With deal, Legg enters risky realm of hedge funds

Investing: Baltimore firm's purchase of a stake in Permal Group was an add-on to the $3.7 billion Citigroup swap.

July 06, 2005|By Laura Smitherman | Laura Smitherman,SUN STAFF

Thousands of people with a penchant for the markets and a creative idea to beat them run hedge funds, or investment pools for the uber-rich. By Isaac Souede's estimation, though, only about one in 50 is any good.

This at once explains why Legg Mason Inc.'s conservative chief executive, Raymond A. "Chip" Mason, was reluctant to expand his Baltimore investment firm into the lucrative but risky and lightly regulated world of hedge funds - and why, when he did, he did it with Souede.

In a surprise add-on to its $3.7 billion deal with Citigroup last month to swap brokerage and money management businesses, Legg Mason agreed to buy an 80 percent stake in Souede's Permal Group, with the option to purchase the remaining 20 percent over the next four years. The total sticker price is capped at $1.4 billion, with some of the financing depending on Permal's revenue.

It marks the first foray for Legg Mason into a business celebrated for its heroes such as George Soros, who once made $1 billion in a single day by betting against the British pound, but denigrated for some spectacular failures, including the 1998 collapse of Long Term Capital Management that roiled markets.

At first blush, Legg's acquisition of Permal seems a departure for Mason, who has described the company's trading style, mostly in stocks and bonds, as "mundane" and even "basic." Hedge funds, in contrast, use complicated, often secretive strategies and bet on almost anything, from currencies and commodities to interest rates and foreign economies. Hedge funds also can "short" stocks by making a bet that they will tank.

But if a hedge fund company could be described as stodgy, analysts say it's Permal, making it a good fit for Legg Mason.

"This is the way to do it, a lower-risk way to enter this market," said Jeff Arricale, an analyst at T. Rowe Price Group. "These guys aren't dabbling in the mysterious stuff. Even if they make some bad decisions along the way, it's more likely to be a bump in the road than a major catastrophe."

Permal Group, based in Paris, is not a hedge fund in itself but one of the world's largest firms that invests in hedge funds on behalf of clients. It advertises its detailed process for picking hedge fund managers - it was an early investor in Soros - with flow charts to demonstrate the decision-making process. The company charges a fee for its services, on top of sometimes hefty fees charged by the hedge fund managers, as high as 20 percent of profits.

In weeding out the managers it chooses to invest with, Souede says, the company not only looks at market data and projected returns but also psychological profiles and background investigations. Souede said he and other executives in New York often debate at meetings whether their jobs are more of a science or an art.

"In truth, this is just another way to manage money based on real economic models," Souede said. "There is no black magic in what we do."

Permal is among the oldest firms in its business, opening its doors in 1973. Hedge funds are not required to disclose much information about themselves, but Permal has voluntarily registered with the Securities and Exchange Commission, and 12 of its 30 funds have been rated by Standard and Poor's, with two receiving the gold-standard "AAA" rating.

"As far as hedge fund investors go, they are one of the most well-known and very highly regarded," said Duncan Hennes, an industry veteran and chief executive of Promontory Financial's hedge fund group. "They've been around forever. They know what they're doing."

News of the Permal deal was drowned out by the announcement that Legg Mason will take over investor accounts at Citigroup of more than $430 billion, making it the fifth-largest money manager in the world. Permal manages a much smaller amount, about $20 billion. But it "adds a lot to the story" of Legg's meteoric rise, CEO Mason said.

The acquisition makes Legg Mason one of the largest players in a mushrooming business - from $38 billion in investor money 15 years ago to an estimated $1.1 trillion today, according to Hedge Fund Research Inc.

Hedge funds traditionally are open only to accredited - and presumably sophisticated - investors, who must have a net worth of at least $1 million or earn more than $200,000 a year, or $300,000 with a spouse. The minimum investments required are typically steep, usually more than $1 million.

These funds are increasingly sought after by institutions such as pension systems, and Permal has established relationships in places Legg Mason hasn't reached, with offices in Singapore, the Bahamas and the United Arab Emirates. Permal also has a fund that invests according to Islamic principles - which, among other things, prohibit the charging of interest - to attract more investors from the oil-rich Middle East.

Permal hasn't made much of a move into the United States, where analysts say investors are hungry for more hedge fund choices.

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