Adds Bunning: "Our goal is to quantify what we can quantify. To take the human element out where we can. To see if we can turn the investment process into widget making."
Thus Citadel aims to automate wherever possible and to study every part of every trading strategy - from information gathering to trade execution - in a formal, rigorous way. In 1998 Citadel took its analysis a step further by hiring Boston Consulting Group to break down all the elements of its investing process. Every step of every trading strategy was put into computerized flow charts.
Citadel collects all information from its high-volume trading in a sprawling database overseen by a staff of 15. The firm's traders regularly record their day-to-day operating procedures on flow charts to make sure they are not overlooking any small detail that can be improved. In terms of automation, the firm looks for opportunities to create efficiencies in every part of the business. Citadel is now testing a natural language processor that will automatically cull broker e-mails for specific bond quotes that can be made immediately available to traders. "Citadel's R&D and planning processes resemble a well-oiled manufacturing company more than a money management firm," says James Greenberg, a J.P. Morgan Chase & Co. investment banker who has done work for the firm.
Citadel's impressive numbers are what makes all of its talk about process, strategy and widgets more than just hype. After almost 11 years of operations, the firm has one of the best long-term records among hedge funds, and it has managed to successfully diversify into a relatively broad set of strategies.
Citadel's net numbers are even more impressive than they might appear, because the firm, unlike almost all of its competitors, deducts all operating expenses from its fund performance before paying investors. Those variable expense charges are higher than 3 percent per year, compared with the typical 1 percent flat asset management fee that most hedge fund investors are charged.
Griffin uses one old-fashioned hedge fund technique to generate his returns - plenty of leverage. Citadel levers its stock positions a steep three to six times, according to a firm official. But S&P analyst Ukeiley, who tracks the firm's balance sheet on a monthly basis, thinks the firm's leverage is reasonable once it's adjusted for offsetting positions.
In 1999, after the firm finished up 45 percent, rumors began circulating that the hedge fund was mismarking its positions to generate these kinds of outsize returns. Intent on ending the speculation, Citadel, which has been audited by Arthur Andersen for the past ten years, commissioned an additional independent audit of all its thousands of positions by a different auditor. The audit confirmed all of Citadel's marks, according to investors. "When a firm has returns like that back to back, you want to find out what is going on," says Mark Yusko, who runs the University of North Carolina's investment office. "We have reviewed their operations every which way to Sunday, and they appear to be marking their positions just fine."
"Every organization has Two choices," says Griffin. "Choice one is to grow. Choice two is to die. If you decide not to grow, it's a clear-cut message to talented people that it's time to leave."
Although convertible bonds still account for about half of the firm's trading profits, Citadel has steadily diversified. Today the firm also invests money in distressed high yield, government bond arbitrage, statistical equity arbitrage, risk arbitrage and event-driven trading. The firm has also developed a business structuring private investments - typically convertible financings - in public, often speculative, companies (see story).
As the firm has grown, Griffin has recruited senior executives into management and strategy roles. Apart from CFO DiRocco, Griffin has brought in chief operating officer Barry Wallach from Andersen, where he was managing partner for U.S. operations; chief information officer Thomas Miglis from Bankers Trust Co., where he was head of global systems; and chief strategist Robert Morette, who ran Boston Consulting Group's Midwest finance practice. An additional eight consultants from such places as BCG and Booz, Allen & Hamilton now work full time at Citadel. It's an extraordinary amount of management skill for a 350-person firm, and it's unique in the hedge fund business. "The systems that Citadel has are far superior to anything that I've seen in the hedge fund business," says Carson Levit, who joined Citadel in July as a portfolio manager in its long-short equity business. He previously worked at Soros Fund Management and Pequot Capital Management.
Griffin is always on the lookout for talent. Last year he hired a team of consultants from BCG to collect detailed information on his major hedge fund competitors in hopes of understanding their strategies and poaching their best people. And when the news broke last October that the successful hedge fund Vinik Asset Management would shut down, Griffin was in Boston 48 hours later interviewing Vinik traders.
Griffin's ability to expand into new areas is rare in the hedge fund business, where most groups stick with one type of trading. "I am not aware of them having a failure at any of the strategies they've diversified into," says Jerry Baesel, a Morgan Stanley managing director who runs an alternative investment fund that has invested with Citadel since 1991.
Now Griffin is pushing ahead with plans to launch a major new trading unit buying and shorting U.S. stocks. New recruits Levit and Labon, who will be based in San Francisco, are gearing up to lure more talent away from hedge fund competitors. Citadel will be competing against much larger and more experienced investment firms, and its sophisticated information-processing systems may be of less value in a market like U.S. stocks, where information flows freely. Nor has Griffin ever tried to fashion a big team in one fell swoop by recruiting quickly from among many firms.
Challenged about the difficulty of applying Citadel's analytical framework to picking stocks, Griffin insists that the firm has done just that in risk arbitrage and has taken a meticulous approach to researching this new business. "I believe we have built one of the best merger arbitrage businesses in the world, even though someone could have made the argument that it wasn't related to our strengths," he says.
With more money than anyone will ever need, Griffin's overriding goal is to build the first great hedge fund shop that's permanent. As always, he's got a process. "I try to surround myself with people who disagree with me," says Griffin. "Successful people tend to be very overconfident about what they know, and it leads to tragic mistakes. That will not be the final chapter in my career."
Secrecy and death spirals
With market-beating returns for the past decade, the traders at Citadel Investment Group in Chicago are among the best in the world. Just don't ask them how they do it. They are as secretive as they are successful.
One night earlier this year, AIG Global Investment Corp. hedge fund investment executive Norman Chait found himself sitting between Citadel's risk arbitrage head, Alec Litowitz, and a trader from another major hedge fund at a dinner sponsored by Morgan Stanley. "When the other trader was turned away, Alec talked to me about business," says Chait. "When the trader would turn in our direction, Alec would immediately start talking about kids' videos. This went on all night."
When pressed, Citadel's partners were no more revealing with this magazine. But interviews with traders and a review of the firm's offering memorandums and investor letters does provide a glimpse behind the curtain.
The firm applies 15 strategies, but about 85 percent of its profits in the past few years have come from convertible bond trading, risk arbitrage and other event-driven strategies, say investors. Convertible bond trading and similar equity derivatives trading account for more than half the firm's profits.
Global in reach, Citadel, which uses leverage aggressively on certain positions, has built up big holdings in Japan; at times these have amounted to more than 70 percent of the firm's convertible positions.
Up 12.6 percent through the end of July, Citadel has outperformed many rivals because it steered clear of the hard-hit telecommunications sector. In risk arbitrage and event-driven trading, one of the firm's coups this year was making money on the failed General Electric Co.-Honeywell International deal, which caused considerable losses for many risk arb units.
The firm has occasionally stumbled. In the late 1990s Citadel amassed big positions in the equity-linked derivatives issued by money-center Japanese banks, hoping to take advantage of mispricings created by the unusual complexity and giant size of the offerings. But the trades soured. The firm scrambled out after suffering a loss of 2 percent in one month, but the same securities became a big moneymaker for Citadel in the next two years. "We respect them a lot," says Louis Salkind, managing director of archrival hedge fund group D.E. Shaw & Co. "They are certainly one of the top players in the world of arbitrage. We cross paths with them all the time. They are huge."
Citadel has become increasingly aggressive in private placements, including the exotic field of Pipes, private investments in public entities. Over the past six years, it invested in 80 private transactions worth $550 million in public companies, according to DirectPlacement, a San Diego investment bank specializing in the area. Many of the Citadel deals, in companies such as MicroStrategy and eToys, had a reset provision allowing the company to convert at a lower price if the stock fell.
One variety of these convertible securities, known as "death spirals," has no floor on the conversion price and has become increasingly controversial. These securities get their name from the combination of the investor's right to short the stock and the right to reset the conversion price, which creates a potential incentive for holders of the securities to push down the price of the stock. In January 2001 Providence, Rhode Island, telecommunications company Log On America sued Credit Suisse First Boston and two funds controlled by Citadel, charging that they had caused the firm's stock price to collapse, from $17 to less than $1, by engaging in short-selling after buying death-spiral converts.
"We are alleging that they bought the security with the intent of manipulating the stock," says David Paolo, CEO of Log On America. Paolo says Citadel engaged in "massive" short-selling, but Citadel, which declines to comment, bought only $3.75 million worth of the convertibles. Citadel is also enmeshed in a small investment in a company whose recent history seems like a bad movie. Soon after Citadel loaned $25 million to a Florida casino cruise company called SunCruz Casinos, a previous owner was murdered while driving down a Fort Lauderdale street by someone firing a gun from a black Mustang. The Miami Herald then printed allegations that one of the new owners, ex-Dial-A-Mattress franchisee Adam Kidan, had made "food and beverage consulting" payments to a caterer with alleged mob connections. Fort Lauderdale homicide detective John King says the murder remains unsolved and Kidan is not a suspect. The Citadel loan is still performing, but the profitable SunCruz filed for Chapter 11 to deal with a blizzard of lawsuits. Kidan, who has since left the company, has said the payments were legitimate business expenses. He did not return a message left with his attorney.
Citadel won't say how it fared on private placement investments in other fallen companies such as eToys. But, says DirectPlacement president Brian Overstreet, "I think they made a lot of money from these other transactions because they were around long enough for them to trade out. But it's impossible for anyone to really know how they did."
That's just how Citadel likes it. - H.L.
©Copyright 2001 Institutional Investor, Inc.
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