For a pair of former Citigroup Inc. (C) hedge-fund managers, Napier Park Global Capital may turn into a multimillion-dollar payday thanks to the Volcker rule.

Jonathan Dorfman and James O’Brien are among executives who got 75 percent of the investment firm for free when it broke off from Citigroup earlier this year. The business may be worth $360 million, according to hedge-fund consultant Ezra Zask. The estimate is based on the $143.4 million in fees the firm may collect this year, according to internal projections obtained by Bloomberg News.
Enlarge image Citigroup Fund Bestowed on Managers Offers Volcker Rule Payday

Jonathan Dorfman and James O’Brien run Napier Park Global Capital and received about 25 percent of the firm, which still operates from the bank’s Park Avenue headquarters in Manhattan, the people said. Photographer: Daniel Acker/Bloomberg
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Any windfall Napier Park executives get stems from former Chief Executive Officer Vikram Pandit’s response to the Volcker rule, a Dodd-Frank Act provision designed to force U.S. banks to reduce investments in hedge funds. While Citigroup says the decision to give away most of the business served shareholders’ interests, the New York-based lender never publicly disclosed how much it’s paying Napier Park executives.

“Investors pay a hefty premium in management and incentive fees to have their assets managed by firms like Napier Park,” Zask said. “It’s difficult to tell if Citi’s motive was to help out their buddies or to take advantage of a superior investment opportunity.”

Bloomberg News first reported Citigroup’s plan to give managers a majority stake in Napier Park in December, citing people with knowledge of the matter.

‘Ensure Compliance’

Pandit and former Chief Operating Officer John Havens, 56, oversaw the design of the spinout before leaving in October. Dorfman, 51, and O’Brien, 53, run Napier Park and received about 25 percent of the firm, which still operates from the bank’s Park Avenue headquarters in Manhattan, the people said. The four men, who joined Citigroup in 2007, had previously worked at Morgan Stanley for about two decades. Other managers share about 50 percent and the bank holds the remaining 25 percent.

“As part of our efforts to ensure compliance with Dodd-Frank, we conducted a thorough process and explored all available options,” Danielle Romero-Apsilos, a Citigroup spokeswoman, said in an e-mailed statement. “This transaction was structured to align the interest of Citi’s stakeholders, while responsibly creating a profitable and stable company.”

Napier Park manages about $6.8 billion, including single-investor accounts and collateralized loan obligations, according to a March 1 statement. About $3.64 billion of that was spread across 10 hedge funds as of April 11, according to the documents obtained by Bloomberg News. Citigroup had $2.27 billion of shareholders’ cash tied up in the hedge funds at the end of 2012, the documents show.

Leveraged Loans

The 10 hedge funds wager on securities including European leveraged loans and credit derivatives. At least five funds, including those investing in mortgage-backed securities and distressed debt, beat peers in 2012, according to the documents and data compiled by Bloomberg. Others, including a fund that bets on interest rates and currencies, underperformed. Nine of the funds gained this year through April 11, while a municipal bond fund dropped 0.8 percent, the documents show.

Romero-Apsilos and Mickey Mandelbaum, a Napier Park spokesman, declined to comment on how much Citigroup is paying in fees.

The documents show how Citigroup intends to withdraw cash from the funds gradually to comply with the Volcker rule, giving Napier Park time to raise money from investors. The documents also contain estimates of performance and management fees the firm stands to collect under scenarios for attracting new capital. Some fees help cover overhead costs.

Bank’s Withdrawal

While Napier Park expects to collect $143.4 million in fees this year under a forecast in which it replaces capital, the sum may drop to $127.8 million in a scenario in which assets under management fall amid Citigroup’s withdrawal, the documents show.

The documents list $4.5 million “executive incentive compensation” that pays out whether Napier Park’s assets under management increase or decline, the documents show. Dorfman and O’Brien, the firm’s senior managing partners, didn’t respond to e-mails seeking comment on the payment.

The documents list higher management fee rates for Citigroup than what Napier Park would charge new investors. The bank’s 2 percent fee on its $356 million in the Mortgage/Credit Opportunity fund at the end of December is 60 percent higher than the 1.25 percent that the fund plans to ask of new investors, the documents show. Similar premiums for Citigroup are listed at six other funds, according to the documents.

Hedge-fund managers typically earn 2 percent of the assets they oversee as a management fee and 20 percent of the profits as an incentive.

Citigroup ‘Pleased’

The bank may pay $71.1 million in total fees to Napier Park in 2013, even as the bank withdraws assets to comply with the Volcker rule, said Zask, head of New York-based hedge-fund consulting firm SFC Associates and author of “All About Hedge Funds,” an analysis of the industry.

Zask said he based his estimate on the data in the documents, including the size of Citigroup’s investment, as well as assumptions about how the funds will continue to perform this year and their fee structure.

“Generally, we have no issue with paying performance fees on funds that are performing well year-to-date,” Romero-Apsilos said. “We are pleased with the year-to-date performance of the funds.”

Zask said the firm could be worth $360 million this year if it achieves projections for performance and attracting new investors. That could rise to $392 million by 2016, he said.

Hit Targets

Kyle Vataha, a vice president at Pluris Valuation Advisors LLC, specializes in valuing private-equity and hedge funds. He said Napier Park could be worth $251 million if executives hit the targets in the projections. That could slump to $61 million if they fail to replace Citigroup’s cash, Vataha said.

Roberto Caccia, who runs the Richard M. Burridge Center for Securities Analysis & Valuation at the University of Colorado, said Napier Park could be worth as much as $300 million by 2016 if the firm replaces Citigroup’s money with outside investment and attracts extra cash.

“They need to survive the initial period of uncertainty,” said Caccia, a former Goldman Sachs Group Inc. (GS) managing director. “If they manage to replace capital and line up to an industry-standard fee structure, then they could get to that ballpark number.”

The deal could produce a gain for shareholders if the funds perform well and the value of Citigroup’s 25 percent stake increases, said Craig Cognetti, a New York-based partner of investment-advisory firm Grail Partners LLC, who reviewed data from the documents.

‘Shutdown Approach’

“If this venture is successful, the long-term value of Citigroup’s minority stake will exceed the fees paid over the next few years,” he said. “More importantly, the net return from this approach will exceed the shutdown approach, which probably would have ended up in a sizable loss.”

The Volcker rule, named for former Federal Reserve Chairman Paul Volcker, seeks to restrict deposit-taking banks from owning more than 3 percent of a hedge fund’s assets or investing more than 3 percent of Tier 1 capital in the funds.

Citigroup may pull about $1.3 billion from Napier Park’s hedge funds this year as it begins to comply, according to the documents. Fund executives would raise a total of $3.2 billion through June 2014 as the bank’s investment shrinks under one of the scenarios, the documents show.

Singapore’s Stake

Napier Park has clients beyond Citigroup, such as a Singaporean state-owned investor, which is the largest stakeholder in one of the funds, people familiar with the matter said in December. That fund manages more than $300 million, the documents show. A separate $352 million municipal-bond fund contained just $46 million of the bank’s money at the end of 2012, according to the documents.

Citigroup remains the biggest investor in the rest of the funds, some of which trace their roots to Old Lane Partners LP, the firm that Pandit and Havens founded and later sold to the bank for $800 million. At least half the money in eight of 10 Napier Park funds comes from Citigroup, the documents show.

Some of Napier Park’s wagers are currently paying off for Citigroup. The European Credit Opportunities fund, which held $172 million of the bank’s money on Dec. 31, climbed 8 percent this year through April 11, the documents show. The fund, which bets on riskier corporate debt, rose 56 percent in 2012.

The $684 million Event Driven Strategies fund, run by former Old Lane executive Mukesh Patel, is among Citigroup’s biggest investments. At year-end, the bank had about $470 million in the fund, which seeks to profit from events such as mergers and acquisitions. The fund gained 3.7 percent this year through April 11, the documents show.

Global Macro

The Synthetic Portfolio Equity fund, the smallest of the 10, wagers on credit derivatives. Fred Hoffman runs the fund, which contained $114 million of Citigroup money at the end of 2012, the documents show. The fund jumped 31 percent in 2012 and 2.6 percent this year through April 11.

A $252 million distressed-debt fund posted a 7.7 percent gain through that date, while the Global Macro fund, which wagers on interest rates and oversees about $245 million, advanced 2.6 percent, the documents show.

The $461 million Mortgage/Credit Opportunity fund gained 4.9 percent, the documents show. Rajesh Kumar, the founder of the fund, left Citigroup after a dispute with Dorfman and O’Brien, people familiar with the matter said in December.

To contact the reporter on this story: Donal Griffin in New York at dgriffin10@bloomberg.net

To contact the editor responsible for this story: David Scheer at dscheer@bloomberg.net