The Alpha Masters: Unlocking the Genius of the World's Top Hedge Funds (12 page)

Bear Stearns was the perfect place for Paulson to grow at his own supercharged pace. They placed no limits on how quickly he could climb the ladder or how long he had to remain at each level. They told him they would promote him as fast as he could handle the next level of activity, and they did. Another reason Paulson was able to accelerate so quickly was that he felt he had to play catch-up. Some of the friends he graduated with were four years ahead of him in pay and position at other banks, while he was back at the bottom.

And after four years of learning the ropes at Bear, Paulson felt prepared to play in the big leagues. “Once I got to the point where I had gained the experience advising in mergers, negotiating merger agreements, underwriting common stock, preferred stock, subordinated debt, and senior debt offerings, and having a Rolodex full of capital providers, I felt then I was ready to move back to the principal side. My experience at Bear gave me the building blocks that I needed to act as principal.”

In the late 1980s, Gruss Partners and Bear Stearns together made a large gain on the sale of Anderson Clayton Company and Paulson became close with Marty Gruss, son of Joseph Gruss, the founder of Gruss Partners and the current senior partner. The firm was founded in 1938 and had built an enviable long-term track record in risk arbitrage. Paulson left Bear Stearns in 1988 to become a general partner at Gruss Partners. At that point, the merger business was slowing as Drexel failed and the economy dropped into a recession. Bankruptcy reorganizations were rising, however, so Paulson focused most of his time at Gruss on distressed and bankruptcy investing. As much as he liked working at Gruss, though, he realized that he ultimately wanted to be in business for himself.

“I’m Sort of an Independent Person”

Paulson wasn’t afraid of the challenge of building his own business. “People kept saying that if you start your own business you’re going to fail,” he says, “but I never thought I would. I thought that in order to do well, all I needed to do was compound at above-average rates of return, and I thought, ‘Why shouldn’t I be able to do better than average?’ That seemed to be the easy challenge. So all you had to do was minimize losses and make more than average. If you could do that, you could be successful. And I already had the skills to do that in risk arbitrage, mergers, and bankruptcies.”

So he launched Paulson Partners in 1994. He started with $2 million of his own money and waited for the phone to ring. He sent out 500 announcement cards to potential investors, saying, “We’re pleased to announce the formation of Paulson Partners,” and told his lawyer he expected “to open” with $100 million.

But raising money was tough. “Although I had a lot of contacts,” he says, “I didn’t have a lot of money. I sent those announcement cards out to everyone I knew, and I thought the phone would ring and everyone would be calling to invest. Well, the phone never rang. I got only one card back from Ace Greenberg offering congratulations.” So Paulson picked up the phone and was met with a mix of indifference, skepticism, and occasional curiosity. “Some did provide a sliver of encouragement and said, ‘John, you know, I like you but you don’t have a track record, so come back when you do.’ ”

Source: Paulson & Co.

 

Paulson knew he had to build a track record. But this was a daunting task given the small capital he had and it took not a small amount of effort to stay positive. He recalls: “It was so very tough coming to work every day, making calls, having meetings, and then getting rejected. People would avoid my calls or make appointments and then cancel. Some of the junior analysts at Bear when I was there were now partners. I’d call them and they wouldn’t see me—guys that worked for me!”

In an effort to broaden his investor base, Paulson waived the $1 million minimum investable amount, and some encouraging conversations buoyed his hopes. He was disciplined and says: “I started managing the small amount of money I had as professionally as I could. I sent out monthly reports with our performance data to anyone with a vague interest.” After receiving the same letter for 12 months showing very positive results, some of those people who had put Paulson off were now ready to invest.

That arduous process took an entire year before Paulson & Co. finally landed its first investor. Paulson had grandiose expectations that weren’t quite met. “I was like, okay, here comes $10 million! And then it was . . . $500,000,” he said, shrugging.

The allocation came from Howard Gurvitch, a friend and former associate of his at Bear Stearns. Gradually, some other friends began to pile in and Paulson built up his investor base. Then one day he got his first $5 million investor. “This was a very wealthy guy; he had at least $200 million, and he sent me $5 million,” Paulson recalls. “That more than doubled my capital. I was so excited—I was finally at $10 million. He was reading all of these letters and thought that from the way I spoke that I managed more than $100 million. He later told me that if he knew I only managed $5 million, he would never have put in $5 million, since he has a policy against being more than 5 percent of any manager.”

Barely raising enough capital to run his tiny fund took a toll on Paulson. “I had to swallow my pride, buckle down the hatches, and just be patient. I ran the firm professionally in terms of research, portfolio management, monthly reporting and audited results, and doing all the work you needed to do even though the position size was small,” he says. Bear Stearns was a great supporter and lent him office space at 277 Park Avenue on a high floor with nice views, conference facilities, and administrative support. As the fund continued to grow, Paulson gradually started building up a staff, focusing on marketing and administrative personnel.

Eventually, Paulson & Co. started to rack up a good performance record compared to other hedge funds. “We stacked up pretty well, within the top quartile. And being in the top quartile allowed us to steadily raise capital. What distinguished us most was making money in 2001 and 2002 just doing conservative spread deals. We took down our equity exposure and were able to show positive returns when most managers lost money in 2002.”

Although the Paulson Funds only made 5.1 percent in 2001 and 5.4 percent in 2002, it was enough to make Paulson & Co. the top-performing merger manager over that two-year period. Then, in 2003, when the economy picked up, Paulson had returns of 22.7 percent in Partners and International and 45.2 percent in Enhanced.

With a seven- to eight-year track record that proved they could operate well in an up market as well as a down market, Paulson & Co. started getting serious investor attention that brought it to the billion-dollar level. But Paulson & Co. was still a little late to the game. Hedge fund industry growth was slowing, and there were other, well-established managers out there like Farallon, Perry Partners, Angelo Gordon, and Och-Ziff. These firms also had excellent track records, had started earlier, and had a loyal investor base. Paulson wanted to find a way to stand out from the pack. He also knew he could not grow through marketing alone as he could never compete with the extensive global marketing operations that firms like Goldman Sachs or J. P. Morgan had. “I realized that if I wanted to get into the top leagues, it would have to be by performance,” he says. “In 2003, we had our first taste of 40 percent performance, and with very little volatility. That was the magic.”

Once Paulson & Co. got into 2005 and 2006, its assets steadily grew to $4, $5, $6 billion and above but it still wasn’t enough to be considered one of the biggest players in the field. Paulson says: “We realized it’s a very competitive landscape. Other event managers were also very good, and the largest funds were in the $20 billion-plus range. I realized if I was to move up, it would have to be through performance—but performance that could be achieved without taking undue risk. There was no reason to jeopardize this fabulous business we had created and our track record just to grow bigger.”

So he went in search of low-risk, high-return investments that would give the fund the boosts they needed to enter the top brackets.

The Greatest Trade Ever

One of the unique skills that Paulson had developed through his career was in shorting bonds. He first practiced this strategy while at Gruss Partners in the early 1990’s when it shorted the bonds of bank holding companies that were at risk of a downgrade or of failing. The holding companies’ bonds were particularly vulnerable to a decline. Unlike the operating company bonds, which had direct access to the assets as collateral, the holding company’s primary asset was the equity in the operating company, which would almost always be wiped out in the event of insolvency.

The attraction of shorting bonds is the asymmetrical nature of the returns. If you could short a bond at par or close to par at a tight spread to Treasuries, then the downside would be limited if you were wrong, but the upside could be substantial if the company defaulted. The trick, though, was in finding mispriced credit that traded at par, which could default. This is no easy task. In addition to banks with two-tiered capital structures, Paulson also found opportunities in other financial companies with a holding company structure, such as insurance companies, and in leveraged buyouts. Almost all investors hated shorting bonds because most of the time the bonds paid out, and the negative carry from paying the interest on the short bond was a drag on performance.

Paulson had not been dissuaded from this challenge. He liked the asymmetrical risk/return potential, and continued to pursue this area as an investment strategy with periodic success over time.

By the spring of 2005, Paulson became increasingly alarmed by weak credit underwriting standards and excessive leverage being used by financial institutions. Credit quality had deteriorated to the point where the worst-performing companies could readily raise financing. And banks had fostered this trend by adding vast quantities of credit assets to their balance sheets and by increasing their leverage. When measured against common equity, the largest banks had leverage ratios of 30 to 40× and in some cases 50×. With that type of leverage, it wouldn’t take much for a loss to wipe out the equity, and with the credit quality deteriorating as it was, this appeared increasingly likely.

At the same time, as credit markets were spinning out of control, Paulson also felt the residential real estate market could be in a bubble. Prices had gone up rapidly and continuously for an extended period, and almost everyone was euphoric about the easy money to be made in housing. Paulson’s own home in Southampton, purchased at a bankruptcy auction in the last real estate downturn in 1994, had appreciated six times in value by 2005, well in excess of the long-term growth rate on home prices. Furthermore, John didn’t adhere to the theory that residential real estate prices only went up, having experienced previous real estate downturns.

The bubble nature of the real estate market, the frothiness of the credit market, and Paulson’s focus on shorting bonds led Paulson to investigate short opportunities in the mortgage market. While Paulson had no previous experience in the mortgage market, he knew it was the largest credit market in the world, larger at the time than the U.S. Treasury market. He asked Paolo Pellegrini and Andrew Hoine, two analysts at the firm, to take a look at the structure of the mortgage market.

Paolo quickly came back and said there were prime, midprime, and subprime segments. “Since we were interested in shorting, we decided to focus on the subprime segment,” explains Paulson. “Although the smallest of the mortgage segments, the market was so large that there was over a trillion dollars of subprime securities outstanding. When we dived deeper into the residential real estate market, the subprime market, and the securitization market, we began to believe that this area could implode.”

At that point, Paulson asked Paolo to focus exclusively on subprime securities. Paulson began to suspect that shorting credit could be the strategy that could give him the outsized performance he was looking for without taking excessive risk. Slowly, Paulson and his team were able to piece together how housing prices, and the trillion-dollar market built around them, were doomed to collapse like a house of cards. This gave Paulson the green light to begin purchasing protection through credit default swaps on debt securities he felt would decline in value due to weak credit underwriting.