The Alpha Masters: Unlocking the Genius of the World's Top Hedge Funds (13 page)

The subprime mortgage securitization market was uniquely suited to buying credit protection. The typical subprime securitization was divided into 18 tranches, ranging from “AAA” to “BB,” with each lower tranche subordinate to the one above. The “BBB” tranche traded at par with a yield of about 100 basis points more than U.S. Treasuries. On average, they had only 5 percent subordination and were only 1 percent thick, meaning a loss of 6 percent in the pool would wipe out the “BBB” tranche. “In other words, by risking a 1 percent negative carry, we could make 100 percent if the bond defaulted,” says Paulson. “That was the precise asymmetrical investment we were looking for. We would lose very little if we were wrong, but could make a 100:1 return if we were right. And given the low quality of subprime loans and the deteriorating collateral performance, we thought the probability of success was very high. Yet, the credit markets at the time were in such a state of exuberance and the global demand for ‘BBB’ subprime securities was so strong that we could buy protection on virtually unlimited quantities of the securities.”

In the end, Paulson bought protection across his funds on about $25 billion of subprime securities. As spreads widened, and the value of those securities fell, Paulson and his team cashed in at an increasingly accelerated pace. Paulson & Co. had amassed $15 billion in profits off these trades by the end of 2007 with the Paulson Credit Fund up 600 percent that year. The firm’s assets under management grew from a respectable $6.5 billion in 2006 to a monstrous $28 billion by year-end 2007.

Paulson’s credit fund returned 20 percent, 30 percent, and 20 percent in 2008, 2009, and 2010, respectively. Paulson liked the neighborhood. “I think I always wanted to be in the top bracket,” he says. “I never imagined we’d get this big but I always liked and aspired to be successful. You can have a goal. You can try. But, you know, at the end of the day unplanned things can happen, too. I had a broad tool kit in the event area: mergers, bankruptcy, distressed, restructurings, which we could apply from either a long or short perspective. I had a great deal of experience working with a lot of brilliant people—Leon Levy, Ace Greenberg, and Marty Gruss—and had seen a lot of great investments including 100-to-1 investments.”

In its year-end 2010 investor letter, Paulson & Co. acknowledged that the fund participated as the lead or one of the lead investors in 10 of the top 14 bankruptcies, highlighting that because of its size and expertise, it was invited by numerous corporate management teams to provide capital on favorable terms to repay debt, strengthen equity, and/or restructure their balance sheets.

While most of the deals Paulson & Co. take on are intricate enough to warrant outsized returns, some stand-alone event-arbitrage investments are so treacherously complex, they brought the firm high prestige and enormous profits in their own right.

Mispriced Risk: Dow/Rohm & Haas

On February 4, 2009, in a letter addressed to Andrew N. Liveris that was made public, Paulson urged Dow’s chief to complete the $15 billion acquisition of the nearly hundred-year-old specialty chemical manufacturer Rohm & Haas. Their agreement had been made on July 10, 2008. Between June 30 and September 30 of that year, Paulson bought 15 million shares of Rohm & Haas, according to documents filed with the SEC, at which time the investment was worth $1.05 billion. Since then, numerous obstacles had delayed the deal, and a significant amount of Paulson & Co.’s wealth was on the line. Paulson was doing everything he could to encourage Dow to execute.

Paulson feels it is easy to compute returns from a spread, but his and his team’s expertise comes into play when evaluating the risk-return trade-off for a deal in trouble.

Deal completion risks are exacerbated when the economy and market weaken. When the economy slipped into a deep recession after Lehman failed, Dow found that the price it had agreed to pay for the company was too high and it wanted to exit the transaction. The spread went from $2 when the deal was announced to $25 as the stock fell to the low 50s. This raises the legal question for investors: can Dow exit the transaction? Luckily for Paulson, his years of experience in mergers and acquisitions gave him a leg up on the market in answering that question.

But even having read and having negotiated scores of them, Paulson wouldn’t consider himself an expert on merger agreements. This is where Michael Waldorf, a Harvard-educated merger lawyer, comes into the picture. “He had the perfect background that I wanted: an expert lawyer to understand all the nuances in various merger agreements,” says Paulson. “Dow was saying, ‘Oh, the economy had changed.’ It was a very different environment than it was when we announced this in June. Rohm & Haas’s earnings fell dramatically. There was a material adverse change in the business. And Dow actually sued Rohm & Haas in Delaware to void the merger agreement.”

In this case, a firm needs to be an expert in Delaware law in order to get involved and understand the legalities. Paulson & Co. is an expert, having observed or been a part of any significant merger agreement that has been litigated in Delaware. Paulson credits this know-how, from having his own attorneys at the courthouse to knowing the judges and their propensity to rule in Delaware court, as being a big part of his competitive advantage. He says: “We can make an estimate . . . with relatively high probability of what the outcome of that lawsuit will be. That is an extremely valuable skill. It’s a very narrow, very focused skill that very few organizations have.”

After closely reviewing the agreement, Paulson & Co. concluded that Dow did not have a case. Based on this background and analysis, Paulson & Co. insisted there were no fundamental obstacles to completing the deal and suggested several financing options that could make both sides content. But Dow continued to back away from its bid to buy Rohm & Haas, asserting that current economic conditions made it impossible to close “without jeopardizing the very existence of both companies.”

Paulson’s team saw that the agreement featured a material adverse change clause, but they felt the fact that Rohm & Haas’s earnings decline since they announced the deal was not a material adverse change. The deal was not dependent on Rohm & Haas’s earnings, and the fact that the economy had dipped into a recession was not a condition of the merger agreement. Paulson repeats: “The fact the stock market fell was not a condition. The fact that Lehman fell was not a condition. The fact that Dow was no longer making money, or that Dow may not be able to raise financing was not a condition to the merger agreement.” Only fraud would apply as a material adverse change, and there was no fraud. Dow had no out.

Why was it such a tight merger agreement? The attorneys representing Rohm & Haas were the best in the merger business: Wachtell, Lipton, Rosen & Katz. Says Paulson: “Generally, you don’t know you have a good attorney until you run into a problem.”

When Dow signed the merger agreement, there were no apparent problems on the horizon for the two strong companies. Even though Bear Stearns had fallen just months earlier, earnings at both companies were still growing, and the firms mistakenly felt that the economy would continue to grow.

That was in June 2008. By January 2009, the picture had changed completely. But by then Rohm & Haas was already protected by an agreement that allowed no wiggle room. Paulson says: “There was a steel door that didn’t allow you to get through. And these steel doors were put in place when no one was even thinking you needed any protection. That’s why Wachtell’s so good at what they do.”

Because there had been another bidder who wanted to buy the company—the world’s largest chemical maker, BASF—Rohm & Haas was not looking for a contingent transaction but an ironclad deal. With BASF hovering nearby, Dow agreed to Rohm & Haas’s terms. And at the time, Dow wasn’t overly concerned about the economy.

When searching for investments, Paulson & Co. looks for situations in which the risk is being mispriced. In the Dow/Rohm deal, Paulson & Co. was very confident in its assessment of the legal risks, which led it to take a large position. However, Paulson says: “What we overlooked or what we didn’t pay enough attention to was not the legal ability of Dow to exit the transaction but ultimately Dow’s ability to consummate its financing.”

To fund the acquisition, Dow had a $2.5 billion investment from Warren Buffett’s Berkshire Hathaway in convertible preferred, and $2.0 billion in preferred from Kuwait Investment Authority. It was also going to sell its joint venture business to Kuwait to fund the balance of the transaction. If, for whatever reason, the Kuwaiti deal fell apart, Dow had negotiated a safety net: a term loan from banks to bridge the facility. It seemed to Paulson that Dow was adequately protected.

Even when Kuwait did ultimately back out of the agreement and Dow sued them, Paulson had little expectation for Dow to succeed. The team had already looked into whether Dow had any legal right to force Kuwait to uphold its end of the bargain. It turned out it had only signed a letter of intent, so Paulson didn’t expect Dow to go through with suing Kuwaitis in a Kuwaiti court. And he was right. Dow had no choice but to drop the suit.

Despite this, Paulson knew that Dow had a backstop. The banks that committed to fund the deal had accepted a commitment fee from Dow, which would make it very difficult for them to back out on providing the financing. If they did, those banks could be liable, depending on the terms of that commitment, for the entire amount of the Rohm & Haas transaction. But in an extraordinary crisis like the one facing the financial system in late 2008, the banks were dying to get out of any and every financial commitment they could. The last thing they wanted to do was fund what could be a failing combination, because by the fourth quarter of 2008, both Dow and Rohm & Haas were no longer making money. If Dow had to borrow money to buy Rohm & Haas, they could go bankrupt.

Because Dow stock in January had fallen from $55 when they announced the transaction down to $6 a share, bankruptcy was looking more and more likely. Every day, more companies were filing for bankruptcy. Lehman Brothers now was the largest bankruptcy in the world. In January 2009, LyondellBasell—one of the largest chemical companies in the world, with $18 billion in debt—filed for bankruptcy as well. And all those same banks were debt holders. And those banks were trading for 40 cents on the dollar.

However, in the bank commitment letter, there was a back door. As a condition of funding, Dow Chemical needed to have an investment grade rating at the time of the drawdown. And in the midst of the crisis, Dow’s earnings turned into a loss and its sales had plummeted. Moody’s had downgraded Dow to triple B minus on negative watch, one notch above junk.

If Moody’s downgraded Dow to junk, the banks could walk away. Dow would not be able to complete the transaction. It would likely lose in Delaware court and be forced into bankruptcy. Moody’s, in its meeting with Dow, said unless Dow raised $1.6 billion of equity and reduced the term loan by $1.6 billion, it would downgrade Dow to junk.

One week before the court case, Paulson met with Dow and its bankers and told them that if they needed equity to complete the transaction, Paulson & Co. would consider investing in Dow to help it finance the Rohm & Haas deal. He says: “There were not too many people around willing to buy equity in Dow Chemical, when their stock was at six and other chemicals were filing for bankruptcy and the world was falling apart. But we said we would be willing to buy a preferred stock.”

If Paulson was going to get involved in such a risky investment he would only buy preferred stock, giving him seniority in the capital structure. When Paulson & Co. structured the preferred, its expertise in capital structures came in to play. “We had to invent a preferred that would give us the protection we wanted and allow Moody’s to consider it equivalent to common equity,” says Paulson. “We came up with what’s called a deferred dividend preferred—a preferred that does not pay cash dividends but pays dividends in additional shares of preferred. Since there was no cash requirement, a deferred dividend preferred could be considered equivalent to common equity in terms of supporting the debt above it.”

Paulson didn’t care whether he got dividends in cash or additional shares of preferred, just as long as he was senior to the common. But the next issue became the ranking of the new preferred relative to the existing preferred outstanding. The company proposed the new deferred dividend preferred would be senior to the common, but junior to the existing preferred outstanding, which was owned by Berkshire Hathaway and others.

Paulson knew that if he were junior to the existing preferred he could get wiped out in the event of a bankruptcy. But if he was pari passu with the existing preferred, the total preferred class would likely become the new common class. So he decided that as long as he could be on equal footing with existing preferred holders such as Buffett, he’d invest. “I don’t mind being in that position with Buffett,” Paulson explains, “where in the event of bankruptcy we’re both on the same side. And also, I said, ‘As long as you’re paying the dividend on our preferred in additional shares of preferred and not paying in cash, then no other preferred can get cash dividends.’ That, combined with the 15 percent dividend rate, created an overwhelming incentive for them to redeem the preferred once financing markets improved.”