The Alpha Masters: Unlocking the Genius of the World's Top Hedge Funds (21 page)

The Force Behind Financials

The extensive time the fund dedicated to Delphi during the rise of the credit crisis in 2006 and 2007 meant that Appaloosa, usually a first mover in the distressed space, missed out on one of the biggest paydays in history: shorting the subprime market. While hedge funds like Paulson & Co. and Harbinger Capital were quietly shorting the market, building positions and raking in gains of several billion apiece, Appaloosa’s usually sharp eye was distracted from the short side of subprime. “It wasn’t that we didn’t have the trade on ourselves,” Tepper explains. “But that we didn’t have the extra time it took to figure out the best way to play it. If we weren’t torn away with some of the Delphi crap, we definitely could have hit the subprime trade better.”

By February 2008, the financial crisis was accelerating—with bank stocks bearing the brunt of market pressures. Instead of panicking like much of the investing world by bolting into gold and cash, Appaloosa was preparing to dive into the very debt and equity of financial institutions. In addition, Tepper had just raised about $1.5 billion for the Thoroughbred Fund, which remained 90 percent in cash. Because the fund had stood back from the subprime market and missed profits, Appaloosa’s performance was up only 8 percent net in 2007 and down 27 percent in 2008.

But Tepper hadn’t yet broken a sweat; he was just getting ready to roll up his sleeves. “We were very liquid when September 2008 hit. It was a financial sector event,” he says. “We had been sitting there waiting for it to tell you the truth,” he shares. “I mean, like everybody else, we were a little taken aback by the size of the declines in the marketplace, but the nine months leading up to it were kind of frustrating. Spreads were very tight in the debt markets and we had just raised money for Thoroughbred, so we had a pretty big liquidity cushion. We just did our due diligence and made sure to read all the indentures and credit agreements we could get our hands on.”

Through its research, Appaloosa had been drawn to the attractiveness of the insurance business initially because of the belief that being senior in the capital structure assured the probability of loss was very small. So they bought a little piece of the last bond issue of AIG in 2008. But when spreads widened out on a fundamental basis, it caused a run on cash collateral at the company. Tepper believes it was a great early learning experience and set up for a big investment on the other side of AIG. “Some of our best positions were ones we initially lost money on,” he says. The ultimate position size of the AIG investment ended up being over 10 percent of the fund.

The ABC’s: AIG, BAC, and C

The underlying thesis regarding financials was twofold: extraordinary measures would have to be taken so the institutions could survive in some form. And in order to see the greatest upside, most of Appaloosa’s investments would initially be debt securities under the premise that as “credits”—rather than equity—the banks would most likely be all right. “So there was a skewed upside versus downside,” Tepper explains. “Everything in the markets, whether investors knew it or not, was a bet on financials at the time. It was the same bet regardless of what you bought.”

Then in February 2009, the U.S. Treasury put out a white paper and term sheet online for the government’s Capital Assistance Program. Connecting the dots, Tepper figured the government wasn’t positioning to nationalize the banks if it was putting out this paper, which signaled the time was right to buy. The conversion price the government was effectively investing at for common shares meant that Tepper could buy securities in the market for a steep discount: 37 percent in the case of Citigroup and 21 percent for Bank of America.

“When the white paper came out, the government tipped its hand,” says Tepper. “If the government was going to raise equity for the banks, it meant it was establishing a floor under the equity indicating at what price that floor was. Essentially the government was telling us that it wasn’t going to let the banks fail.”

So Appaloosa quickly began buying all the common, preferred, and junior subordinated debt it could get its hands on, paying as little as 5 cents on the dollar for securities of AIG, Bank of America, and Citigroup, in addition to Fifth Third Bancorp, Commerzbank AG, and Lloyds Banking Group. “There was a lot of paper available and we had a pretty high conviction that we were right,” says Tepper. “It was all so deeply discounted—it was crazy!” The financials ended up representing more than half of the entire portfolio in late 2008 through 2009. “We typically hold anywhere from 10 to 20 positions at a time that are really meaningful,” says Tepper. “And during 2008 and 2009, there was no trade more meaningful than financials.”

As the stocks soared through the end of the year, with Bank of America up more than 330 percent and Citigroup up more than 220 percent, the fund raked in more than a billion dollars on those two names. AIG would end up being the best single trade, topping off gains from financials with another billion dollars from that name alone. Following his 2009 record-making earnings, Tepper was recognized as the only hedge fund manager to make
Vanity Fair
’s Top 100 most influential people list for 2010, coming in at 76.

His conviction in selected financials still stands, even though he closed out of his position in Bank of America in the second quarter of 2011. Tepper believes Citigroup stock has the potential to go up more than 50 percent depending on how well the foreign businesses perform. “We still think it’s underappreciated just how big the emerging market business is within Citigroup,” he says.

Sizing Up the Sweet Spot

Tepper’s hope for Appaloosa is that it never gets so big that it turns into an asset gatherer rather than an investor. Instead of thinking about how to get bigger, Tepper and his team strive to decrease the amount of assets. “We don’t want to be bigger than we can invest,” he says. “The question is what size gets you—except more fees for the manager. But it doesn’t necessarily make the investor more money.”

Tepper thinks that for most funds, growing over a certain amount doesn’t do anyone any good. “Fixed income funds should naturally be a little bit larger than, say, equity funds. You want to be big enough that you can see everything and small enough that you don’t kill yourself with size. So I think different sizes are right for different types of funds.”

He gives an example. “Say you want to buy 5 percent of a $2 billion company, and have it be meaningful. That means it’s a $100 million position, which is a 1 percent position in a $10 billion fund. So if you’re an equity fund, if you keep getting bigger and get to $20 billion, that means your position is now only a half percent position. The 1 percent position doesn’t do much for the fund and so the half percent position does half as much. So there’s an aspect to the business, in equity funds especially, that gets funky on size.”

By March 2011, Appaloosa’s funds had appreciated so substantially that Tepper decided to return $600 million to investors. For the Thoroughbred Fund, however, investors had committed money for three years. The fund opened in July 2008, with a mandate to invest 70 percent of assets in fixed-income securities. Thoroughbred gained 22 percent net in 2010, after soaring 96 percent net in 2009, according to investors. The lock-up period expired at the end of 2011.

Tepper reiterates that he’s in the game to make returns, not to have assets, and is looking to place some of his personal wealth with a select few other managers. But he has no desire to get out of the game. He says: “I have too much money to quit. I mean, somebody has to manage my money. I’ll also put some money out to other managers so it will be a sensible balance.” He rejects the worry that he’ll downsize so much that he’s only left with his money to manage. Tepper says: “That may happen at some point, but not in the near future. I love what I do and it’s good to have the discipline of outside investors.”

“The more I make, the more I’ll give away,” says Tepper, who continues to be devoted to reforming public school education in New Jersey with his B4NJKids nonprofit organization. He has been a generous contributor to the Food Bank and numerous Jewish causes, such as United Jewish Appeal. In fact, an orthodox rabbi is known to show up at Appaloosa’s offices every month for
tefillin
and prayer with Tepper and his colleagues. He looks out the window of his office as the sun sets in the distance.

“Listen, it’s a complicated world out there,” Tepper says. “Sometimes it’s time to make money, sometimes it’s time not to lose money. Last year was a time not to lose money; we’ll see what this year brings.”

Chapter 6

The Activist Answer

William A. Ackman

Pershing Square Capital Management

This is not a black-box strategy. With most of our investments, we share our thesis about what’s going to happen.

—Bill Ackman, February 2011 interview

“What motivates people to succeed?”

That was the question posed by the 45-year-old hedge fund manager Bill Ackman to a roomful of students in a real estate entrepreneurship class at Wharton Business School. It was a sunny afternoon in October, the last class of an eight-lecture series, and the students had prepared by reading Christine Richard’s book
Confidence Game
, which details Ackman’s six-year battle with bond-insurer MBIA. But even after a few hundred pages on that struggle, and the subsequent fight with then New York Attorney General Eliot Spitzer, the students were still not prepared for Ackman’s answer.

“Sex,” he told them. “People don’t like to admit it, but it’s the primal driver.”

There was pin-drop silence. Slowly, a few chuckles began to break out from the back of the room. Ackman took off his suit jacket, rolled up his sleeves, and glanced up at the clock. Perpetually overcommitted, the founder and CEO of $11 billion fund Pershing Square Capital Management had been in meetings in surrounding Pennsylvania all day and, by then, was running low on energy.

Pershing Square’s goal is to work closely with the companies in which it invests to make their businesses more valuable by improving operational performance, selling or spinning off noncore divisions, recruiting new management, or changing the company’s strategic direction or corporate structure, among other approaches. In time, these changes should be reflected in the stock price. “We buy 8, 9, 10 percent of the company when we see long-term value in the investment, when the pieces are worth significantly more than the entire business or an operational change needs to take place,” he said. “We don’t predict when the stock market is going up and down or what’s causing that,” said Ackman. “So we’re not in a rush to get out.”

Ackman says that he expects most of the firm’s investments, particularly ones in which it takes an active role, will be owned by his fund for years. Pershing Square is typically the largest or one of the largest shareholders of a company, and therefore assumes a degree of illiquidity in taking such large long-term holdings. This strategy evidently worked. The fund has never relied on leverage and has averaged a 21.4 percent return since inception in 2004.

After taking a sip from the water bottle beside him, Ackman propped himself up on the desk at the front of the class and glanced at the clock once more. There was an hour and a half to go. “Fundamentally,” he continued, “what drives most human behavior is basically foreplay.” The students began turning to look at each other, not quite sure how to react. He trailed off as the room erupted in laughter and Ackman smirked goofily, sporting a slight blush.

His shock of prematurely white hair, dark black eyebrows, and light green eyes earned him the nickname “silver fox” by disgruntled employees of Target during his long and ultimately unsuccessful 2008 proxy campaign. To them, he looked dangerous and rich, yet there are facets to Ackman’s life that are simple—for example, he has had the same close friends for 25 years. Professionally, Ackman hopes to be known for creating value, not for arrogance, which he believes people who don’t know him confuse with confidence.

His friends agree. “Bill has an innate self-confidence that is a force of nature,” says Jonathan Gray, senior managing director and head of Global Real Estate at private equity firm Blackstone. The two met in 2000 through their wives at Temple Emanuel, their daughters’ nursery school. “It not only makes him a brilliant contrarian investor, but also the ultimate couples’ matchmaker and a philanthropist who can and will make the world a better place.” For example, he’s proud of his investment in shopping mall owner General Growth Properties and helping to make the company more valuable by successfully steering it through the bankruptcy process in 2009 and 2010. “I get thank-you notes from people who bought the stock at 50 cents who still own it. When someone buys something that goes up 40 times, it can actually make a big difference in his or her livelihood. I have letters from people who lost their job and then invested some of their IRA in General Growth, and it saved them,” he says.