The Alpha Masters: Unlocking the Genius of the World's Top Hedge Funds (11 page)

At the time, LTV had a high of $66, a low of $3, and was trading at $3. Paulson bought it with the idea that he would buy, trade, and then sell it as soon as the stock went back to $66. It just wasn’t going to be that easy—instead of going up, LTV went bankrupt. So how did it end up yielding some of the largest returns he ever made in a stock? Paulson kept the worthless stock in his portfolio, and when the company emerged from bankruptcy, he received out-of-the-money warrants in LTV Aerospace. LTV Aerospace took off like a rocket ship. While Paulson was at Harvard, the company was bought out and his stock was suddenly worth around $18,000.

Accidentally, he had received his first lesson in bankruptcy investing and warrants through LTV. Paulson says: “It was a portfolio position I barely even knew I had and it couldn’t have been more speculative, but it turned into a high multiple return. Those warrants are tricky little instruments.” He taught himself some very valuable basic lessons early on like how to read stock tables, earnings reports, and account statements; a little bit about bankruptcy reorganization; and, of course, what a warrant was.

When Paulson entered college in 1973 he had no interest in business. With antiwar and civil rights protests front and center, “Nothing in business was fashionable. It was all about counterculture.” As a freshman, he worked on fulfilling his general curriculum requirements with classes in creative writing, philosophy, and film production. But school wasn’t enough to keep him focused; he needed a break.

When his father, Alfred, bought him a plane ticket to South America to help brighten his mood, Paulson readily embarked on what would become an extended journey through Panama and Colombia that finally ended in Ecuador, where he would stay for over two years. Initially, at 18 he took a job with an uncle who developed condominium projects along the coastal city of Salinas. At first, Paulson was enamored with his uncle’s glamorous lifestyle and his responsibilities but realized he couldn’t make much money on a salary; if he wanted to succeed, he would have to venture out on his own. At 19 years old, he started a business manufacturing children’s clothing and made his first big sale to Bloomingdale’s. He liked being successful, being independent, making money, and having employees, and this exposure gave him his first taste of what it would be like to run his own firm. Gradually, however, he realized that if he wanted to succeed in business, he would have to go back and finish college.

He entered NYU. Two years behind his classmates, Paulson felt a certain pressure. This time, though, he was keenly focused on business and pushed himself to excel, getting straight A’s. As a senior, Paulson took a course that changed his life forever. It was called The Distinguished Adjunct Professor Seminar in Investment Banking, a semester-long course that was led by John Whitehead, who, at the time, was chairman of investment banking at Goldman Sachs.

Whitehead brought in other senior partners of Goldman Sachs to the class including Stephen Friedman, the former head of mergers and acquisitions (M&A), and Robert Rubin, the former head of risk arbitrage, which were described as two of the most profitable areas of Goldman Sachs. Rubin had a reputation as the smartest guy at the firm, and Paulson learned that his department hired only the best and the brightest. He had heard the risk arbitrage department produced the most profitable partners, and Paulson remembers, “That’s when I got very intrigued with both M&A and risk arbitrage.”

But like all good things in life, it just wasn’t that easy. The executives advised the students that if they wanted to work in risk arbitrage, they’d have to first prove themselves in mergers and acquisitions. But they wouldn’t get a job in M&A without an MBA. So Paulson made a decision. He says, “I decided I’d go to Harvard, get my MBA, and then work in M&A and then risk arbitrage. That was my strategy.”

He tactfully executed just that. When the dean of NYU suggested he apply to Harvard Business School, Paulson leapt at the opportunity, and John Whitehead, who was a member of the Harvard Board of Trustees, offered to write his recommendation. After gaining admission, he received the prestigious Sidney J. Weinberg/Goldman Sachs scholarship, an endowment started in 1950 for exceptional students. He was elated.

It was at Harvard that Paulson really hit his stride. After graduating summa cum laude from NYU business school as valedictorian of his class, he felt that he had really earned his spot with the rest of the world’s brightest business-minded students. He joined the investment club and even wrote a guide to investment banking. As a part of the finance club, he sent out surveys to all the major banks asking them specific questions about the firm’s culture and specialties. To his surprise, he got enough responses back to publish the guide. A copy still sits in his office.

Paulson thrived on being challenged in the classroom and felt excited about his future for the first time in a long time. The case study approach made attending class fun for him, and the lively, interactive environment it created appealed to the young student. But it wasn’t until years later that Paulson realized the case study method had instilled in him a better approach to testing potential investments. “When I look back on the experience, it taught me how to analyze situations quickly and how to articulate myself to other people. It showed me how to try and convince people to my way of seeing things.”

It’s Not All Numbers

When his firm started to hit its stride in the early 2000s, Paulson drew on some of the skills he’d learned in the nonfinance courses he had taken at Harvard: simple concepts like product/market segmentation. In fact, Paulson credits his marketing knowledge for some of his recent success. He says: “You know, one of the ways we grew was not by coming up with more products but by reformulating the same product.”

Paulson Partners originally started out with a domestic merger arbitrage fund in 1994. “While we were not pioneers in the hedge fund space, we still were early in its evolution. By 1996, we thought it may be the right time to launch an international product.”

It was the same product, just targeted to different investors. Paulson says: “It was the same portfolio; Paulson International just targeted a foreign investor base and added all the bells and whistles to appeal to international clients.” The fund today is about four times the size of the domestic fund.

Then they came up with another idea to further extend their offerings: an enhanced version. “You know, ‘enhanced,’ ‘new,’ and ‘improved,’ the name was right out of consumer product marketing,” he says. “And ‘Paulson Enhanced’ is the same exact portfolio as the merger and international funds, only it’s twice as much leverage. These marketing terms helped me create new products for new markets and differentiate the product without more work.” Today, the Enhanced and International funds combined are 11 times the size of the original Paulson Partners Fund.

Paulson & Co. launched the Advantage fund in 2003 and the Advantage Plus in 2004. These funds added to the merger arbitrage base by including bankruptcy, distressed, and other forms of event investing.

Initially, Paulson & Co. grew slowly, but once it had a five-year track record and proved steady performance, making money in both 2001 and 2002, when many other funds were feeling the strain of the post-9/11 market collapse, it started grabbing investors’ attention. In 2002, Paulson was managing $300 million. By the end of 2006, the firm was up to $6.5 billion, and that was before it made any money on its legendary subprime trade. That trade hit in 2007 and earned them $15 billion in profits, bringing Paulson & Co. to $28 billion in assets under management by the end of the year.

The Stuff of Legends

One day at Harvard Business School in 1979, a classmate told Paulson to skip squash club for a day, telling him: “You got to hear this guy Kohlberg speak. Jerry Kohlberg’s the one making all this money in leveraged buyouts.” Paulson didn’t know who Kohlberg was, but his interest was piqued and he went along, entering a class of only about 15 people, expecting “nothing special.” Kohlberg, founder of legendary private equity firm Kohlberg, Kravis, & Roberts Co. (KKR), meticulously went into the details of how a leveraged buyout worked, complete with an impressive example of how the firm made a $17 million profit on a $500,000 investment purchasing a company for $34 million. They financed the acquisition with $20 million in bank debt, $14 million in subdebt, and $500,000 in equity. The bank debt was secured, while the subdebt got 16 percent plus warrants. KKR was able to sell the firm for $51 million two years later, pocketing the $17 million profit.

These numbers seemed staggering to Paulson. As he says: “It was a wild amount of money to be making on an investment at that time.”

It was at that point that Paulson decided against investment banking, choosing instead to focus on leveraged buyouts because, as he says, “The principal firms were smaller but they made a lot more money. And the principals were a lot richer.”

At the time, the firms that were doing well in this area were KKR, Odyssey—the former partnership of Oppenheimer—E. M. Warburg, Pincus & Co., and Allen & Co. “They were very different than the big investment banks like Goldman,” says Paulson. “I think the wealthiest man on Wall Street at the time was Charlie Allen, who ran a small bank and made exceptional returns. Like Charlie Allen, Leon Levy and Jack Nash were far wealthier than the senior partners at the other banks. They were the ones on the Forbes 400 list, not the presidents of the investment banks. Although their corporate finance businesses were tiny and they didn’t have the prestige that the larger banks did, for me, I found these people fascinating. I was more attracted to the principal business than the agency side.”

Envisioning himself among those luminaries on the Forbes 400 list seemed impossible to Paulson, but he at least wanted to work for them. As he says: “I called them the financial entrepreneurs. Those are the people I gravitated to, and I wanted to learn what they were doing.”

Upon graduating from Harvard Business School as a Baker Scholar, Paulson accepted a job at Boston Consulting Group (BCG). It was a tough economic period, and the firm paid a large salary, but Paulson soon realized consulting wasn’t for him. While intellectually interesting, he wouldn’t be making deals like Jerry Kohlberg’s or earn the leveraged buyout–type paydays. Despite that, he valued his first job. Paulson says: “Although it wasn’t ultimately where my heart was, my experience with BCG was very useful to me in terms of understanding business strategy and what makes one business better or more valuable than others.”

When he saw Jerry Kohlberg at a tennis match, Paulson approached him, telling him how much he enjoyed his presentation at Harvard, and asked for help finding a job. While KKR didn’t have any openings at the time, Kohlberg introduced him to Leon Levy of Odyssey Partners. Like Kohlberg, Leon was famous among the cognoscenti for making widely successful deals, including the late 1970s’ $40 million buyout of Big Bear Stores, which produced a $160 million gain on a $500,000 investment. He was equally admired for buying one million shares in the bankrupt Chicago & Milwaukee Railroad for $6 per share and selling it several years later for $160 per share.

After a visit to Leon’s posh apartment on the Upper East Side, Paulson earnestly argued why he should work for the hedge fund titan. Odyssey was expanding and needed hardworking young talent. He got the job. Odyssey was one of the original hedge funds, and working for Leon and Jack Nash in their 10-person office helped Paulson build a solid foundation. In fact, most of what he learned there, Paulson still does at his own firm: risk arbitrage, bankruptcy investment, and corporate restructuring of public companies.

Knowing What You Don’t Know

Paulson was drawn to Leon and Jack Nash’s tough character and “get it done” attitudes and felt he had the type of thick skin needed to keep up with them. He didn’t realize, though, how his lack of experience in investment banking would hold him back, and he was the first to acknowledge that he needed to learn the business from an agency perspective.

“When they wanted to do a buyout, it was ‘Okay, call some bankers and arrange the financing.’ But coming from consulting, I didn’t know any bankers. I’d never raised any money and I really wasn’t yet equipped to handle that type of responsibility. I realized I’d skipped a very important stage between school and being a principal; I needed to learn the business from an agency perspective. As much as I wanted to avoid earning my dues, being the bottom associate at an investment bank, I realized that the skills learned during that training was what I was lacking. And there was no way around it. If you wanted to be a principal, you had to learn the investment banking business first.”

Nevertheless, Paulson learned a lot about investing at Odyssey and remained in contact with Leon and Jack. In fact, in the late 1990s, Leon and affiliated foundations became the largest investors in his hedge funds.

Paulson felt fortunate to land a job as an associate at Bear Stearns in 1984 right when M&A was taking off. He says: “I felt very lucky to be there, when Ace Greenberg was at the helm running Bear. They didn’t have a lot of people in M&A but had a lot of business. So I worked very hard and advanced fairly rapidly. Associate vice president, limited partner, then managing director all within the span of four years.”