Steven Rattner's next headache

NEW YORK (Fortune) -- Steven Rattner, the New York banker-turned-Obama Administration car czar, has been much in the news lately. Riding high in early April thanks to laudatory profiles in the Wall Street Journal and the New York Times, Rattner's name has been in the press this week in connection with a scandal involving a New York State retirement fund.

What's gotten short shrift in all the coverage, though, is the complicated situation that Rattner left behind for his former partners and himself at Quadrangle Group, a New York-based private equity firm that Rattner co-founded.

On this Friday, April 24, Quadrangle's investors are scheduled to vote on whether they want to keep funneling money into a Rattner-free Quadrangle. Rattner's departure from the firm on February 23 came at a precarious moment for Quadrangle thanks to less than stellar returns and some high-profile flops like an investment in Alpha Media, the parent company that brings you Maxim and the recently shuttered music magazine Blender.

The catalyst for the vote is that Rattner's departure triggered what on Wall Street is known as a "key man clause." The way the provision works is that if the key man (in this case Rattner) decides to leave the firm, Quadrangle's investors have the opportunity to block any further investments that can be made with capital they had previously committed. So a "nay" vote effectively terminates the funds' ability to do new deals from scratch (although some capital still could be invested in existing portfolio companies.)

The recent barrage of publicity about Rattner, 56, has the remaining partners of Quadrangle concerned about the vote's outcome. There was a meeting March 31 so that Quadrangle executives could answer investors' questions about the management and performance of the fund and to get "candid input on changes you thought were necessary to reflect the changed circumstances at our firm and the world more generally," is how Quadrangle's leadership phrased their position in a subsequent letter to investors.

Rattner started the firm in March 2000, shortly after he left his position as Deputy CEO of Lazard Frères in New York. He was joined by three of his former Lazard partners: Josh Steiner, a Clinton-era Treasury Department chief-of-staff; Peter Ezersky, Rattner's longtime number two in Lazard's hugely successful media banking group; and David Tanner, a former partner at Warburg Pincus and the only one of the four men with actual experience making private equity investments (including achieving an IRR of 145% in six investments at Lazard Capital Partners), a fact touted by the group to raise money.

With a lot of hard work by the Monument Group, a private equity fundraising firm, and a few phone calls by Rattner to his former Lazard media clients -- such as Comcast CEO Brian Roberts, Craig McCaw, the billionaire telecom investor, and IAC Interactive CEO Barry Diller -- Quadrangle was able to relatively quickly raise a $1 billion first fund (in which I am an investor). As it was on its way to being fully invested in 2004, the Quadrangle team hit the road to raise money for a second fund, which closed with $2 billion in March 2005. (It was Rattner's efforts to raise capital for this fund that have landed him in a recent SEC complaint about a "pay-to-play" scandal in New York State. Rattner is not a defendant in the SEC case that focuses on the kickbacks that a former deputy comptroller and a prominent political advisor allegedly received from investment management firms seeking to manage investment assets held by the New York State Common Retirement Fund.)

For the first fund, Rattner's departure and the tripping of the "Key Man" provision is moot (the fund was fully invested). The key man event is very much operative, though, for the second fund, which still has around $500 million to invest and to call from its investors. In a letter to Quadrangle's investors, Rattner wrote that he hoped they would decide not to block the balance of the money in the second fund from being invested because of his departure. He added, "My family will enthusiastically fulfill its capital commitment to QCP II and looks forward to participating in the continuing investments and portfolio value creation of the firm." The Rattners, as well as the other members of the general partners of Quadrangle, had $55 million invested in the first Quadrangle fund and have another $120 million in capital commitments to the second fund.

On April 17, as an inducement to convince investors to stay the course, Quadrangle's remaining partners decided to take what in Wall Street parlance is known as a "haircut" following their discussions with limited partners. Quadrangle leaders voluntarily agreed to take a reduction of the fund's management fees from 1.75% of the $2 billion -- $35 million a year -- to 1.7% for the remainder of 2009, 1.65% for the first half of 2010 and 1.55% for the second half of 2010. Quadrangle also agreed to decrease to 15% the amount of the fund that could be put in any one fund investment and agreed to escrow 25% of all after-tax carry proceeds.

As Quadrangle comes under greater scrutiny there may be other public relations headaches ahead for Rattner. One relationship that is likely to draw attention in the near future is Rattner's connection to two former Quadrangle partners, Michael Weinstock and Andrew Herenstein. Weinstock and Herenstein had led Quadrangle's distressed investing team with great success before leaving last year to start their own firm called Monarch Alternative Capital LP., which has some $3 billion under management.

Presently, Monarch has ongoing financial dealings with several companies that Rattner may be overseeing as Car Czar. Most prominent among these investments is a debtor-in-possession loan facility provided to Delphi, the large auto-parts manufacturer. What is unclear is whether Rattner has any ongoing financial relationship with Monarch.

Rattner, like the other Quadrangle partners, had a deferred compensation account at Monarch -- with more than a million dollars in it -- that was tied via a formula to the performance of the Monarch fund. Aware that his financial interest in Monarch might be a problem, Rattner spent weeks earlier this year trying to negotiate a settlement with Monarch. Although the two sides failed to come to an agreement, a spokesman for the Treasury department said Rattner has taken the necessary steps to satisfy the ethics police. (Neither Rattner nor Monarch would comment about their financial relationship for this story).

"Like all employees, Steven Rattner was required to comply with financial conflict of interest rules, including divestitures where needed, and he has done so fully," according to Jenni Engebretsen, the director of the Treasury's office of public affairs.

Rattner left behind other problems at Quadrangle, too - the investment portfolio being a prominent one. There have been a number of successes, such as the firm's investments in Cablevision, ProSiebenSat.1, a German TV network, and NTELOS Holdings, a Virginia-based data and telecommunications company. But there have been a series of clunkers too, most notably Pathfire, a digital-media management company; MGM, the movie studio (now marked down 90%); Good Times Entertainment, a producer of Richard Simmons workout videos that lost 96% of its value; Grupo Corporative Ono, a Spanish cable, telephone and internet company, and Alpha Media Group, the parent of Maxim.

Quadrangle invested - and lost - $90 million in the $250 million Alpha deal. The balance of the funds was borrowed. Cerberus Capital, a big investor in Chrysler -- the fate of which Rattner and his team in large part will determine -- will likely end up with control of Alpha Media based upon its investment -- of around $100 million -- in the company's senior debt.

The Journal reported in its Rattner profile earlier this month that Quadrangle's first fund delivered "net annualized returns of 10.7%" to investors as of the end of 2008 while the Times said the first fund "returned 15 to 20%," but that's a gross number i.e. before office expenses, management fees and carried interest. It is very hard for Quadrangle's investors to see where the 10.7% IRR number comes from because it is based upon in part Quadrangle's subjective valuation of unrealized gains. To boot, the fund's investors did not get their original investment returned until the second half of 2007 - more than seven years after the fund began (although not all of investors' money went in at the beginning) - let alone get a return on that original investment. The Journal also reported that the second fund has delivered a "net annualized return" of -1%.

The key to understanding how the firm calculated the 10.7% IRR for the first fund rests with its fully audited valuation of the firm's unrealized investments. Some of these investments - such as those in NTELOS, Cinemark, a movie theatre operator, and Protection One, a home security-alarm company - are in the equity of publicly traded companies. Together these three companies alone represent 59% of the first fund's unrealized value as of December 31. The problem for investors in that fund - and the IRR calculation - is that in the first quarter of 2009, NTELOS' stock has fallen 32%, Protection One's stock has fallen 35% while Cinemark's stock has increased around 27%. The rest of the unrealized investments are in private companies that are valued through a series of generally accepted but purely subjective methodologies.

For instance, Quadrangle valued its equity investment in ONO, the Spanish media company, at $49.8 million as of the end of 2008, even though the senior debt of ONO trades at around 25 cents on the dollar, implying that investors don't think that loan will be repaid. To value the ONO equity then at anything above zero is a bit of an investment-banking dream. If the unrealized investments in Quadrangle's first fund are excluded from the IRR calculation - implying a valuation of zero for them - then the fund has returned to its investors (including me) on an annualized basis very little indeed: $1.294 billion of gross returns - before fees, expenses and carry, on invested capital of $1.079 billion. The fees and carry alone reduce that $215 million to close to nothing. Meanwhile, Quadrangle's partners and employees have taken out from the first fund alone $94 million in management fees and millions more in carried interest. Quadrangle declined to comment for this article.

Not all the news coming out of the Quadrangle offices at the Seagram's Building, at 375 Park Avenue, has been gloomy. The firm received a huge vote of confidence in early 2008 when New York City Mayor Michael Bloomberg announced that he would allowed Quadrangle to invest a portion of his $16 billion fortune. The fact that Rattner and Company did not then have the expertise on board to manage the Mayor's billions and that the firm had never intended to be an asset management business appeared not to be particularly relevant to the billionaire Mayor.

Soon after Bloomberg bestowed upon Rattner his billions to manage, Rattner hired Alice Ruth as chief investment officer from the Gordon and Betty Moore Foundation, where she had the same job. Since then, Quadrangle has built out its staff of investment management professionals. The biggest irony of all may be that Quadrangle, once touted for the hope that its rarefied connections would lead to superior private equity deals, may be saved from dissolution, in part, by a fee-based asset management business that is barely a year old.

William D. Cohan is the author of House of Cards: A Tale of Hubris and Wretched Excess on Wall Street, published in March by Doubleday Books, a division of Random House, Inc.