UBS Embraces Hedge Fund Risk to Woo Wealthy Clients, Boost Fees

Date: Friday, September 23, 2005

Sept. 23 (Bloomberg) -- Seven years after UBS AG lost $700 million in the collapse of Long-Term Capital Management LP, Chief Executive Officer Peter Wuffli is creating a new hedge fund to tap increasing demand for riskier investments. UBS, Europe's largest bank by assets, expects wealthy people to put as much as 20 percent of their money into hedge funds in the next five years, Wuffli said in an interview. The Zurich-based bank plans to invest about $2 billion in its new Dillon Read Capital Management unit, people familiar with the situation said. ``The hedge fund industry, while there will be bumps in the road, is a secular growth industry,'' Wuffli, 47, said. ``There is not just pent-up demand by institutional but also, increasingly, private wealth management segments.'' The bank's commitment to hedge funds, loosely regulated investment pools that typically attract clients with more than $1 million in assets, comes at a time when the $1 trillion industry is suffering from slowing inflows and declining returns. New York-based Dillon Read will be led by former investment banking CEO John Costas, 48, and initially focus on fixed-income investments. UBS will also consider acquisitions to help the bank expand in the U.S. and strengthen its position as the world's No. 1 money manager, Wuffli said. UBS had $2 trillion of invested assets at the end of June. Investors will press UBS for details about the risk the bank will allow Dillon Read to assume, said Andrea Solari, a fund manager at Banca del Gottardo in Lugano, Switzerland, who helps manage about $30 billion, including UBS shares. ``They should come out with detailed figures because it is difficult for an investor to understand what they are doing in this area,'' Solari said. ``I doubt they will make the same mistake as in 1998 with LTCM.'' `Very Ambitious' Wuffli declined to confirm the amount of money UBS will invest in Dillon Read, saying he expected the new unit to become an important business under Costas's leadership. Dillon Read will use UBS's balance sheet to leverage its investments, he said. ``John Costas is a very ambitious person,'' Wuffli said. ``If that were not an attractive, sizeable business, he would not be attracted to that job.'' Costas, through New York-based UBS spokesman Mark Hengel, declined to comment. After equity markets plunged in 2000, investors began turning to hedge funds to make money regardless of whether stock and bond markets were rising. The number of single-manager hedge funds has risen more than 45 percent to about 6,000 over the past five years. Hedge fund investments have begun to slow amid declining returns. Investors worldwide put $11.6 billion into hedge funds in the second quarter, down 53 percent from the first quarter and the lowest since the end of 2001, according to Tremont Capital Management Inc. of Rye, New York. Tough Market Fixed-income arbitrage funds have risen 0.38 percent this year, according to the CSFB/Tremont Hedge Fund Index. U.S. Treasury securities have returned 2.47 percent this year, including reinvested interest, according to New York-based Merrill Lynch & Co. Second-quarter revenue at UBS's fixed-income unit fell 26 percent from the previous three months to 1.6 billion Swiss francs ($1.3 billion). UBS's investment in Dillon Read comes after banks such as New York-based JPMorgan Chase & Co. expanded into hedge funds. ``They may be a little late to the table, but they can still make good profits,'' said Dieter Buchholz, who manages about $2.8 billion at BNP Paribas Private Bank in Zurich, including UBS shares. Retaining Talent Costas will take 120 traders from the investment bank's fixed-income unit to start Dillon Read in January. Those traders were previously part of a unit that traded fixed-income securities and commercial real estate for the bank's own account. The group generated 695.7 million Swiss francs in the first half, or 18 percent of UBS's fixed-income revenue. Investment banking accounts for about 40 percent of 2004 pretax profit at UBS, with wealth management generating an additional 39 percent. Wuffli said the creation of Dillon Read was also motivated by the need to keep key executives. ``The hedge fund industry is very attractive for talent in certain phases of their career,'' he said. ``We obviously prefer to retain the talent, as opposed to offering it to the Street.'' UBS will pay an unspecified portion of the compensation for Costas and the other principals in the form of deferred investments in the fund. Dillon Read plans to raise as much as 60 percent of its initial capital from institutional investors in its first year, with the rest coming from UBS, Costas said Sept. 8. The unit will be one of the biggest fixed-income hedge funds when it begins doing business in the first half of next year, he said. Dillon Read Rebirth That may place Dillon Read on par with the $3.4 billion Moore Global Fixed Income Fund, run by New York-based Moore Capital Management LLC, one of the biggest fixed-income hedge funds. The unit's name comes from Dillon, Read & Co., a U.S. investment bank that was acquired by Swiss Bank Corp., which later merged with Union Bank of Switzerland to form UBS. The bank dropped the Dillon Read name in 2000 when it created a single brand for its financial services. Costas, a former bond trader at Credit Suisse First Boston, built UBS's investment bank into the No. 2 underwriter of stock offerings worldwide and the No. 4 adviser on global mergers this year, according to data compiled by Bloomberg. When he took over as CEO of the investment bank in 2001, UBS ranked No. 6 in stock underwriting and No. 8 in merger advice. Driving Growth Costas drove the UBS expansion in the U.S. by hiring more than 50 senior bankers when most companies on Wall Street were cutting workforces and bonuses. UBS probably manages 4.5 percent of the global wealth of people with more than $1 million to invest, said Ted Wilson, a consultant at Scorpio Partnership Ltd. in London. Building a hedge fund company from scratch may help Wuffli maintain the bank's position as the world's biggest wealth manager, said Orun Palit, who manages about $1.2 billion, including UBS shares, at AIG Private Bank in Zurich. ``He has been able to get assets in the growth areas,'' Palit said. ``He has really established a worldwide global wealth management operation.'' Wuffli declined to comment on investor speculation that UBS will buy Chicago-based Northern Trust Corp. to capture a bigger share of the U.S. custody business. Asset custodians provide administration, safekeeping and other services for clients including mutual funds, pensions, corporations and endowments. Northern Trust ``We don't speculate about acquisitions, we talk about them after the fact,'' Wuffli said, adding that he considered Northern Trust to be expensive. ``Northern Trust is a great company, but very, very richly valued.'' UBS's shares have climbed 14 percent this year, compared with a 10 percent gain in the 78 member Bloomberg Europe Banks and Financial Services Index. The shares traded for a record 110 Swiss francs on Sept. 20, valuing the bank at 124 billion francs. The previous high of 108.8 francs was set in July 1998, shortly before Long-Term Capital Management collapsed. As trading in equities and bonds becomes less profitable, many investment banks are turning to higher-margin businesses such as hedge funds, which typically charge fees of 2 percent of assets under management and earn an additional 20 percent or more of any returns. In contrast, most U.S. mutual funds charge less than 5 percent of assets under management. JPMorgan Chase, the third-largest U.S. bank, last year bought a majority stake in Highbridge Capital Management LLC, a New York hedge-fund firm with $8 billion in assets. `Reputational Risk' UBS's prestige may suffer if the hedge fund doesn't outpace its competitors, said Christopher Wheeler, a London-based analyst for Bear Stearns Cos. ``There's not a lot financial risk but there's reputational risk,'' Wheeler said. ``The downside is that they give it too much profile and it doesn't work, then it makes UBS uncomfortable. Suddenly if money is going back to investors in two years time, it's embarrassing.'' The creation of Dillon Read came shortly before UBS agreed to sell GAM, which manages $37 billion in funds of hedge funds. UBS bought what was then known as Global Asset Management Ltd. for $675 million in 1999. Zurich-based Julius Baer Holding AG agreed to buy the division and three small Swiss private banks for about 5.6 billion Swiss francs in September. ``GAM was very focused on independence and not very open to being integrated into large corporate structures,'' Wuffli said. Turning away from the fund-of-funds model and creating its own hedge funds will give UBS more control and higher fees, said Florian Esterer, a fund manager at Zurich-based Swisscanto Asset Management AG, which manages about $39 billion. `Brilliant Move' ``It was a brilliant move,'' Esterer said. ``You could interpret it as a concession that they were never able to integrate GAM into UBS as a whole. Now, they are moving their own guys into Dillon Read.'' UBS already has another hedge fund unit. Chicago-based O'Connor LLC is run by Joe Scoby, who joined Swiss Bank Corp. when it bought O'Connor & Associates, a U.S. equity derivatives firm, in 1992. The O'Connor division started with $500 million under management and is now part of a unit that oversees $39.2 billion. ``We clearly, over time, would like to grow and be as important in the business for UBS as O'Connor is,'' Costas said Sept. 8. Wuffli, a former McKinsey & Co. consultant, joined what was then Swiss Bank Corp. as chief financial officer in 1994. When that company merged with Union Bank of Switzerland in 1998, Wuffli remained as CFO, helping the new company reduce risk after Union Bank of Switzerland's failed investment in Long-Term Capital. LTCM Woes Greenwich, Connecticut-based Long-Term Capital collapsed in 1998. The fund, which had used $2.3 billion in capital to build up $125 billion in securities, crumbled when Russia defaulted on 281 billion rubles of domestic debt, amounting to about $12 billion at the time. Russia's default sent global markets tumbling, wiping out many of the fund's assets. The time is right for UBS to take on closely monitored risk, Wuffli said. ``We obviously do take risks, particularly for our clients, where it helps us strengthen our franchise,'' he said. To contact the reporters on this story: Alice Ratcliffe in Zurich at Stephanie Baker-Said in London at