Grayken Without Heir Apparent at Lone Star Raised as Risk

John Grayken, founder of Lone Star Funds, has a record of generating more than 20 percent returns over two decades as the world’s biggest buyer of delinquent mortgages. What he doesn’t have is a designated successor.

That deficiency became a focus of discussion for the state of Oregon’s pension trustees as Grayken, 56, pitched his latest investment, a $5 billion fund he finished raising last week to buy soured residential loans from Europe’s banking crisis.

“I want to have a succession strategy in place,” State Treasurer Ted Wheeler said. “That’s important to me.”

While the issue didn’t impede Lone Star’s ability to raise the new fund, with Oregon voting to invest as much as $400 million, Grayken has faced the question of an heir apparent since the 2007 resignation of his longtime right-hand man, former Vice Chairman Ellis Short. Short left the firm just as the global credit crisis caused investors to shun risk, hampering Grayken when he set out to raise the predecessor fund to the $5 billion one he closed last week.

Succession issues are particularly important for pension funds, which invest with a horizon of decades. Private-equity funds, including Lone Star’s, typically contain a provision known as the key-man clause to protect investors in the event of senior-management departures that could affect the running or performance of their investments.

‘John Show’

“John has no intention -- you can ask him -- of building an institution,” said Nori Gerardo Lietz, founder of Arete Capital and an early champion of Grayken’s in her prior role as a pension-fund consultant. “Unlike some of these other organizations that are trying to really build an ongoing entity that will survive the founders, it is the John show,” Gerardo Lietz said at the May 1 meeting of Oregon’s pension trustees.

Grayken, through spokesman Jed Repko of the public relations firm Joele Frank, Wilkinson Brimmer Katcher, declined to comment on succession.

Grayken, who turns 57 on June 1, has already committed 20 percent of the new fund to buy assets from failed Belgian lender Fortis, and is about to raise another pool for commercial assets this summer. He also has set his sights on acquiring mortgage-servicing rights from U.S. banks. The current fund was $1 billion oversubscribed.

Since Grayken founded Lone Star in 1995, the firm has bought distressed mortgage-related assets valued at more than $85 billion, helping banks in Canada, South Korea, Japan, Taiwan, Germany, Ireland and elsewhere rid themselves of bad loans following economic declines. Now the action is in Europe, where Boston-area native Grayken has been based since 1997, having given up his U.S. citizenship in 1999 for an Irish passport and married a British woman.

Critical Planning

The company has senior executives in each of the regions in which it operates.

“Succession planning is critical,” said Theresa Whitmarsh, executive director of the Washington State Investment Board, which oversees about $89 billion in pension and related assets. “We’re buying people and we’re buying the strategy and we have to make sure it’s sustainable.”

Whitmarsh declined to comment on Lone Star. Washington has been an investor, or limited partner, with Lone Star, a general partner, in the past. “The LP community has been pushing the issue a lot more,” she said. “I don’t think any GP can ignore the issue.”

Doubled Money

Oregon has invested about $1.87 billion in 10 prior Lone Star funds and the firm has roughly doubled the state’s money, for a net annual internal rate of return after fees of about 18 percent, according to figures cited at the May 1 meeting by Anthony Breault, acting senior investment officer for real estate at Oregon’s pension fund.

“These guys have done a great job for us, they’ve delivered outstanding returns, but no succession strategy for me is really problematic,” Wheeler said. “This is a long-term investment and it’s a pension plan.”

Whereas the previous fund invested mainly in U.S. residential debt, including whole loans and securities, “our expectation now is that the percent of the capital, of the collateral that is in Europe will grow substantially,” to more than 60 percent, Grayken told the Oregon pension overseers on May 1. The predecessor fund was $4.6 billion.

“There are still opportunities in U.S. residential,” Grayken said. “It was a very, very aggressively financed asset class prior to the crisis and despite the fact that we see appreciation in housing prices today, there’s still a lot of debt that is underwater and has to get cleaned up by the banks.”

Global Buying

The firm ran another fund at the same time, the $5.5 billion Real Estate Fund II, which bought distressed commercial mortgage debt around the world, including in Europe, the U.S. and Japan, Grayken said. That fund, Lone Star Real Estate Fund II, is approaching 70 percent invested or committed, Grayken said. “The market’s been very good for us. This part of the cycle, that is the best part for an investment strategy like ours, and we are at this time projecting that we are comfortably going to exceed return targets for those two funds.”

Grayken said the firm expects to start raising Lone Star Real Estate Fund III this summer.

Lone Star made its name buying distressed loan portfolios and lenders in Asia starting in the late 1990s. In some cases, it bought financial institutions to get at the underlying assets and work them out, reviving the lender and taking it public for a profit. In 2005, Lone Star reaped a sevenfold return on its investment in Tokyo Star Bank Ltd. That same year, the firm sold a third of Japan’s biggest golf-course operator, Pacific Golf Management KK, in the first initial public offering of such an asset.

Asian Investments

As the most senior executive after Grayken, Short helped lead the firm’s move into Asia in the late 1990s. Besides buying billions of dollars of delinquent mortgages from Japanese and South Korean banks, golf courses in Japan and consumer lenders, it bought office towers in both countries. Short oversaw the firm’s Asian operations from Tokyo and later supervised European deals as well.

Short, a native of Independence, Missouri, teamed up with Grayken at Colony Advisors, the Los Angeles-based real estate company that Texas billionaire Robert Bass started in 1991. Short then was working at GE Capital, General Electric Co.’s finance unit, which had bought bad loans with Colony.

When Grayken formed Lone Star in 1995, he brought in Short and relied on him to help run the firm.

Kildare Partners

Short recently formed a new firm called Kildare Partners and aims to raise about $1 billion to invest in distressed real estate and related debt in Europe, PERE, a publication of London-based PEI Media, reported May 13.

Short didn’t immediately respond to an e-mail and call placed after regular business hours.

In 2008, Lone Star bought $30.6 billion of collateralized debt obligations from Merrill Lynch & Co. for about 22 cents on the dollar in one of the first and largest distressed deals of the financial crisis. It also acquired San Diego-based subprime lender Accredited Home Lenders Holding Co., and a mortgage unit of Bear Stearns Cos.

Lone Star has an approximately 800-worker back office in Hudson Advisors, which takes loans that Lone Star buys and collects on each.

“I’ve asked him, over the years, ‘Why do you keep doing this?’” Gerardo Lietz said at the Oregon Investment Council meeting May 1. You have “more money than Croesus, you know. He said, ‘As long as I can get up, have that thrill, the jazz of doing it, I’m going to keep doing it,’ and I said, ‘What happens that day you don’t?’ And he said, ‘Then I shut it down,’” she said he told her.

Succession Plan

Grayken’s lack of a succession plan, and lack of interest in institutionalizing his business, veers from the path espoused by KKR & Co. and Blackstone Group LP, whose founders have taken the firms public.

Lone Star Fund VIII, which closed last week, was the largest of the private-equity real estate funds being marketed, according to Preqin, a London-based researcher. It’s the third-largest fund of its kind raised since the beginning of 2009.

“If he gets hit by the proverbial bus, which is sort of the worst-case scenario, the investments that have been made will go into their machine,” Gerardo Lietz said, referring to Hudson Advisors, the asset-management arm of Lone Star. “Just sort of work themselves through the investment and the asset-management process. Hudson can certainly do that.”