The Alpha Masters: Unlocking the Genius of the World's Top Hedge Funds (15 page)

In 2011, Paulson’s strategy had shifted to one that emphasized long restructuring investments. As Paulson said, “No one strategy is correct all the time. We shifted from short credit in 2007, to short equities in 2008, to long credit in 2009 and 2010, to now long restructuring equities. We believe at this point in the economic cycle the greatest gains will come from post-reorganization equities and companies that came close to bankruptcy but were able to raise equity or otherwise restructure capital structure to avoid bankruptcy.”

Paulson’s bank investments fit this strategy, as do his investments in insurance companies, other financial firms, hotels, select automobile companies, and other industrial companies.

A stakeholder in both MGM Resorts and Caesar’s Entertainment, both acquired via restructurings to increase equity and reduce debt, he held the Advantage Funds meeting in Las Vegas in April to showcase those investments. In addition, Paulson held his annual midyear workshops in Paris this year, instead of the customary London, to highlight the importance of Paris as a financial center. Carlos Ghosn, CEO of Renault—another large Paulson & Co. position—kicked off the all-important opening dinner ceremony.

Last year’s meeting was more uneasy than the past. While the Advantage funds started the year in positive territory, by June they had drifted to a loss. A loss in the flagship fund following recent news of fraud by the Chinese paper manufacturer Sinoforest had been splashed across the papers for the past week. Paulson originally invested in the company on the basis of it being an acquisition candidate, as well for the potential that the company would relist from the Toronto Stock Exchange to either Hong Kong or Shanghai, where it would receive a higher valuation. Paulson & Co. had issued a brief letter to all investors explaining the origination of the position and the actual size relative to the portfolio: two percent. Still, there were many outstanding questions. It was time for Paulson to reassure investors face to face. He was the largest investor in the Advantage funds, after all.

When asked about Paulson’s position in Sinoforest, his former boss Ace Greenberg said: “People seem to be making a big deal about this but they are not giving him enough credit. You can’t fly with the eagles and poop with the canaries, as I said to a newspaper reporter once. It’s a relatively small position in a very big fund. One of the things that makes investing difficult is that you are relying on management to have the same ethics and principles as you do.”

Despite some short-term setbacks, the mood was overall jovial. Paulson & Co. had made the people at this conference a lot of money. Some of Paulson’s longest investors and dearest friends had come to this meeting. Back in London a week or so later, Paulson called his friend Rick Sopher. Sopher is the Managing Director of LCF Edmond de Rothschild Asset Management Ltd. and Chairman of three investment vehicles, which are fully listed on the Euronext Exchange. They include Leveraged Capital Holdings, the first multimanager fund of hedge funds, which was launched in 1969. He has a senior role in the Edmond de Rothschild Group that had been responsible for deploying over $10 billion in investments all over the world and was a big player that had purposely stayed under the radar.

After a busy couple of weeks, Paulson was looking forward to a relaxing dinner with his good friend. But a few of London’s power players had already heard that Paulson would be in town and were asking for an introduction. Instead of a quiet evening, Sopher organized a dinner for Paulson at Spencer House at the bequest of Lord Rothschild, inviting London’s finest dignitaries and investing elite.

“When John travels now, the world’s most impressive names clamor for the chance to meet with him, see what he’s all about,” Sopher says. LCH had started investing with Paulson & Co. in 2006. They had identified problems in the credit markets but were having difficulty finding suitable investments to capitalize on the downside opportunity. When LCH came across Paulson & Co.’s research, it knew it had found a like-minded firm and joined forces.

Though Sopher was a believer in his strategies from the beginning, he notes the significant change in his countrymen’s perception of John Paulson. “This wasn’t the story a few years ago,” he said. “It’s really quite incredible. John is undoubtedly one of the greatest investors of all time.”

Fighting Back

But an unexpectedly high degree of global economic uncertainty can betray even the most methodical strategies and well-positioned investors at certain points in time. The continuing weakness of the U.S. economy and fiscal standing, headline inflation risk, and the subsequent downgrade of the U.S. credit rating to one notch below “AAA” for the first time in history all applied intense pressure on the markets. Combined with the European debt crisis and the potential fallout from all of the underlying exposures across the globe, it manifested huge swings of volatility during the summer of 2011, sometimes by as much as over 500 points a day in the Dow Jones Industrial Average.

Paulson & Co., like most other funds, weren’t immune to the instability, which threw the fundamentals of some of their core positions off target. In his third quarter letter to investors, Paulson apologized for the fund’s year to date 2011 performance, acknowledging it was the worst in the firm’s 17-year history. “We are disappointed and apologize for these results,” the letter started. “We have learned from the 2011 experience and are committed to returning investors to their high water marks and to producing above average returns for the long term.”

Says Paulson, “Volatility in our portfolio in 2011 was caused by macroeconomic events that negatively effected capital markets, such as the Standard & Poor’s downgrade of the United States’ credit rating and sovereign debt issues in Europe. Despite this, many event plays across our portfolio have been performing at record levels in terms of earnings, but have not yet been rewarded by the marketplace, resulting in portfolio losses.”

Paulson would also go on to concede that the firm’s expectations for economic growth were overly optimistic coming into 2011, causing them to position the funds for a strong economic rebound. When global markets fell sharply midyear, Paulson & Co. was hit particularly hard given the economically sensitive nature of some of their holdings—including bank stocks. Bank of America, another prominent position that Paulson & Co. had been steadily reducing over the past year but was still a meaningful holding, continued to face headwinds from mortgage problems and related lawsuits.

In Paulson’s third-quarter letter to investors, he addressed his outstanding banking sector exposure as well. “Despite the negative perception of the banking sector and the considerable difficulties faced by Bank of America, three of these banks in our portfolio, Wells Fargo, J. P. Morgan, and Capital One have reported record trailing 12-month earnings as of 3Q 2011,” said Paulson. “These banks have high capital levels, strong operating earnings, and high reserves. The strength of their earnings in this unfavorable environment highlights the potential for profits in a better economic environment.”

Hewlett-Packard, the world’s number one PC vendor by unit shipments and another position in the flagship Advantage funds, took a big hit mid-August on the announcement that it would be considering shedding the PC business and discontinuing its line of handhelds to focus on higher-margin businesses. In response to shareholder anger over the company’s puzzling moves, Leo Apotheker, CEO of Hewlett-Packard for just 11 months, was ultimately ousted and replaced by former eBay CEO Meg Whitman. The company later reaffirmed its commitment to the PC business.

Paulson’s main Advantage funds ended the year down 36 percent with the gold share class of the same fund losing 24 percent. With losses incurred across most of his other funds as well, assets dropped to approximately $25 billion by the end of 2011. To help the firm better analyze macroeconomic conditions going forward, Paulson & Co. added on Martin Feldstein, President Emeritus of the National Bureau of Economic Research, to their Economic Advisory board.

“Entering 2011, I thought we had a positive macro outlook that gave us the confidence to increase our net exposure,” Paulson explains back in his office in mid-December as we reflect on the year. “In retrospect, we were too overconfident with this scenario and the macro risks effected the market and our overall portfolio. Though the draw downs have been more extreme than we are used to, as fear subsides, we believe our positions offer great upside and are poised to outperform,” he says.

Even though the losses of 2011 were extreme, Paulson is optimistic he can gain significant ground in the year ahead. “I continue to believe the equity market is oversold for several reasons,” he starts. “For one thing, price-to-earnings ratios are at historic lows, which has created great buying opportunities where companies are trading at extremely low valuations irrespective of strong performance,” he says. “Moreover, the discrepancy between earnings yields and Treasury yields is at an all time high,” he adds, noting the further discounts the market has been pricing in. He explains. “The dividend yield of the S&P 500 exceeds that of 10-year Treasuries, even though equity dividend yields grow over time while treasury yields are fixed,” says Paulson.

“Similar fear-driven periods in the past have been used as buying opportunities for savvy investors. Unfortunately, many investors make the mistake of buying high and selling low while the exact opposite is the right strategy to outperform over the long term,” he explains.

For all of last year’s losses, Paulson & Co. started 2012 on an encouraging note with all of the funds in positive territory for the month of January. The merger arbitrage fund, Paulson Partners, closed the month up 2.34 percent and Paulson Enhanced, 4.84 percent. The fund’s flagship Advantage funds were up 3.95 percent with the levered Advantage Plus up 5.4 percent. The Paulson Gold fund gained 13.4 percent with the gold share classes for the respective funds outperforming the dollar share class by an additional 4 to 6 percent across the board.

Chapter 4

Distressed Debt’s Value Seekers

Marc Lasry and Sonia Gardner

Avenue Capital Group

You need to understand how a company’s going to operate in the bankruptcy process and how that’s going to affect its ongoing operations. You’ve got to mesh many different disciplines into one. That’s our edge. We have the expertise to understand those different disciplines better than others.

—Marc Lasry, February 2011 interview

By December 2008, Lehman Brothers had filed for Chapter 11, pushing the financial system to the brink of collapse. Freddie Mac and Fannie Mae had been put into conservatorship, and, despite an $85 billion loan from the Federal Reserve, AIG faced the prospect of liquidation. TARP was passed into law, giving the Department of Treasury $700 billion to attempt to avert an even worse financial crisis, and yet there was considerable doubt that this would be sufficient. With the Dow Jones Industrial Average down more than 30 percent, Marc Lasry faced one of the toughest decisions of his career. Was this the right time to commit capital to new investments? Were asset valuations close to bottom, or would macro conditions deteriorate further?

For Lasry, chairman and CEO of Avenue Capital Group, one of the pioneering investors in distressed assets, it was a pivotal moment. Avenue focuses on undervalued opportunities investing in public and private bonds, bank debt, post–reorganization equities, trade claims, and other securities of companies under financial distress, but if the financial system were to collapse, no investment would make sense, particularly entities already in trouble. And Avenue Capital, the hedge fund Lasry and his sister Sonia Gardner founded in 1995, was already having a rough year, with its funds down about 25 percent.

Lasry’s decision would be guided by extensive credit analysis conducted by his team, rather than a gut attempt on his part to time the market. The analysis indicated that Avenue’s existing investments had experienced mark-to-market hits—not permanent impairments. Moreover, the Avenue team had identified a range of new opportunities. “We did our research and we invested in specific credits where we were confident we fully understood the downside—not only the upside.” Lasry’s belief is that you can’t time the market—“we invest when we have conviction in the credit and we believe it’s cheap. If it gets cheaper, then we buy more. We were investing where we thought we were right on credit at the end of 2008 and 2009, unlike others who were somewhat paralyzed by the turmoil in the markets, or simply just didn’t have cash. In retrospect, we may not have invested at the absolute bottom of the market, but we were close.” According to one of Avenue’s investors, the U.S. hedge funds were up more than 60 percent in 2009, so Avenue’s decision to invest the cash paid off.

The Auto Bailout

Perhaps the best example of Avenue’s credit analysis and investment discipline during the turbulent 2008–2009 period was the firm’s concentration on the U.S. auto industry. The auto industry was in desperate shape, with the economy slumping, unemployment soaring, and gas prices topping $4 per gallon. As vehicle sales dropped to levels last seen in the 1980s, the chief executives of the Big Three automakers faced Congress in November 2008 to plead for assistance. It was clear that the operating hurdles faced by the Big Three were insurmountable and painful restructurings were inevitable. But because of the massive amounts of capital that would be required and the close links between automakers and their suppliers, the risks were huge.