The Alpha Masters: Unlocking the Genius of the World's Top Hedge Funds (10 page)

As an example, Lagrange points to automobiles. “Our research shows that in order for a household to buy a car, it must have $3,000 in disposable income after taxes. In China, the number of people reaching this level is doubling. The amount of disposable income a household needs before it starts purchasing goods at the luxury level is $10,000. The number of people who will reach that level will triple over the next five years. It’s that kind of analysis that can lead you to detect the opportunity.”

“It is not a crime to make a mistake in the investment business,” Lagrange says, “but you have to recognize your mistakes early and take decisive action to reverse the decision.” As an example, at one point a GLG fund was long on some young oil companies, making the incorrect assumption that because they had low levels of debt, they were somehow immune to financing pressures. “But implicitly these companies needed to come to the stock-market to raise equity because they were involved in long term projects that did not generate any cash in the short term. When the market essentially shut down in October 2008, it became clear just how risky these investments were. We had to get the hell out of them as quickly as possible.”

Lagrange sidesteps the prediction made by CEO Clarke that the combined Man-GLG team will become the first $100 billion hedge fund. “We’re definitely not targeting a number,” he says, without quite dismissing the possibility. He prefers to stress that the Man Group is “not one hedge fund with $150 billion or $70 billion or wherever. It’s 50 different funds including long only.” For Lagrange, the company’s underlying identity is that of a group of elite, autonomous managers, and at the moment, the group is nowhere near a capacity.

In the meantime, any conflict between whether the Man-GLG team will have offices in Sugar Quay or Mayfair was neatly resolved in July 2011, when the Man Group moved its international headquarters to 2 Swan Lane on the banks of the Thames in London. In the spirit of thinking long-term, the company signed a 20-year lease.

Chapter 3

The Risk Arbitrageur

John Paulson

Paulson & Co.

Nothing is right in all markets at all times.

—John Paulson, May 2011 Midyear Investor Conference

Hedge fund manager John Paulson had traveled from New York to Capitol Hill to address the Committee on Oversight and Government Reform on November 13, 2008. A series of well-executed complex trades at the height of the financial crisis had made Paulson a very rich man at a time when many banks and institutions were on the brink of collapse. Among these was a trade that has been widely hailed as far and away the greatest trade in financial history, one that earned his firm a record $15 billion by the end of 2007. Now Congress wanted to hear what he had to say about the systemic risks that hedge funds posed to financial markets, and to listen to proposals for regulatory and tax reforms.

Paulson was not the only hedge fund manager who had been summoned by the Committee that day, although he was certainly the best performing over the past year. Joining him was fellow subprime winner Phil Falcone, as well as George Soros, the head of Soros Fund Management, Jim Simons of Renaissance Capital, and Ken Griffin of Citadel, all industry legends and billionaires in their own right. Each of these industry titans would have his turn to address the Committee, but right now the floor was Paulson’s. The entire room, indeed, the entire financial world, wanted to hear what this man had to say; his remarks were running live on CNBC, Bloomberg, and, of course, C-SPAN.

“Chairman Waxman,” he began, calm and unruffled, peering through his dark-rimmed glasses at Henry Waxman, the liberal Democratic congressman from California who was presiding over the hearing, “the problem in the U.S. financial system is one of solvency. In general, financial institutions are undercapitalized and have insufficient tangible common equity to support their overlevered and deteriorating balance sheets.” Perfectly silent, the room hung on his every word. “Remarkably, the average tangible common equity to total tangible assets for the 10 largest U.S. banks is only 3.4 percent, or 30 percent leverage. The solution to solve the problem is to strengthen their balance sheets by raising equity both privately and publicly.”

Addressing Congress was an uneasy moment for Paulson. He didn’t like being called onto the carpet, so to speak, to justify his successes. He’d been in the business for over 15 years focusing on event-driven transactions, and the financial crisis of 2008 happened to be the biggest event-driven trade since the Great Depression.

Paulson began his testimony with a synopsis of his background— graduating summa cum laude from New York University (NYU) in 1978, attending Harvard Business School as a Baker Scholar in 1980, and working as a managing director of mergers and acquisitions at Bear Stearns. He opened his hedge fund in 1994, and by 2008, it was the fourth-largest such fund in the world. He then explained how it happened that his firm managed to pull off a $15 billion trade. He explained that, in 2005, he and his team had become concerned about weak credit underwriting standards and excessive leverage among financial institutions believing that credit was fundamentally mispriced. “To protect our investors against the risk in the financial markets, we purchased protection through credit default swaps on debt securities we thought would decline in value due to weak credit underwriting. As credit spreads widened and the value of these securities fell, we realized substantial gains for our investors.”

Paulson explained this as if it were just that simple. The funny thing is, to Paulson, it
was
that simple.

He concluded his testimony with some recommendations for steps the government could take to relieve the credit crisis. The top idea, one that he had just offered in a
Wall Street Journal
op-ed article, was for the U.S. government to “purchase senior preferred stock in selected financial institutions, which provides for maximum taxpayer protection.” Following his op-ed, the Troubled Asset Recovery Program (TARP) was reoriented to focus on the purchase of preferred stock. When John Paulson speaks, people listen.

The Making of a Risk Arbitrageur

Sitting with John Paulson on an April afternoon, it is easy to see why people—friends and investors alike—have always flocked to him. He is a financial genius, of course, but socially savvy as well. People feel safe around him and trust him.

On the fiftieth floor of 1251 Avenue of the Americas, we talk easily over Diet Cokes in a long conference room with plush cream carpeting overlooking the midtown skyline, skyscrapers surrounding us. Paulson looks right at home. An avid runner, the 55-year-old is fit and slightly tanned.

“Let me tell you a little about what I think I do. I think what I am is a risk arbitrageur,” he tells me. From a small beginning as a $2 million fund with just one analyst and a receptionist in 1994, the Paulson & Co. portfolio has risen to a gargantuan $38.1 billion as of June 2011 with 51 investment professionals. It is the fourth-largest hedge fund in the world, according to a recent ranking by hedge fund trade publication
AR Magazine
. The portfolio is divided across the $6.5 billion Paulson Merger Funds, the $9.7 billion Credit Opportunities, the $3.0 billion Recovery funds, and the $1.1 billion Gold funds, and the $17.9 billion Advantage funds.

Paulson & Co. specializes in three types of event arbitrage: mergers, bankruptcies, and any type of corporate restructuring, spin-off, or recap litigation that affects the value of a security.

In merger arbitrage, a major focus of the firm’s proprietary research is to anticipate which deals may receive another bid, and then to weight the portfolio toward those specific deals. The goal of the Paulson funds, like any fund, is to produce above average returns with less volatility and low correlation to the broader equity markets. Their correlation with the S&P 500 since 1994 has been 0.07 percent.

But finding arbitrage opportunities is not where the science kicks in. In fact, Paulson says he often learns about big mergers and bankruptcy filings on the front page of the
Wall Street Journal
just like everyone else. What gives his team an edge over the competition, he believes, is having the skills and special expertise to evaluate both the potential return and the various risks of a potential deal. “It’s very easy to compute what the returns are from a spread,” he says, “but what’s not easy to compute is what the risks of the deal breaking apart are. There’s financing risk. There’s legal risk. There’s regulatory risk, amongst others.”

Other corporate events are also in the news, but Paulson looks beyond the face value of these events to find the bigger impact. As an example, he points to the Macondo oil spill that devastated the Gulf of Mexico during the summer of 2010. The event depressed the prices of BP, Anadarko Petroleum Corporation, and offshore drilling contractor Transocean. “We established that the decline in the price of these securities exceeded the ultimate liabilities,” he says, “and an arbitrage opportunity exists between where the securities trade today and where we estimate they’ll trade once this liability is settled.” As a result, Paulson purchased shares in Anadarko in late 2010 and early 2011, according to 13-F filings with the Securities and Exchange Commission (SEC), and hedged these positions with short positions in oil exchange-traded funds (ETFs). The short positions should insulate the portfolio from swings in the oil sector or broader stock market isolating the potential return to the settlement of the liability.

Risk arbitrage investing, a specialty of the New York financial community, began in the 1930s with investors buying bankrupt bonds and swapping them into other securities when the company emerged from bankruptcy. The arbitrage spread is the difference in the value of the bonds purchased in bankruptcy and the value of the securities post-reorganization. Because of the complexity, the risks, and the specialized skills needed to invest in this area, the spreads can be wide and the annualized returns high. Over time, risk arbitrage evolved to include other types of corporate restructurings such as mergers, spin-offs, restructurings, and litigation that could affect the value of a security independent of the market.

A risk arbitrageur, Paulson explains, typically gets involved when others want to get out. “Say you get a $50 offer from a company that was trading at $35 and it immediately jumps to $49,” he offers. “Now most investors don’t want to stick around for the last dollar and risk losing $14 if the deal breaks. They made a good profit and want to take the property and go home. On the other hand, the arbitrageur steps in, and for that extra dollar, takes the $14 risk of deal completion. Now a dollar may not sound like a lot. But a dollar over 50 is roughly a two percent return. And let’s say it’s a tender offer and will close in 60 days. That means you can do that deal six times a year so six times two is a 12 percent rate of return. That can be an attractive rate of return for a relatively short-term investment.”

But a 12 percent return isn’t outsized by any means, let alone by hedge fund standards of excess. There are other reasons to invest, namely the fact that risk arbitrage is not correlated with the market. “Let’s use that same example,” he says. “If you bought the stock at $49, and the market fell 10 percent over the next two months—you would still earn that 12 percent annualized return, just as long as the transaction closed. The beauty of arbitrage is you can earn good returns that are noncorrelated with the market. A deal like this could get exciting if another bidder came in and offered $60. That would be a 20 percent bump, or $10. That would boost the return from 12 percent annualized to 120 percent annualized. It doesn’t happen all the time but it happens often enough that we spend a lot of time trying to determine which of the announced deals could get a competitive bid to capture that potential excess return.”

Traditionally, there were three major specialists in risk arbitrage: Goldman Sachs, Bear Stearns, and Gruss Partners. All three of these institutions would end up leaving their mark on Paulson as he climbed the sky-high ladder on Wall Street.

Paulson, in many ways, developed his core risk arbitrage skills well before he landed on the Street. When he was five, his grandfather Arthur bought him a pack of Charms candies during a visit. The next day, he sold the candies to his kindergarten classmates. After they counted the proceeds, Arthur took his grandson to a candy store where the six-year-old bought a pack of Charms for five cents. The difference between the sales proceeds and the cost of the pack was the profit. His grandfather instilled in him an appreciation of math and numbers. It worked. “I liked buying and selling. I would take the profits I made and put them in a piggy bank—that was what I called ‘the bank.’ Eventually, I filled up the bank and that’s what I thought banking was. So at a very young age, I wanted to be a banker.”

A good student, by eighth grade, Paulson was taking high school–level courses in calculus and Shakespeare as part of a program for gifted students. But he also thrived on independence and soon started to dabble in stocks with some money his father had given him when he was about 14. He was instantly hooked and spent time every day poring over the
New York Times
stock pages. Paulson recalls: “They had the high and low for the year column, so I said, ‘I’ll go find the stocks that are trading at their lows with the widest discrepancy.’ I found that in a stock called LTV.”