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In accordance with sources, activist ValueAct performed a key function in accelerating the Citigroup CEO's retirement

CEO Michael Corbat answers questions at Citi's 2017 Investor Day.

Source: Citigroup.com

Three years ago, Michael Corbat took the stage in a ballroom in Midtown Manhattan and announced that a new day had arrived at Citigroup.

The bank launched the event in July 2017, its first investor meeting since the 2008 financial crisis, as an almost bubbly reset for the shareholder community. In a large limestone building that once housed the Greenwich Savings Bank, Corbat's message was clear: despite a lack of previous performance targets, the bank had done an expensive overhaul and could now be trusted.

"You were patient with us," said Corbat to the audience, sounding almost apologetic. "And I want you to know that we do not take this patience for granted and do not consider it inexhaustible."

But Corbat and his management team have largely disappointed investors since that 2017 meeting, and this was a key factor in the CEO's acceleration of his retirement planning, according to knowledgeable people. Last week Citigroup said the 60-year-old Corbat would step down in February and that his Lieutenant Jane Fraser would become the first female head of a major Wall Street bank.

In particular, the activist hedge fund ValueAct was "very disappointed" with the performance of the bank under Corbat and his deputies since they built a stake in 2018, mainly because the bank continuously missed its performance targets or changed according to the people rejected or identified when one speaks about the matter.

CNBC reported Thursday that Corbat had postponed its retirement date due to regulatory pressure on the company's internal controls and investors, including ValueAct, had lost patience. On Monday, the Wall Street Journal reported that banking regulators will give Citigroup a informed consent about the bank's risk management systems.

However, details of the pressure the New York-based bank faced from its activist investor were not known. Lessons from this episode are likely to shed light on how Corbat's successor, Fraser, interacts with the bank's major investors.

ValueAct never requested the removal of Corbat, according to those with direct knowledge of their interactions. Instead, the company, led by partner Dylan Haggart, spoke to the bank's board of directors and management about the company's shortcomings, creating internal tension and a situation where the company's operators knew they were underperforming.

The best analogy to this was the role ValueAct had in prompting Microsoft CEO Steve Ballmer to retire after acquiring a stake in the tech giant in 2013, which according to one of the characters paved the way for Satya Nadella's successful Tenure paved.

ValueAct prides itself on a reputation in the industry for working transparently with management, providing feedback and only getting involved when needed. The hedge fund has signed a data exchange agreement with the bank since the beginning of 2019, which gives it access to board members and non-public information.

After CNBC reported last week that investors' patience with the bank had waned, ValueAct executives were concerned that other CEOs working with the activist would get the false impression that they were expressly pushing for Corbat to be removed had.

Instead, what had happened at Citigroup wasn't the standard playbook for the activist-investor, which consists of dealing with the company's board of directors and executives to accelerate change, and hopefully the stock price over time to improve.

Since ValueAct built its stake in 2018, Citigroup has replaced most of its top executives, including Corbat, the company's longtime CFO, and several department and regional heads. In particular, according to one respondent, ValueAct had a poor view of former CFO John Gerspach and former head of consumer banking, Stephen Bird.

The hedge fund is trying to "create accountability, and with that the boards tend to be sharper, more related to their game," the person said. "When it works, that extra urgency increases performance. The CEO gets praise and everything works great. If it doesn't, you can make decisions sooner."

ValueAct spokesman Drew Stroud responded to the details in that story that investment firm Citigroup "provided our perspectives on strategic priorities, budgeting and performance expectations."

He added that they "appreciate our open and constructive dialogue with Mike, the entire Citi management team and the board of directors."

Citigroup spokeswoman Jennifer Lowney said the bank has a "constructive relationship" with ValueAct and "they continue to be an important partner. We have benefited from their expertise and value their perspective."

She added, "As for Mike, his decision to retire was entirely his own and he always planned to do it in 2021."

How Citigroup came up short

Here is the reason for ValueAct's disappointment with Citigroup: Under Corbat, the bank missed the key performance targets for returns and expenses that it set at this 2017 investor meeting.

At that time, the bank had announced that it would achieve a return on tangible equity of 11% by 2020. Adjusted for Trump's subsequent tax cuts and the impact of deferred tax assets, investors had expected a return closer to 14%.

In January, Corbat announced that the bank had posted a return of 12.1% in 2019, just short of an adjusted target of 12% for this year. However, the analysts immediately asked if they had actually achieved their goals, taking into account one-off factors that closed the figure at 11.6%.

To make matters worse, the bank said in January that due to lower interest rates and a slowdown in the global economic outlook – factors all banks have been dealing with – Citigroup was deviating from its original return targets, saying they would likely be lower.

Overall, it was part of a pattern of ever-changing goalposts and movements that the source had classified as "tact," obscuring a deeper truth: Just like before 2017, Citigroup was still missing its goals, if only modestly.

"It is unacceptable that you fail to achieve your own numbers, which are initially padded numbers. These goals are likely to be exceeded," said one of the people with direct knowledge of Thinking ValueAct. "The fact that they haven't even hit their punching bag numbers is the disappointment."

In fact, Citigroup has missed a key target for return a total of ten times since Corbat became CEO in 2012. This comes from a research report by Mike Mayo, the banking analyst with a long history who covers the lender.

Underwater investment

The return measurement is a key metric for ValueAct and other bank investors as the broader market assigns this number a valuation multiple. An improving ROTCE usually leads to a higher stock value.

ValueAct owns around 27 million shares in Citigroup. While the company typically thinks on a five to seven year horizon, Citigroup's stake hasn't been a winner so far. The hedge fund is under water from this week, according to the experts.

The activist's agreement to share information with Citigroup ends next year. At that point, the company will decide whether to renew or apply for a seat on the board, the person said.

The bigger picture at Citigroup was one of slow progress and missed opportunities compared to rivals JPMorgan Chase and Bank of America. The fact that investors couldn't fully trust Citigroup's goals is a major reason the bank deserves the lowest stock valuation of any of the six largest US banks.

Perhaps it all harks back to that unfortunate 2017 AGM, which took place in a ballroom under the 70-foot vaulted ceilings of a former failed bank. Instead of proving that the bank's leaders "are known to do the things we say we will do," as Corbat said at the time, he is stepping down in February. This will allow him to close the books on the bank's 2020 filings. This should be the year that the performance gap with the competition was closed.

It's a lesson that can't be lost at Fraser. When her promotion was announced last week, she had this to say:

"I will do everything I can to make all of our stakeholders proud of our company as we continue to build a better bank and improve our returns," said Fraser. "I'm looking forward to writing the next chapter with my colleagues."

With contributions from Nate Rattner of CNBC.

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