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Asset management division's stumbles tarnish Goldman Sachs

By Richard Teitelbaum
Bloomberg News
Saturday, February 5, 2011; 9:47 PM

On Jan. 2, Jim Clark, a founder of such technology icons as Netscape Communications and Silicon Graphics, was at home in Palm Beach, Fla., when he got an e-mail from an executive at Goldman Sachs Group's private wealth management division.

Goldman was offering Clark a chance to invest in the closely held social-networking company Facebook. The deal - through a fund overseen by Goldman Sachs Asset Management - was being extended to other Goldman investors at the same time. The firm would levy a 4 percent placement fee on clients. It would also require investors to surrender 5 percent of any profit, known as "carried interest," according to a Goldman Sachs document.

Clark, 66, turned Goldman down. In June 2009, he had yanked most of the roughly $400 million he had invested with the firm because of 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 bought 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."

Clark isn't the only investor unhappy with GSAM. The division managed most of the $840 billion in assets Goldman oversaw in December, a figure that dwarfs the money managed by major firms such as Legg Mason and Franklin Resources. Yet evidence suggests the behemoth inside the 141-year-old investment bank is generating subpar returns for investors and is a persistent headache for its chairman, Lloyd Blankfein.

The CEO has dispatched a series of lieutenants on missions to fix the listless asset manager. Investment management is now run by Ed Forst and Timothy O'Neill, who are the eighth and ninth Goldman investment chiefs in eight years.

Last year pension funds in California and Nevada withdrew a total of more than $900 million from GSAM because they were unhappy with its performance and concerned about turnover. At the same time, the asset management division has become increasingly important to Goldman as the firm's trading powerhouse has idled.

Revenue from Goldman's Fixed Income, Currency and Commodities 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.

Goldman declined to make Blankfein or any other executives available to comment.

A big chunk of GSAM's assets are its separate accounts - pools of money invested for institutions and wealthy individuals. EVestment Alliance, 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 Sept. 30.

Chicago-based financial publisher Morningstar 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, foreign stock and taxable bonds, over the 3-, 5- and 10-year periods ended Dec. 31.

Yet investors have not only stuck with GSAM; they've added tens of billions of dollars to its assets since 2000.

"Given the golden reputation of Goldman, it's amazing," says Anton Schutz, founder of Mendon Capital Advisors, 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."

About-face on Facebook

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 company's stock to clients through a GSAM-affiliated fund.

Instead, on Jan. 17, Goldman halted its offering to U.S. investors, citing scrutiny from the news coverage 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.

Analyst Josh Bernoff of Forrester Research expects a Facebook initial public offering in 2012.

Bundling Facebook shares into a GSAM special-purpose vehicle might have helped Facebook avoid an SEC requirement that any company with more than 499 investors meet its 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.

On Jan. 21, Facebook announced that Goldman had completed an oversubscribed offering to its non-U.S. clients for a fund that invested $1 billion in Facebook Class A shares.

A run of controversy

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 the bank 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.

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 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 .

"Goldman repeatedly put its own interests and profits ahead of the interests of its clients and our communities," said Sen. Carl Levin (D-Mich.) who led the subcommittee.

Blankfein said 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.

"When it came out that Paulson had the biggest payday in history, I got angry," Clark says. "They just butter their own bread and charge huge fees."

The conflict between what Goldman does for itself versus what it does for its customers was addressed by Blankfein and other top executives in a 63-page internal document released in January. The report recommended the creation of a simplified balance sheet that would make transparent the division between the deals Goldman does for its own profit and those it carries out for its customers.

A reputation to uphold

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 Rochdale Securities. "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."

The numbers tell the tale.

According to Morningstar, 44.9 percent of Goldman's U.S. diversified stock funds managed to beat their peer average over the three years ended Dec. 31. Just 34.7 percent of such funds beat their peer average over five years and 28.3 percent over 10 years.

Only 11.5 percent of Goldman's foreign stock funds beat their peer average over three years; 6.7 percent over five years; and none 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.

Goldman spokeswoman Andrea 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.

So why do investors keep their accounts at the New York firm? The prestige of the Goldman Sachs 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, 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's annual ranking. 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.

"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.

Schutz says getting early access to the latest hot investment makes it easier for investors 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, Goldman's star power may be dimming.

$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 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."

In June, California's Kern County Employees' Retirement Association, a pension fund with $2.8 million in assets, pulled $347 million from two GSAM accounts. Executive director Anne Holdren cited 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 a partnership called Goldman Sachs Trading, which invested in the then-booming stocks of banks, insurers, utilities and industrial companies.

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. "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.

Blankfein and his cohorts periodically remind investors of the firm's commitment to expanding GSAM. In a February 2010 letter to shareholders, they 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 to hire.

Blankfein has tried to solve the performance problem with a parade of new asset management chiefs. He has also tried to tether the traditionally independent GSAM unit more tightly to the head office by tying compensation to the performance of the larger firm.

None of the changes 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," he says, "and I don't want these Goldman Sachs managers."

In 2009, Clark moved almost all of his money to Morgan Stanley.

- Bloomberg News

A version of this story will appear in Bloomberg Markets magazine in March.

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