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.
Legg Mason is the latest big-name financial firm to get into the hedge fund business. UBS AG agreed in 1999 to buy Global Asset Management, and Bank of New York acquired Ivy Asset Management the next year. Last year, J.P. Morgan Chase bought Highbridge Capital.
Mason first approached Permal through a Wall Street connection and met with Souede five years ago, the two men say. A deal didn't come through back then because some of Permal's owners, which included a holding company controlled by the Italian Agnelli family, didn't want to sell, according to Souede. It wasn't until family patriarch Umberto Agnelli died last year that Mason and Souede found themselves talking again.
"Chip was intrigued about our business, and I think we had great chemistry, but our parent wasn't willing," Souede said. "When we began a strategic search for a partner later on, we didn't want to be part of a conglomerate, and we wanted someone with a strong record in the United States. That's when we began our conversation again with Legg Mason."
The negotiations took nine months, as Legg Mason and its lawyers "looked at every single piece of paper, each of our managers, every contact," Souede said. The talks were also complicated because three parties were involved - Permal management, Legg Mason and Sequana Capital, which is majority owned by the Agnelli family, who control the carmaker Fiat.
Permal will operate as an independent subsidiary under Legg Mason. Mason also secured employment agreements from Souede and other Permal brass.
While Permal is praised by its peers, others in the hedge fund industry have been marred by failures. Perhaps the most infamous was Long Term Capital Management, which lost more than 90 percent of its $4 billion fund after a financial crisis in Russia. The Federal Reserve orchestrated a $3.5 billion bailout.
While industry insiders complain that their field has been tainted by a few rogue funds, they say it is important to find a trustworthy manager. Permal's specialty is trying to do just that.
"It seems like every two years, there's a hedge fund blowup; someone goes off the reservation," said Hennes, who oversaw Long Term after its implosion. "So from that perspective, it's important that people pick the right managers, and I don't think individuals are equipped to do that. "
Hedge funds are becoming more widely accepted. Driving the growth is the pain of losses in the stock markets in the late 1990s, said Mark D. Wolfinger, author of Create Your Own Hedge Fund.
"When the bubble burst and hedge funds were making money because they could play the short side, a lot of people wanted to get into them," Wolfinger said.
Some of Permal's funds have posted impressive runs. Its Haussmann Holdings fund had a 52 percent cumulative return from 1999 through mid-June, compared with an 8 percent rise in the S&P 500 Index.
"It almost sounds like a free lunch," said Ed Easterling, a hedge fund expert at Crestmont Research in Dallas. But hedge funds are intended to be part of a diversified investment portfolio. He pointed out that hedge funds aren't keeping up with returns on bonds, considered the most conservative investment choice, so far this year.