The Alpha Masters: Unlocking the Genius of the World's Top Hedge Funds (14 page)

In the end, Paulson’s team was able to negotiate the deal for preferred stock, allowing Moody’s to give Dow equity credit for it. It also gave Paulson & Co. the protection it needed to collect a decent return on its money. Paulson & Co., together with the Rohm & Haas families, funded the preferred shares, which allowed Dow to maintain its credit rating, raise the bank financing, and close the acquisition.

On March 6, 2009, once the financing was locked in, Dow dropped the lawsuit and announced that it would close the deal on April 1, causing the Rohm & Haas stock to shoot up from $55 to $78 a share.

When the transaction closed on April 1, 2009, Paulson & Co. netted a $600 million profit in the Rohm & Haas stake, which was the most amount of money the fund ever made in a merger arbitrage transaction. Fortunately, the economy soon recovered, the credit and equity markets rallied and Dow was able to sell investment-grade bonds, redeem the preferred, and refinance the bank loans. While a harrowing experience for Dow, the acquisition was ultimately a success and Dow’s stock revived to a high of over $40 per share in 2011.

Jumping into the Deep End: Citigroup

About the time the Rohm & Haas/Dow deal closed, another exceptional event-arbitrage opportunity presented itself, this time in how-the-mighty-have-fallen financials. As the crisis picked up steam and it became clear which banks were saddled with billions of dollars in toxic assets and which were doomed to fail, the financial system was playing a dangerous game of doomsday musical chairs. On January 16, 2009, the U.S. Treasury Department triggered the TARP, which had been announced that past October as a part of the Emergency Economic Stabilization Act of 2008, by purchasing a total of $1.4 billion in preferred stock from 39 U.S. banks under the Capital Purchase Program. The same day, the U.S. Treasury Department, Federal Reserve, and Federal Deposit Insurance Corporation (FDIC) finalized terms of their guarantee agreement with Citigroup. About a month later, on February 27, Citigroup announced the U.S. government would be taking a 36 percent equity stake in the company by converting $25 billion in emergency aid into common shares. Citigroup shares dropped 40 percent on the news. In aggregate the aid provided to the bank totaled $45 billion.

Because banks are highly leveraged, it is crucial to thoroughly analyze their assets, as a small percentage loss can quickly wipe out the equity. During the financial boom, Citigroup made many speculative investments, particularly in collateralized debt obligations (CDOs), mortgages, derivatives and other types of structured products. When the value of these assets deteriorated, they took enormous write downs, which in turn required them to raise more equity. Investors lined up to purchase equity in Citigroup starting in October 2007 as they thought the decline in the stock price represented a good buying opportunity.

However, as the losses mounted and the write-downs increased, the stock price collapsed. Citigroup’s stock price fell from a high of $56 per share at the end of 2006 to a low of $1 per share in March 2009. Many early investors in Citigroup and other banks subsequently saw their investments either wiped out or severely diminished. As Paulson explained, referencing the lifeline TPG threw to Washington Mutual in the spring of 2008: “They put in $7 billion and they lost it all within six months. Investing in banks at the wrong time is very risky.”

Paulson & Co. stayed away from investing on the long side of any banks until after the government commenced the stress tests and put forth an accurate appraisal of how much capital the banks needed.

Paulson had been scrutinizing the industry closely since 2006. When Paulson’s team saw the first signs of the asset-backed security market falling, it tried to figure out which banks were most exposed to losses on these same securities. Paulson estimated the losses banks would take and then compared those losses to the common equity in each. Ranking them from high to low, the list revealed which banks were in the most trouble. “Fannie and Freddie were in the worst shape,” Paulson says. “We projected losses of 400 to 600 percent of their equity. But Lehman was also high on the list. We predicted they would fail, and Citigroup was at risk as well. Citigroup without government help would have failed like Lehman failed.”

However, commencing in the second quarter of 2009, we sensed a turning point in bank valuations. Bank stocks were oversold and, due to the write-downs and capital raising, were unlikely to fail. We ranked the top 50 banks by the return potential and started acquiring bank stocks with the most potential upside.

Paulson & Co. quietly bought its initial 2 percent stake, or 300 million shares, in Citigroup in the third quarter of 2009. “Citigroup has some very valuable franchises. It’s the most global of the large U.S. banks. It has the largest U.S. banking operation in emerging markets, where the growth is. They have very good capital markets businesses, a valuable regional banking franchise, as well as a global transaction services business, which is almost unparalleled in banking anywhere in the world. So when all of those came together, it made Citigroup a very attractive situation.”

In buying Citibank, Paulson & Co. primarily bought preferred stock, which they then converted into common at a cost of around $2.50 a share. “We felt that once the government preferred and the existing preferred was converted into common that there wouldn’t be a need for additional common equity. We felt at that point we could invest without fear of further dilution.”

By the fourth quarter of 2009, Paulson upped his bet on Citi to over 500 million shares according to SEC filings. But by the end of the third quarter, Paulson & Co. trimmed its holdings to 424 million shares. “It’s not a reflection on our view of the stock specifically,” says Paulson, “but we have size limitations in our funds. As the share price doubled from $2.50 per share to $5 a share, the position size grew to $2.5 billion. That became too big for our portfolio. We pared that position down to keep the weighting in the portfolio below 8 percent as we don’t want to be too concentrated on one name.”

Paulson acquired a second billion-dollar-plus investment in a bank that received government bailout funds during the credit crunch. He had acquired 168 million shares of Charlotte, North Carolina–based Bank of America Corporation in the second quarter of 2009.

Paulson and his team then realized they were underweight in other banks with similar strong upsides like Wells Fargo and Capital One. They decided to further scale back on Citigroup and Bank of America, and increase their position in Wells Fargo and Capital One. But Paulson made the decision to keep the total allocation the same, just shifting the financials portion to other names to “broaden out the portfolio.”

In January 2011, Paulson & Co. reported its stake in Citigroup gained 43 percent, earning it over $1 billion in gains since initiation in mid-2009, according to Paulson’s 2010 year-end letter to investors, and was the largest position in their flagship Advantage funds.

Though they continued to reduce their position, reportedly down to 414 million shares as of February 2011, Paulson and his crew see much upside potential over the next two to three years, particularly if Citi’s losses continue to decrease and earnings grow. “Growth in the rest of the bank plus the elimination of the negative drag on those earnings from the legacy portfolio should allow Citi to make good profits,” he says. “When you convert these profits into a per-share estimate and then apply a modest multiple to those earnings, you could see somewhere between 50 and 100 percent upside in Citigroup’s stock over a two- to three-year period.”

At the time, it was one of Paulson’s most successful investments. “The Citigroup trade was very complicated,” Paulson says. “People were afraid to invest. People that invested early lost a lot of money and they wouldn’t invest any more. The valuation was low. We were correct to assume the government recap plan was the right plan and that would be the last capital they needed. We thought that the valuation of Citigroup was well below what it would have traded at on a normalized earnings multiple, and that it was the most discounted of all the banks. We did the analysis on the banks with the most return potential and Citigroup came out on top.”

Good as Gold

Paulson & Co. initiated a gold share class for all of its investors in April 2009. Paulson says, “Of all the investments we made in all the bankruptcies, all the events, all the mergers, etc., the single most important investment I made was switching to the gold share class.” While the holdings of each portfolio would mirror those of the other Paulson funds, the investments would be denominated in gold as opposed to dollars, allowing for investors to benefit from both the expected rise in value of the portfolio as well as the expected rise in the value of gold versus the dollar over time. Investors that opted for the gold share class earned any dollar returns, plus any incremental returns in the appreciation of gold versus the dollar.

In 2009, Paulson and his credit team were closely monitoring government actions to stimulate the economy and aid the recovery. When the Fed adopted quantitative easing as a tool for monetary stimulus Paulson became concerned about the potential for future inflation and dollar depreciation.

Quantitative easing historically had not been used in the United States and was a very unorthodox monetary tool, but the United States had entered into a financial crisis that was deeper than any since the Great Depression. And it required innovative and unusual thinking in order to stem the crisis and return the country to recovery. “Due to our concerns about the dollar, we started to look for another currency in which to denominate our investments,” says Paulson. “But in our search, we found other countries, such as the United Kingdom, were also printing money, and we had separate concerns about the stability and long-term viability of the euro. We thought that, given all the uncertainties regarding paper currencies, gold would be the best currency.”

He stresses, however, that gold as a currency has a three- to five-year time horizon. “Gold is very volatile in the short term and could as easily go down in the near term as go up. But if you’re invested over a three- to five-year horizon, I think you’d be much safer in gold as a currency rather than the dollar.”

A Little Help from His Friends

Paulson is the first to tell you he gets by with a little help from his friends. Over the years he has benefited from sage advice from influential advisors to the fund, one of whom is a rather famous former chairman of the Federal Reserve.

In the spring of 2007, Deutsche Bank’s global head of investment banking, Anshu Jain, threw a dinner in the firm’s executive dining room on the forty-sixth floor of 66 Wall Street. The dinner was hosted by special adviser to the bank Dr. Alan Greenspan, and the guest list comprised a selective group of the firm’s biggest trading clients. Among those invited were Paulson, Bruce Kovner of Caxton Associates, Henry Swieca of Highbridge, Israel “Izzy” Englander of Millenium Partners, and Boaz Weinstein, the firm’s hot-shot head of credit-focused proprietary fund Saba Capital. Anshu’s department historically generated 70 to 80 percent of the firm’s profits and these relationships needed to remain intact.

Dr. Greenspan at the time said he’d take on only three clients when he retired from the Fed. He already had two: one was a bank, Deutsche Bank; another an asset manager, PIMCO; and the third would be a hedge fund. “I met him at that dinner, we got along well, and he said he would consider taking on one more client. We were fortunate to be that client.”

Before Greenspan joined the advisory board in January 2008, Paulson admits that he did not have a good understanding of how the monetary system works, what the Fed does, or how money is created. “I was very focused on individual companies and had never looked at a Fed balance sheet,” he admits. “I didn’t know what the monetary base was or what money supply was. I didn’t know the relationship between the Fed and other banks nor their relation to the Treasury.”

Once a month or so, Dr. Greenspan flies up for the day from D.C. with his director of research, Katie Broom, to attend meetings with Paulson in New York, where they spend the day discussing current monetary policy and economics with regard to the portfolios. They often have a lunch of Diet Cokes and turkey sandwiches together at the Paulson & Co. offices. “When the financial crisis started to evolve, the government was a very important player in the restructuring of the financial system, so I really wanted to learn how the system worked,” says Paulson. “I couldn’t have found a better adviser than Dr. Greenspan for that.”

Says Dr. Greenspan, “John Paulson has an uncanny ability to judge relative risk, and to capitalize on such judgments. He may slip from time to time—we all do. But with the discipline he brings to investments, continued success is far more likely than not.”

As another record year ended and he sent out his annual 2010 letter to investors, Paulson announced he’d begin hosting various fund-specific conferences for investors in addition to his June and November reviews and workshops. Though Paulson & Co. did see some redemption, on the whole investors were quite pleased. At the end of 2010, LCH investments conducted an independent study of hedge funds that produced the greatest net gains for investors since inception. It ranked Paulson & Co. number three, behind only George Soros’s Quantum Endowment Fund (started in 1973) and Jim Simons’s Renaissance Medallion Fund (started in 1982). In his 2010 year-end letter to investors, Paulson proudly included a graphic that listed the top 10 managers, stating, “We are proud that we are number three on the list with over $28 billion in net gains, even though we started our funds 12 and 21 years after Renaissance and Quantum, respectively.”