The alternative investments unit is the latest casualty of the turmoil in the US subprime mortgage industry.
John Costas, then chief executive of UBS Investment Bank and at the height of his authority, astonished market participants in July 2005 by resigning to set up what was often described as an internal hedge fund.
Dillon Read Capital Management invested UBS’s and clients’ money, and was expected to make Costas and many of his closest lieutenants extremely rich.
For UBS, it was an innovative approach to a problem many banks have faced: how to dissuade their star traders from leaving to set up their own funds; maximise the traders’ value to the firm; and manage hedge fund-style risks with an investment bank’s discipline.
The announcement yesterday that DRCM was "to transition" back to the main bank is humiliating for Costas and for UBS.
The transition process had in fact already started. On Wednesday fixed income traders in London greeted their former colleagues as they moved desks down from the DRCM floor.
Suneel Kamlani, the former head of debt capital markets who was appointed chief of staff to Huw Jenkins, UBS Investment Bank chief executive, in February, will act as interim chief executive at DRCM for the transition period.
Ramesh Singh, global head of securitised products and head of debt capital markets Americas, will be interim chief investment officer.
Costas will be responsible for the transition. He will then become senior adviser to the group executive board and to Peter Wuffli, chairman of UBS Investment Bank and chief executive of UBS group.
Mike Hutchins, who left his position as UBS’s head of fixed income, rates and currencies in 2005 to become DRCM’s president, is leaving the bank.
UBS said that: "DRCM will continue operations until the transition period is complete, which is anticipated to be in Q3 2007."
Clients’ money will be paid back, while UBS has recorded a Sfr150m first quarter loss from the fund’s investments. UBS is believed likely to have to pay a further $300m restructuring charge to wind up DRCM, including payments to employees.
At that point the Dillon Read name — once one of the most famous in US investment banking — will become defunct.
UBS said there would be few job losses in DRCM’s total staff of 250, including support staff, most of whom work in New York and London.
"The plan is for them to be reintegrated within their former divisions," said a UBS official. Around 120 traders and bankers moved to DRCM when it was set up.
The official said the decision to bring DRCM back inside UBS’s global banking arm was made for operational reasons, particularly the difficulties of having a business model where the same unit was handling client and proprietary money.
John Fraser, chairman and CEO of global asset management at UBS, said: "Operating a proprietary trading platform outside the investment bank and managing client money alongside became too complex and expensive. That, among other reasons, is why we have chosen to reintegrate DRCM into the investment bank and to redeem the outside investor funds."
Another equally pressing factor — one of the "other reasons" referred to — was the Sfr150m loss DRCM made in this first financial quarter.
UBS also announced its results yesterday. The losses came from the mortgage securities market — "which was obviously weakened by the US subprime sector", said a UBS official.
Several commentators have drawn parallels between the closure of DRCM and the failure of Long Term Capital Management in 1998, when UBS lost $700m.
Then, as now, UBS was not the only bank to suffer. The latest losses caused by the downturn in the US subprime lending market have also caused headaches for other investment banks, such as Bank of America, Citigroup, Barclays Capital, HSBC and Morgan Stanley.
Gloomy finale
The closure of DRCM is an ignominious end to a novel attempt to reconcile leading traders’ ambitions with the interests and strict risk monitoring of the parent bank.
The plan, announced in June 2005, moved UBS’s already large principal finance and commercial real estate trading businesses from the fixed income, rates and currencies area of its investment bank to form the core of the new unit.
The plan was for the trading strategies managed by UBS’s prop traders to be opened up to co-investment from sophisticated, principally institutional clients, and to be supplemented by further new offerings.
"In this way UBS will build a new stream of investment management fees from what has until now been a purely in-house trading activity," said the bank at the time. "UBS will retain its current direct investment in the relevant trading portfolios, with any incremental future investments subject to UBS’s usual risk management processes."
To commentators it sounded like hedge funds with some of the risk taken out. For his part, Costas called it: "An entrepreneurial opportunity to build a new business within UBS."
The large rewards on offer and the exciting challenge of the work were seen as a way for UBS to entice Costas and senior trading figures to stay with the firm and not launch hedge funds on their own.
UBS had lost out before. Wesley Edens, Robert Kauffman and Randal Nardone spent just a year at the bank in 1997-98 before leaving to found Fortress Investment Group. In February Fortress floated in New York for $634m, and the firm is now worth nearly $13bn.
Signs of disarray
Insiders had suggested from early on this year that all was not well at Dillon Read. The unit’s first fund closed with some $1.5bn raised from institutional investors, a total some saw as disappointing.
Then the escalation of the subprime crisis in January and February shook confidence among all investors exposed to the US mortgage market.
The sudden departure of Ken Karl in March — who with Mike Hutchins and Brian Harris was a member of Dillon Read’s inner management circle — stoked speculation that further change was on the way.
At the time, rumours over the health of DRCM were fuelled by talk in the US press that there had been differences of opinion on strategy at a senior level, and that asset management in the property field had been split between a proprietary team and a group managing client money.
UBS results modest
The announcement of the closure of DRCM coincided with UBS’s release of first quarter results, which were slightly below market expectations.
Group net profits fell 7% to Sfr3.3bn ($2.7bn). Pre-tax profits at the investment bank nudged up 3% to a record Sfr1.8bn, while asset management profits were up 8% to Sfr404m.
This was UBS’s third successive decline in quarterly profit versus the year-ago quarter. However, the Sfr229m fall from the same period a year earlier is explained by the inclusion in first quarter 2006 figure of a Sfr290m after-tax gain from the sale of Motor-Columbus, a Swiss holding company with interests in energy, property and finance.
UBS Investment Bank generated record revenues from equity trading, which rose a tenth to Sfr3.1bn in the first quarter.
But the weak performance at Dillon Read dragged revenues from the overall fixed income, rates and currencies trading business down 7% from first quarter 2006, to Sfr2.3bn. Excluding Dillon Read, revenues from that business rose nearly a fifth from last year.
Advisory and underwriting revenues rose 30% to Sfr865m, with strong growth in Asia and the Americas pushing revenues to a record.
UBS said advisory work benefited from a buoyant market, while capital markets work also enjoyed "significant growth", particularly in equities and leveraged finance.
Mike Halls