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John Costas, UBS: DRCM offered him a painful lesson |
The lesson to be learnt from UBS’s unexpected closure of Dillon Read Capital Management? Don’t mix bank and client money.
John Costas, head of UBS’s investment bank, was given the remit in June 2005 to carve out and run the bank’s proprietary trading business. The subsidiary, Dillon Read Capital Management (DRCM), was to be developed so that outside investors’ money would be accepted in managed accounts and funds. Both the outside money and the prop money operations would be headed by Costas.
The vastness of the task at hand became apparent last year. The legal entity was formed in January 2006 but it took until June 2006 to move over the proprietary trading positions. Not until then did marketing of the funds to outside parties begin, with the funds not up and running until November.
"In terms of infrastructure and working out how to run proprietary capital alongside external money, it was becoming a nightmare," says a source familiar with the efforts.
Keeping an eye on both sides of the business proved too much. While the external investor fund attracted $1.5 billion, producing positive returns, and generating around 11% net of fees, the proprietary trading business was falling apart. In the first-quarter earnings press release, DRCM posted a $123 million trading loss (from the prop business only).
Sub-prime
The strategies being run are undisclosed, but it is believed that the prop money was significantly long sub-prime. Indeed the party line is: "Turbulence in the US sub-prime market affected the performance of the outside investor funds slightly but the main effect was felt in the controlled [prop] fund."
In Costas’s defence, it should be noted that many of the positions that were in the prop fund were made before he took charge, while the external funds were created afresh in November. But the complexities of overseeing the two sides were clearly too much from a risk management perspective. One investment banker says: "What’s he going to do? Look after the private-client money and make sure that does well and therefore keep the firm’s and his public reputation up? Or focus on the prop side, which can fall back on UBS’s big balance sheet? If it was too much to oversee both, then it is better to do the former."
It’s a blow for Costas, who was seen as somewhat of a hero at UBS. The $3 billion in prop money is now to be reintegrated into the investment bank, and the external investor money redeemed. UBS says Costas will then take on a senior advisory role to the UBS group executive board after the transition. But the transition is being overseen by Suneel Kamlani, chief of staff of the investment bank, and CEO of DRCM. The cost of reintegration is put at $300 million but UBS says it will benefit from an annual cost saving of $200 million. Some redundancies are expected among the 250 employees.
So where will the $1.5 billion of client money end up? UBS says it is "working with clients to identify other alternative investment opportunities", but it would be fair to assume that most of that money will be gently nudged towards UBS’s asset management business. Its hedge fund business, Alternative and Quantitative Investments (A&Q) within the overall global asset management arm of UBS, has $51.8 billion in invested assets comprising single-manager funds and funds of funds.
Although competitors on Wall Street say the whole DRCM debacle is an admission of failure, and are only too keen to revel in the demise of a European firm encroaching on the US space, there has to be some credit for the swiftness of the decision-making. "It was recognized by those above that it wasn’t working, and it seemed best to pull it immediately and get out," says a source familiar with DRCM. "The business model, the complexities operationally of managing prop and client alongside each other along with the technical, regulatory and administrative complications were just not worth it."