The Alpha Masters: Unlocking the Genius of the World's Top Hedge Funds (20 page)

There was no fear within Appaloosa’s walls during the 2008 financial crisis. Tepper says the crisis wasn’t a shock to Appaloosa; the team knew exactly how to handle it. “The recent crisis wasn’t so hard because we went through two others before this,” he says. “1998 was hard because that was the first one we really went through. We took our book down, raised cash, and did different things than we had ever done.” During the final quarter of 2008, Tepper bought cheap commercial mortgage-backed securities, credit card debt, and government-guaranteed student loans. That seemingly noxious stuff no one else wanted at the time ended up being a critical component of Appaloosa’s $8 billion gain the following year.

Appaloosa has no investment committees, no daily meetings. “The daily meeting is every second of every day of the year,” he told
Bloomberg Markets
magazine in February 2010. “There’s no place to hide at Appaloosa.” The firm’s $8 billion gain in 2009 resulted in a $4 billion payday for Tepper, reported to be one of the biggest single-year paydays for a hedge fund manager ever. Tepper has since trimmed the fund size by returning money to investors, bringing it down to $12 billion, closer to what he calls a hedge fund’s “ultimate sweet spot.” He says, “You have every advantage of being a big fund at $10 billion. Above that, it gets tough to manage.”

Tepper feels that what separates his firm from the pack and enables it to bang out such stellar returns is that they are not afraid to lose money. Besides the fact that Tepper and his partners own about 55 percent of the firm’s assets (the other 45 percent is owned by outside investors, including institutions, wealthy individuals, and foreigners), the firm is allowed to lock up 75 percent of the assets for a period of three years if need be, even though it has never put this into effect—and for good reason. This sets up a stability that leads to long-term clients rather than “hot money,” he says. “We’re value-oriented and performance-based like a lot of funds. But I think what differentiates us is that we’re not afraid of the downside of different situations when we’ve done the analysis. Some other people are very afraid of losing money, which keeps them from making money.”

Tepper thinks of his investment track record as something similar to a connect-the-dots game, except the puzzle is never finished and the prize is billions of dollars. “When I got to Goldman, I changed the way junk bonds were traded. It was pretty radical, moving the whole market to trades on sectors. It used to be traded by maturities, which helped perpetuate the monopoly held by Michael Milken at Drexel Burnham,” explains Tepper. This approach to the U.S. junk bond market would serve Appaloosa well in its pursuit of global opportunities.

International Intrigue

Venturing into the world of emerging markets in the mid-1990s was like second nature to Tepper, who had been a key player in many “different capital markets and things that were happening around the world,” he says, from his time at Goldman. Tepper had sat next to guys who ran the emerging markets desk at the firm and learned a lot from them. It is just a different type of credit analysis, according to Tepper. He says: “You’re basically doing country analysis, which wasn’t really that hard for us to pick up. And then, it’s just like everything else—analyzing all kinds of investments. You’re trying to figure out that inflection point.”

Tepper remembers his first trip to France, which ended up being unforgettable, but not for the right reasons. In 1995, he was invited to Paris to meet with a custodian for the Getty family and a French bank. So Tepper and one of his partners boarded the Concorde jet, which could fly at twice the speed of a regular aircraft. Less than an hour into the flight, right after breakfast had been served in first class, Tepper heard an explosion at the back of the plane and turned around to see that the passengers were white as sheets. Tepper looked at his partner, Ronnie Goldstein, and said, “I think we’re in serious trouble here.” Ronnie responded, “If we’re going to die, I’m finishing my breakfast. I’m not dying without a full stomach,” Tepper recalls with a chuckle. “It was classic Ronnie.” One of the plane’s engines had died, but, miraculously, the pilot was able to turn around and get everyone back to JFK safely. “There was already another Concorde on the runway waiting for us, but only about five people reboarded, including me and Ronnie. We were told that we were lucky to have made it out alive. They offered us $500 apiece for our trouble. I couldn’t believe it.” By the time they reached Paris around midnight, they just wanted to head to the hotel and go to sleep. “But the French bank salesmen were still waiting to meet with us! We didn’t want to go, but in the end we decided to just do it. That’s when we knew we were getting big.”

Starting in 1995, Appaloosa made a lot of money during the Latin America crisis, as the firm held big positions in Argentina, Brazil, and Venezuela. Tepper saw that people had finally recognized the inflection point in Latin America, after which the market moved up. And that’s what the firm has done since in other countries. For example, in Argentina, they figured out they had to watch bank deposits. Tepper says: “As soon as money started coming back in the country, that market took off. So we were able to figure out the right variable, to look at the right thing to focus on. And when it changed, we were fairly early and we were able to make a lot of money.” Appaloosa’s fearlessness has served investors well. The firm was the first to buy Korean Treasuries in 1997. Tepper sent a handful of analysts to Korea to see what was going on in the country and was stunned by their findings. “We discovered the country was an export machine—a real industrial country. They were sacrificing their gold for the good of the country. We were frankly surprised by the level of sacrifice,” says Tepper.

Russian Roulette

In 1997, Tepper was scheduled to meet Russian investor Boris Jordan at the Renaissance Capital offices in Moscow, but when he arrived, Jordan was not there. Tepper and a colleague somehow ended up in the basement facing five men with machine guns. Tepper had learned some Russian in high school and managed to say, “We’re going upstairs!” He later received a call from Jordan’s assistant canceling the meeting because there was a bomb scare in the building. “I was like, ‘Are you kidding me? Why didn’t you tell us before bringing us into the middle of a death trap?’”

In retrospect, Tepper was just too long in Russia going into 1998. He had made a lot of money in 1996, but then miscalculated the risks. The Russian ruble had been devalued, and the country defaulted after an International Monetary Fund (IMF) deal. Tepper had thought that bond prices would go up, which they did for about a day and a half before going straight down. Appaloosa hadn’t realized how fast the markets were becoming illiquid, as Russia’s default brought on a near global financial meltdown. The firm was about $1.7 billion in assets at that time, and lost approximately 29 percent on the whole and $80 million on Russia.

“It was the definitely the biggest screw-up of my career,” says Tepper. “We had huge emerging market and junk positions that we sold down to avoid disaster, so we were able to act fast. Our biggest mistake was not realizing how illiquid markets could get so quickly. Many firms went out of business at the time, and at one point, I wondered if we would be able to survive. That was kind of an interesting lesson for a lot of people,” he says.

But Tepper bounced back in 1999—and with a 61 percent net gain, no less—as he bought back the Russian bonds post-default. The banks couldn’t get the bonds off their books fast enough, so Appaloosa was able to swoop in and collect the debt at five cents on the dollar. “It was like minting money,” he recalls. “It was almost worth all of the hell we had to go through,” he says with a laugh.

Bullish on Bankruptcies

Tepper knows that his way of doing things invokes a certain degree of risk, but for the most part, it yields bar-none results. In 2001, Tepper generated a 67 percent net return by focusing on distressed bonds. He has made significant gains year after year by investing in under-the-radar stocks such as MCI, Mirant, and Marconi, leading to huge profits for the fund. His 2003 investment in Marconi Corporation was a prime example of how Appaloosa successfully jumps into the mix during a reorganization process and cherry-picks cheap assets ahead of the pack, which would only serve as a warm-up for the behemoth bankruptcies following on its heels. Tepper estimates that the Marconi investment added more than 5 percent to the flagship fund’s percentage gain that year. The bulk of the fund’s 2003 gains came from purchasing the distressed debt of three of the then-largest bankruptcies in corporate history: Enron, WorldCom, and insurance giant Conseco. When the companies emerged from bankruptcy and the debt appreciated, Appaloosa went up a whopping 149 percent net in 2003.

Former employee Alan Fournier, who now runs $6 billion Pennant Capital, sent Tepper a fitting present to celebrate his success: a pair of massive, veiny, brass testicles affixed to a plaque inscribed with the words
The Most Valuable Set of All Time
. Fournier says that every time Tepper is working on a big trade, he calls him up and screams into the phone: “I’m rubbing your balls for good luck!”

Delphi Dilemma

Tepper’s photographic memory is one of his most valued possessions. It’s also what brings him pain. Like a professional athlete after missing an important shot, Tepper replays his losses in his head. “It is the only way you learn from your mistakes,” he says. Appaloosa’s four-year struggle with Michigan-based auto parts manufacturer Delphi Corporation is one of those what-doesn’t-kill-you-makes-you-stronger events that has brought Tepper both pain and the opportunity to learn.

In October 2005, Delphi filed what was then the biggest bankruptcy in U.S. automotive history. Then, in March 2006, a U.S. bankruptcy judge granted a motion by one of Delphi’s largest shareholders to create a committee to represent the interests of stockowners in the auto parts maker’s reorganization. At that time, Appaloosa held 9.3 percent of Delphi shares and asked for a separate committee, claiming that Delphi overstated liabilities when it filed for bankruptcy in October.

But after two years of negotiation, the situation wasn’t getting any easier and Appaloosa couldn’t see a light at the end of the tunnel. Tepper decided he had had enough. “It wasn’t worth the time at that point,” he explains. “We’re known as people that will fight till the end but I’m not going to fight something just to fight something. I’ll fight if I have to, but I’m actually a lover and not a fighter at heart.” In the end, Appaloosa and the consortium were collectively ordered to pay Delphi $82.5 million in fees plus expenses.

“Delphi was a big investment commitment that we thought had significant upside potential at the time. But the situation soon became very aggravating,” Tepper admits. “We thought we did everything right.” Following the Appaloosa exit in 2009, Delphi CEO Rodney O’Neal picked up the phone and gave Tepper a call. “He thanked me for everything we did to help save the company. I thought that was interesting,” he says with a smile.

WaMu Winner

Throughout 2007, Appaloosa sought ways to continue to execute on its distressed strategy, looking for various exposures across many markets. In January 2007, Tepper was just starting to see a little bit of a crack in subprime—which was an indication of things unwinding in the financial sector. As the Appaloosa team began looking closely at opportunities, one bank in particular stood out to them as particularly exposed to mortgages: Washington Mutual. Appaloosa had been keeping a close eye on the company as part of the basket of financials it had identified at distressed levels.

The Seattle-based bank, which had been the nation’s largest savings and loan, saw its stock price sink from its 2007 high due to mounting losses on risky loans and subprime mortgages. By April 2008, a group of investors led by private equity firm TPG Capital stepped in with a rescue plan, offering the bank $7 billion of capital in an effort to stabilize the company. But rising delinquencies and mortgage losses caused the Office of Thrift Supervision to step in and take over Washington Mutual’s banking unit, putting it into receivership and selling the unit to J. P. Morgan for $1.9 billion. In September 2008, the company filed for bankruptcy with 2,200 branches and $188 billion in bank deposits, becoming the largest U.S. bank to fail.

Enter Appaloosa. “We had been following WaMu very closely,” says Tepper. “We knew there was still about $4 billion in cash from TPG sitting at the holding company—and it wasn’t going down to the bank. We also knew there would be a potential tax refund,” Tepper continues, referring to the company’s ability to apply operating losses to prior years’ income to reduce taxes. “We knew we would be rewarded if we’d just be patient.”

So Appaloosa started scooping up the senior debt at between 50 and 60 cents on the dollar just ahead of the bankruptcy. “And after the bankruptcy filing, we became the largest creditor of WaMu—we understood the capital structure and the details of the corporate structure, so we knew there were assets for a recovery,” Tepper says. “We believed there was a good probability of recovery at the holding company for the bonds versus the bonds at the bank level.”On February 17, 2012, Washington Mutual was awarded court approval for a $7 billion reorganization plan by U.S. Bankruptcy Judge Mary Walrath in Wilmington, Delaware. The creditors have rights to more than $7 billion in cash from bank deposits and tax refunds, with the first slice of monies payable as early as March 8, 2012. Appaloosa’s patience paid off handsomely, although Tepper remarked, “it was a really long and incredibly painful bankruptcy process.”