The Billionaire's Apprentice: The Rise of the Indian-American Elite and the Fall of the Galleon Hedge Fund (19 page)

There was no physical surveillance of Rajaratnam, but on March 4, 2008, the day after the Justice Department attorney’s email was received, FBI special agent Kang tried physical surveillance of Rajaratnam at his office in midtown Manhattan, at his Round Hill Road mansion in Greenwich, Connecticut, and at his Sutton Place apartment in New York City. He didn’t find Rajaratnam. Only in the evening did Kang figure out why: Rajaratnam was in California. Before submitting the wiretap application, the attorney at the Justice Department in DC suggested that Goldberg explain the reason surveillance had not been tried on Rajaratnam. “It’s a fairly apparent omission…My guess is that this wire will likely be litigated more aggressively than the average drug wire, so the necessity section is particularly important,” the Justice Department official observed presciently.

As Anil Kumar looked around, he was pleased to see that so many luminaries from the corporate world had turned up for cocktails after the Manhattan conference for the Indian School of Business. Since Kumar’s mentor at McKinsey, Rajat Gupta, had first hatched the idea in 1995 for a business program in India, his vision had grown, morphing from an early plan to start a management department at his alma mater, IIT Delhi, to what he had built now: a world-class business school with links to prestigious international institutions such as the Wharton School and the London Business School. No longer was it just Indians who were intrigued by its success.

At the drinks and dinner after the conference that cool evening in September 2003, Kumar was happy to see the computer magnate Michael Dell, a newly named board member of ISB, in the crowd. The Sri Lankan hedge fund manager Raj Rajaratnam was mingling too. Kumar had approached his old Wharton classmate Rajaratnam when he and Gupta raised the initial funding for the school. Though Rajaratnam was not Indian, he gave $1 million “anonymously” to the school in 2001. Kumar had never expected Rajaratnam’s generosity to extend into seven figures.

When Kumar moved to India, he had lost touch with Rajaratnam but had heard through the grapevine that his classmate from Wharton profited spectacularly well during the dot-com boom. News of success traveled fast among South Asians. By 2001, the assets at Rajaratnam’s Galleon fund made it one of the ten biggest hedge funds in the world.

When Kumar learned that Rajaratnam had decided to donate money to the fledgling business school, he told Gupta about the sizable donation. Lest Gupta forget, Kumar had friends with money too. He could tap them just as well as his boss. It was no secret that without Gupta, the Indian School of Business would not have gotten off the ground. Gupta marshaled his vast Rolodex of contacts to get the elites of corporate India to open up their wallets and contribute.

But Rajaratnam’s $1 million donation was among the more sizable gifts, and Kumar had every reason to believe that the school could count on the thriving hedge fund manager to contribute more. He only wished he could bank on him hiring McKinsey to provide advisory work for the Galleon Group. Then he’d be making it rain on both fronts—business as well as philanthropy.

The truth was that in the fall of 2003 Anil Kumar was in deep trouble at McKinsey. It was the second big career setback for Kumar at the firm. Even though he had prospered with clients in India and was of the view that he would be named successor to Puri as office manager, he was passed over for the position. He felt betrayed and misled by his bosses. As shocked as Kumar was, his colleagues in India were not surprised. His work was brilliant; the problem was his personality. The first time he had been nominated to be a director he was rejected. Puri, then the managing director in India, suggested that Kumar meet with each of the principals in India and ask if they thought he could win partnership support or if he should quit. Kumar made the rounds, asking each what he could do to be a better partner and what their view of him was. The effort paid off. In 1997 he was promoted to director.

After he was passed over to run McKinsey India, Kumar picked himself up and headed back to California. When he arrived, he didn’t have a practice group to join, so he decided to start an e-commerce practice for McKinsey with four e-business accelerators—centers with McKinsey project teams that could assist dot-com companies in getting off the ground. It was a prescient move. McKinsey was flooded with work from large technology companies looking for ways to provide Internet services for their customers. At the same time, there were scores of small tech companies who needed advice about whether they should merge with the behemoths or go it alone. The challenge Kumar faced was rewiring old-fashioned McKinsey so it could take advantage of the opportunities in the newfangled world.

Unlike the blue-chip companies that McKinsey traditionally served, many of the technology start-ups had only one currency to offer as payment: equity. If a hot new start-up boomed, colossal riches would accrue to McKinsey. The firm’s intellectual muscle would be acting like venture capital.

McKinsey had long been averse to taking equity stakes in companies in lieu of cash payments. In the early eighties Bob Waterman recalls accepting stock for his services from Genentech, at the time a tiny San Francisco biotechnology firm with little in profits but a lot in promise. Waterman felt that the company had enormous potential and believed that the only way for McKinsey to get a foot in the emerging world of biotech was to do something unusual. There was no other way for Genentech to pay McKinsey. Waterman wasn’t prepared, however, for the firestorm he sparked.

The move to take stock “elicited cries of horror from my partners,” says Waterman. In the end, McKinsey sold the stock, forgoing a huge windfall a decade later when Swiss drug giant Roche acquired a majority stake in Genentech, a first step before ultimately buying the entire company for nearly $47 billion in 2009.

Even by the late eighties, the sentiment toward stock was little changed. Jeffrey Skilling, the former chief executive of Enron, remembers sitting on a committee to look at the appropriateness of nontraditional fee structures—equity interests or contingency fees and earn-outs that were tied to a company’s performance. There was a lot of pressure from the consultants in New York to accept stock equity as payment. They were enthralled with the ability to act like investment bankers, and a critical number of clients were interested in the alternative payment plan, Skilling says. But as the committee mulled the idea, it was clear the nontraditional fee arrangements posed outright conflicts of interest in some cases and in others were totally at odds with the culture of the firm.

The case against contingency fees or earn-outs was clear: they posed an “insurmountable conflict of interest between the client and firm,” says Skilling. For instance, if McKinsey is hired to help a client to reduce expenses and gets 20 percent of the first two years’ expense reductions, “at that point the firm has an incentive to reduce expenses even if expense reduction, or some component of expense reduction is not in the client interest,” says Skilling. It is “a direct conflict. We looked at a number of ways to structure such arrangements, but none eliminated the conflict.”

Accepting equity instead of cash had a potentially more damaging consequence: “It seemed to us that there was a danger in almost any outcome: whether the concept was a failure or even if it was successful,” says Skilling. “Say you take equity that is ultimately worth less than the normal fee level, the recriminations would fly.”

But the problems of success could be more thorny. If the firm made a huge gain, how would the rewards be parceled out? Would the people on the specific client service team get a disproportionate payout? Ultimately, Skilling says, the committee decided “it was impossible to manage the conflicts and the internal ‘shears’ that it would cause, and concluded that it was not a good idea.”

In 1998 McKinsey, now with Rajat Gupta as managing director, reluctantly moved to accept small-equity stakes in start-up companies that could not otherwise afford its fees. A committee was formed to vet any equity investment proposals. Only 50 percent of fees could be taken in equity, and the committee would consider investments under $1 million. The plan solved one vexing problem. It offered McKinsey a creative way to work for cash-strapped Internet companies that might someday be as big as IBM or Apple.

But it did nothing to solve another, perhaps more pressing, challenge: McKinsey, like many old-economy companies, was losing talented young associates to the brave new tech world. To help stanch the exodus, Kumar pushed for McKinsey to give junior consultants the opportunity to buy into its Internet start-up investments. Among the options mulled over was to allow associates to buy stakes in a pool of McKinsey clients that paid the firm equity instead of cash. It was an elegant way of giving junior consultants a reason to stay at the firm. Kumar’s idea met with immediate resistance: it was mind-boggling to think that the firm had to cater to the whims of an aggressive group of twentysomethings.

But in the heady climate of the time, it was hard to argue with Kumar, and the tech consulting practice would grow to represent 25 to 30 percent of the firm’s revenue. Even though he’d spent a good part of the decade in India, Kumar seemed to understand the Internet space better than most, and he had an impressive network around Silicon Valley with lines into the growing number of Indians becoming titans of technology. He claimed to be close to the Indian-born venture capitalist Vinod Khosla, who had cofounded Sun Microsystems in 1982. Khosla later became a renowned venture capitalist at Kleiner Perkins Caufield & Byers, which, in the thick of the Internet boom, invested in some of the era’s biggest home runs, companies like Amazon, Google, and Netscape. Kumar dropped Khosla’s name frequently in conversation and let it be known that he had gone with Khosla to visit with S. M. Krishna, then chief minister of Karnataka, the state in which the high-tech hub Bangalore is based.

During that trip he stunned family and friends when he professed to have little time for socializing. His excuse, or at least the one he gave them, was lame. “I have come in Vinod’s aircraft,” he told them. “I have no time to see anyone.” (It does not appear that Kumar traveled with Khosla and it is not even clear if he met Krishna.)

On October 22, 1999, McKinsey executives woke up to a story in the
New York Times
carrying the headline “Big Consultants Woo Employees by Offering a Piece of the Action.” Written by David Leonhardt, the story detailed Kumar’s buy-in plan for associates. Everything about the article was distasteful to McKinsey’s top executives, including Rajat Gupta. The headline, with its focus on giving employees “a piece of the action,” ran counter to what McKinsey represented.

Even though it had been years since the principled Marvin Bower stalked the corridors of 55 East Fifty-Second Street, McKinsey’s New York headquarters, clients still left the building with the impression that consulting at McKinsey was a profession, not a business. The last thing it wanted was for clients to think that its consultants hoped to profit alongside the companies it served. But it was exactly this kind of commercialism that veterans of the firm noticed creeping into the culture. The article revealed various options that McKinsey partners had been mulling for months, even though the firm was still in the throes of fine-tuning the details.

Don Waite, one of Gupta’s rivals for the managing director’s job and now a lieutenant, strode into a meeting waving the
New York Times
and said, “Have you seen this?”

The revelations in the article were bad enough, but what angered Waite and others was that one of their own, Anil Kumar, was widely quoted in the piece. McKinsey took extraordinary care cultivating its image. Whenever it embarked on a step that was a departure from traditional practice, McKinsey would ponder for months the reception its new initiative would get. By and large, McKinsey eschewed floating trial balloons in the press, but with his comments to the
New York Times
, that was exactly what Kumar had done. “We don’t want the best talent to feel they don’t have a vehicle to join in this wealth creation,” Kumar told the
Times
. His remark with its obvious reference to personal profit went against the grain for McKinsey.

Top executives were so appalled that Gupta convened a meeting with his kitchen cabinet to decide what to do. Some thought Kumar should be fired for overstepping the boundaries. To send a message to the broader partners, one idea floated was to announce his dismissal at the directors’ meeting. In the end, though, it was decided that Gupta would speak to Kumar and rebuke him sternly. He would receive a “slap on the wrist.”

But by 2003, the implosion of the tech bubble hit Kumar and McKinsey hard. Kumar’s gambit to have McKinsey plunge headlong into the tech space had profound and sobering implications for the firm and for his own career. From the beginning of 2001 to the end of 2002, McKinsey’s gross revenues declined by some 12 percent, according to
A History of the Firm
, a book McKinsey privately published. Rumors spread through the ranks that the firm had to make a capital call to its partners, who were already reeling from the dramatic drop in revenue. Though unfounded, the rumors served to destabilize the firm. Meanwhile, the additional awards that directors received in December plummeted by 87 percent.

McKinsey’s aggressive drive to recruit junior consultants in the late nineties compounded its problems when the bubble burst. During the buoyant times, Gupta’s McKinsey was hiring young associates at a furious rate to keep pace with its burgeoning book of clients. Historically, new arrivals as a percentage of McKinsey’s total consulting staff were 20 percent a year, but in the late nineties, the new blood soared to the mid-to-high 30 percent range. The jump had a profound impact on the partnership and its profitability.

Compensation per partner is hardwired to two economic statistics—hourly billing rates and the ratio of deployable associates to partners. “You want LOTS of associates per partner,” explains Skilling. Between the mid-nineties and 2000, the ratio of directors to consulting staff, which includes associates, increased to 1:17 from 1:12. Even as revenues grew by more than three and a half times, the partnership grew more slowly, by about two and a half times, the McKinsey-sponsored company history declared. The effect of the discrepancy was to enrich the existing partners.

These numbers “suggest a HUGE increase in Director compensation,” says Skilling. “It also suggests a selfishness of the directors since the ratio was not held constant.” In effect, the firm wasn’t naming new partners as fast as it was hiring associates. Growth profited the few. More money was spread over the same number of partners. It was the opposite environment from 1973, when Gupta joined McKinsey.

When the bubble burst in 2001, it aggravated McKinsey’s pain.