The Alpha Masters: Unlocking the Genius of the World's Top Hedge Funds (29 page)

One of Third Point’s investments that performed particularly well was Dade Behring, a company that manufactures testing machinery and supplies for the medical diagnostics industry. Third Point became involved in a “high-profile distressed deal” in which the company bought Dade Behring’s bonds and bank loans. “The more we learned about the company, the more we liked it,” says Loeb. “We visited the company, which was run by a man named Jim Reid Anderson, who was extraordinarily astute. And it wasn’t just him, but his entire team was of superior quality. When the stock emerged from bankruptcy, it traded down, and Third Point bought more stock. Over the next four years, the management proceeded to grow the business, grow margins, take market share from competitors, and innovate new products.“

“We don’t usually hold onto companies for so long,” says Loeb, “but this was such a good company, that kept having catalyst after catalyst emerge. We thought that inevitably it would be an attractive acquisition target, which it turned out to be.” In 2007, Dade Behring was purchased by Siemens. Third Point earned a 600 percent profit from what it paid four years earlier. “It was one of the best investments we ever made,” says Loeb.

Like most investors, Loeb suffered during the financial crisis and the turbulence that immediately preceded it. In July 2007, amid great optimism, Loeb launched a public vehicle, Third Point Offshore Investors Limited, which was the first permanent capital vehicle for a U.S.-domiciled fund in Europe, and also the first float of an event-driven fund anywhere. Although staked at inception with investments from several large funds of hedge funds and high-net-worth investors, and with long holdings that included the New York Stock Exchange, DaimlerChrysler, and Phillips Electronics, it sailed into the first fears of market meltdown and struggled to meet its capital target. The initial public offering (IPO) managed to raise $525 million from listing a fund in London after a 24-hour delay, below its $690 million target but not a bad outcome given the uncertainty facing the markets at that time.

Loeb didn’t let the challenges of the London-listed fund’s raise distract him from a profitable 2007. As clouds darkened the horizon that September, Loeb saw compelling spreads in an assortment of big private equity–led public deals presenting a huge upside opportunity in risk arbitrage transactions if the funding markets stayed open. In short order, Loeb made the call that several large deals would close and in a time of escalated fear put $1.5 billion or about 28 percent of the firm’s capital into a set of risk arbitrage plays that earned the firm $125 million of profit in six weeks. In addition to those trades, successful bets on large companies in Europe and India and an insightful—and ultimately very meaningful—short position in the ABX Subprime index, Third Point finished the year up 16.6 percent.

The financial crisis brought on the worst year in Third Point’s history. In September, just before Lehman Brothers collapsed, Third Point had about $5 billion under management with earnings up 4 percent for the year; it ended the year with about $2 billion under management, and down 30 percent. “Many of our investors needed to raise cash and had to withdraw their money,” explains Loeb. “We weren’t going to prevent that, and so we liquidated every dollar back,” he says.

Third Point needed stable capital just like every other fund; it just wasn’t going to keep investors’ money hostage—an industry practice referred to as “gating”—during the worst financial crisis since the Great Depression. “There are a few funds out that weren’t able to comply because they couldn’t liquidate their positions fast enough, but they’re in a small minority,” Loeb continues. “Many funds that chose to ‘gate’ put the interests of their management company and its fee-generating ability above their most precious asset—their investors’ partnership. They put their own interests above those of their investors. And I think many of those funds are languishing now regardless of their performance because they violated their partners’ trust.”

Catching the Big Wave in the Storm

In March 2009, Warren Buffett was quoted famously on the cover of the
New York Post
saying, “I’ve never seen anything like it, the economy has fallen off a cliff.” At that point, Loeb was “super bearish.” The day after the
Post
’s Buffett cover, Loeb wrote a letter to his investors that he later explained said, “‘Brace for impact,’ and went on and on about how Armageddon was coming and how we needed to protect our assets.” By that point, Loeb had taken Third Point out of most equities, and net and gross exposures of the funds were at all-time lows. By early April, Third Point’s assets had fallen to about $1.6 billion.

During this rocky period, in February 2009, the Treasury Department announced that it would be applying “stress tests” to 19 of the United States’ largest bank holding companies. Banks that failed the tests would be eligible for the “Capital Assistance Program,” recapitalizing the banks using government monies. At the same time, Citibank, one of the weakest banks, announced an offer to exchange preferred shares for common equity, a confusing and much talked about trade whose net effect was to strengthen Tier 1 capital at the bank.

In mid-March, a trickle of “green shoots” data suggesting modest improvement in the U.S. economy and the government initiative to stanch the bleeding at U.S. financial institutions caused the market to snap 20 percent, “a big move off a low,” before the results of the stress tests were even announced. “I had to think really hard and reassess my bearish position,” Loeb says. “If the market was coming back, that’s one thing. If this was a dead cat bounce, that’s something else. A key rule in investing is that you don’t necessarily need to understand a lot of different things at any given time, but you need to understand the one thing that really matters. And at that point in time, what I had to understand was the wellbeing of the financial system. Were we going to have more Lehmans and AIGs and Bear Stearns? Or was the ‘stress test’ sleight of hand going to calm the markets?”

In order to answer that question, Loeb decided that he personally needed to have a deep and thorough understanding of the stress tests that the government was administering. He took the train to Washington and met with consultants, lobbyists, and others who explained their understandings of basic principles of the “stress tests.” They also shared their beliefs that Treasury planned to allow banks to respond to the results of the tests by converting existing securities to Tier 1 capital.

During his day in D.C., a light bulb came in Loeb’s head. He realized that financial institutions, in earning their way out of the mess they were in, would have to look forward to the future cash-generating ability of the institutions—thus cleaning up their balance sheets by getting rid of toxic assets and drastically slashing the size of risky businesses, like proprietary trading arms, essentially internal “hedge funds,” and credit restructuring divisions. A lifetime of recognizing patterns also paid off as Loeb realized that the much-discussed Citi trade at the end of February represented a kind of “blueprint” for the banks to solve their capital inadequacies with implicit Treasury permission.

If this was the low point for many of the financials, it should only go up from here, thought Loeb. But the conclusion was far from consensus. “Economists like Nouriel Roubini were looking at this the wrong way,” he said. “They were thinking the financial system is insolvent—which it may have been technically if an immediate liquidation of any of the major banks was ordered. Roubini predicted the S&P would hit 600, and possibly even 500! He and others were wrong, and the main reason why they were wrong was that they didn’t understand the framework of the stress test. They were focusing on the balance sheet when the Treasury was focusing on
both
the balance sheet
and
the income statement over a period of time.”

At that critical inflection point in early April 2009, a more bullish Loeb went to work. Over the next four weeks, Third Point deployed hundreds of millions of dollars of capital by scooping up preferred shares in insurance companies like the Hartford Group and Lincoln National. He also purchased preferred shares of Bank of America and Citigroup in addition to the debt of many of the undervalued, bottom quartile banks.

Returning to its roots, Third Point also put money to work in distressed debt. The fund started building significant positions in companies that were going through bankruptcies and reorganizing on the heels of the 2008 crash. So it bought big chunks of debt of distressed firms like Ford, Chrysler, CIT, and Delphi. Loeb also began buying high-quality mortgage backed securities trading at fire sale prices, reversing their successful 2007 bet against the mortgage market. These chunky distressed positions and a large portfolio of individual mortgage bonds formed the core of a home run in credit investment performance over the next two years.

Loeb calls this one of Third Point’s defining moments. “I was able to say, ‘Hey guys, they’ve rung the bell. We may be two or three weeks late, but this is not another dead cat bounce or a bear market rally; this is the real thing, and we need to get invested.” Eight months later, at the end of 2009, Third Point was up 45 percent, which put the fund up by 39 percent for the calendar year. They followed up with a 35 percent gain in 2010. There was little surprise that Third Point was named
AR
magazine’s event-driven fund of the year in 2010 and 2011.

Evolution and Revolution

The crisis taught Loeb how to get better at sidestepping volatility. “I think one of my big improvements since 2008 is how to manage a portfolio for high returns, while avoiding the kinds of draw-downs that we’ve had in the past. Over the years, we’ve had multiple 10 percent monthly drawdowns. You can’t outperform the market the way we have been and not expect some sharp drawdowns. But we’re getting much better at generating very good numbers with relatively light exposure.”

Going forward, Loeb is placing increasing emphasis on emerging markets. “They are obviously essential,” he says. “While the U.S. markets are still the biggest, most important, and most profitable, and while the United States still has the best capital markets and companies, the rate of change is much greater in places like India, China, Brazil.” Such countries are an increasing factor both in producing companies that service the local markets, as well as businesses that compete internationally. “You simply can’t ignore what’s going on there,” he says. “Even if all you do is focus on U.S. companies, a lot of the suppliers of American companies coming out of the emerging markets. I believe our success over the next decade or two will be dependent on our ability to apply our investment framework around event-driven investing to these markets. You can’t understand the global copper markets if you don’t understand China. And you won’t understand markets in general unless you know where China is going. It’s essential.”

Lately, Loeb has returned to his literary ways, but much like in other areas of his life, his tone, although tough as ever, has been refined. As of February 2012, Third Point’s funds collectively hold 5.6 percent of Yahoo!, making it the second-largest shareholder of the perennially undervalued company. Loeb took on the board of directors in sharp, hard-hitting letters, assailing Chairman Roy Bostock for presiding over four CEOs in four years and for an overall absence of leadership and strategic vision. Yahoo! has lost ground to other Internet companies in recent years, but it remains, in Loeb’s words, “a huge, huge value proposition.”

In September 2011, Loeb wrote this missive to Yahoo! founder and then board member Jerry Yang (Roy Bostock was chairman of the board):

Dear Mr. Yang:

Thank you for taking the time to speak with us by telephone on Monday. We are only sorry that we were not able to finish our conversation as a result of Mr. Bostock’s abrupt unilateral termination of the call.

Mr. Bostock’s failure on the call to acknowledge his pivotal role in, and accept responsibility for, the decline of Yahoo! makes clear that he does not intend to voluntarily follow his recently terminated hand-picked executive, Ms. Bartz, out the door. It is our strongly held belief that not only has Mr. Bostock been a destroyer of value, but also so long as he serves as Chairman of the Board, the Company will not be able to attract the talent it needs and deserves, particularly at the CEO level. This opinion is based not only on our prematurely truncated conversation, but on numerous discussions with Silicon Valley
cognoscenti
and other people familiar with both Mr. Bostock and the Company.

As a Founder and major shareholder of the Company, the abysmal record of the current leadership must be heart-rending to you personally, as well as damaging to your net worth. We urge you to do the right thing for all Yahoo shareholders and push for desperately needed leadership change. We are prepared to support you and present you with suggestions on candidates who could help bring Yahoo back to its rightful place among the world’s top digital media and technology companies. . . .

Loeb maintained the pressure behind the scenes throughout the fall of 2011, though he never spoke on the record to journalists. It was clear that Silicon Valley players had heard Loeb rattling his saber. Large private equity firms, long interested in purchasing Yahoo! began to circle. Industry insiders who had followed the company for years posited that Loeb’s shareholder activism might finally push the company in the right direction. Loeb, however, remained mostly mum. When rumors surfaced of a potential sweetheart deal between Yahoo! and interested private equity firms that would have entrenched management and the board at the expense of shareholders, Loeb spoke up. He voiced concerns about one of Yahoo!’s largest shareholders, powerful founder and former CEO Jerry Yang. In December, he wrote: