The Alpha Masters: Unlocking the Genius of the World's Top Hedge Funds (28 page)

—Daniel Loeb, October 2011 interview

Call it confidence, call it aggressiveness, or call it a passion for risk. There is a theme running though the life of Daniel Loeb, the founder of the $9 billion hedge fund Third Point. You see it in the boy on the surfboard challenging the waves off Malibu Beach (whose legendary break inspired the name Third Point); in the 12-year-old who fought the bullies at Paul Revere Junior High School in Los Angeles with his allowance, hiring a classmate as his bodyguard for a quarter a day; in the college student who precociously amassed $120,000 in profits from playing the stock market then lost it all on one bad trade; and in the hungry young junk bond salesman at Jefferies & Co., who late in 1992 heard that David Tepper was planning to leave his job as the head trader on the high-yield desk at Goldman in order to launch his own firm. Loeb promptly called Tepper at home. “I want to cover you,” he told Tepper.

“Unfortunately, I don’t have a need for you; I’m unemployed,” Tepper responded. Or anyone else, for that matter; Appaloosa was not yet formed.

“That’s okay,” said Loeb, “If you want to buy 50 bonds or something for your PA (personal account), I just want to cover you. I’m sure you’re going to end up someplace.”

Daniel Loeb smiles at the recollection of his confident younger self. “Note to the salesmen out there—be aggressive,” he says. “I literally cold-called him at home, when [Tepper] had no job. So by the time he started Appaloosa, I had established the relationship with him. He became my biggest client. I was his biggest salesman.”

You can also see this attitude in what has become a signature of Loeb’s investment style and what he is perhaps best known for—the letter to the executive. Dan Loeb’s frank, insightful missives to the officers of the companies in which he is invested have made him feared in underperforming boardrooms and companies, and created a new literary art form. Call it the Blast. Since he started Third Point in 1995, Loeb has periodically shared with the delighted public candid, direct letters he has written to the top brass at companies suffering poor results brought about by management’s missteps. His assertions attract attention and his criticisms run the gamut from accusations of incompetence (“To ensure you a dazzling place in the firmament of bad management,” he writes to one recipient), to laziness (“I saw the crowd seeking autographs from the Olsen twins just below the private box that seemed to be occupied by Mr. Dreimann and others who were enjoying the match and summer sun while hobnobbing, snacking on shrimp cocktails, and sipping chilled Gewürztraminer.”), to lame corporate governance (“I must wonder how in this day and age, the company’s board of directors has not held you . . . responsible for your respective failures and shown you both the door long ago—accompanied by a well-worn boot planted in the backside.”)

Many observers noted that Loeb’s “poison pen” quieted during the past four years and in its absence, the investment world’s focus shifted to how Third Point has spent 95 percent of its time since its founding investing in classic special situations globally in long/short equities, corporate credit, mortgage bonds, and tail risk trades. Loeb’s rigorous investment process, honed over almost 18 years and taught intensively to his analysts, produces bottom-up investment ideas that have generated 21.5 percent net annualized returns for his investors since inception and multiplied a dollar invested on day one 26-fold.

As much as Loeb’s investors love him for his returns, the public loves him for his rabble-rousing. In 2011, Loeb announced that he would no longer author the lively quarterly letters to his investors (which inevitably became public) where so much of what the
New Yorker
called his “hedge-fund populism” was expressed. Until late 2011, Third Point had shied away from high-profile activism for four years.

Activist or not, Loeb remains a forceful manager who is seldom shy about expressing his convictions, more recently in civic life. Loeb was one of the first on Wall Street to enthusiastically support his former Columbia classmate Barack Obama’s presidential campaign from its launch in 2007, and also one of the first to repudiate him. Loeb’s case against the president’s policies generated front-page stories in the
Wall Street Journal
and the
New York Times
Business section for representing a shift in the zeitgeist. Young, politically minded hedge fund managers who had supported Obama’s campaign were beginning to move away from the president based on policies intent on what Loeb characterized as “redistribution rather than growth.” Confoundingly, one of the first things Loeb did after switching his support to Republican candidates was to enthusiastically work with New York’s Democratic Governor Andrew Cuomo to push for the legalization of gay marriage in New York State.

Loeb is confident in his convictions, intellectually honest, eager to take on the system, content to cut his losses, and always unpredictable—in short, a perfect blueprint for a high-returning hedge fund manager.

The Young Whippersnapper Finds His Way

Loeb grew up in Santa Monica, California, one of three children of his father, an attorney, and his mother, an historian. He attended the University of California at Berkeley before transferring to Columbia University, in part because he wanted to be in New York, the better to pursue a career on Wall Street. After graduating, he worked in private equity at Warburg Pincus for several years in the mid-1980s, where he acquired the building blocks of value investing, business analysis, and valuation. By chance, he moved into the music industry, taking a job at Island Records where he became the main financial adviser to Chris Blackwell, the label’s founder, who in his heyday had signed Bob Marley and U2 among others. The company was undergoing corporate realignments during this period, and Loeb helped Blackwell complete a successful restructuring and acquire the Bob Marley estate consisting of rights to the artist’s music. Returning to finance, Loeb spent three critical years at Jefferies & Co. as an analyst and bond salesman focusing on distressed debt and forming relationships with the buyers of this paper—many of which were managing their nascent “hedge funds.” In 1995, he made his biggest leap and launched Third Point with $3.3 million of capital.

It was a move the famously confident Loeb almost passed up, and for the most un-Loeb-like reason. “I almost got stage fright the day before I started the fund,” he says. “I had five or six family members and a few friends and $340,000 of my own money, which was my life savings from ten years working on Wall Street.” Obviously, Loeb went ahead, but taking responsibility for the funds entrusted to him put Loeb under a lot of pressure. He kept expenses low, in part by running the fund from a creaky, used desk in a space that otherwise served as David Tepper’s weight room, for which he paid $1,000 a month. “I kept my own books. I did all the marketing. I did investor relations. I didn’t even have a secretary—I wrote all my letters and I mailed them personally.” Loeb says the biggest challenge was raising money. “That was very hard early on,” he says. “I remember when I got my first check. It came after I did an interview in
Barron’s
, and a Tennessee-based entrepreneur in the grain trading business wrote me a check for half a million dollars. He sent it regular mail, without any of the subscription documents. So then I had to get the sub docs from him myself. He remains an investor to this day.”

Would Loeb have a harder time or an easier time starting a hedge fund today than he did nearly 20 years ago? Costs were lower, he acknowledges, and there were fewer expectations about compliance and operations. Raising money, he says, was much more difficult. “Today, there are seeding groups handing out money to relatively inexperienced managers,” he says. “It took me five years to get to $100 million, and today people are starting out of the gate with that much. You hear about people all the time that are unproven, untested managers, but because they came out of a big name firm and have fancy credentials, they go off and raise billions of dollars. So I’d say it’s actually much easier now.” Unfortunately, says Loeb, this model has not necessarily led to the formation of really good, high-quality funds. “The problem with the business is that it can force the managers to be overly focused on what their funders think of them and their short-term outcomes,” Loeb says. “The secret to our success is congruence between our investment style and my personal investment style and philosophy, the fundamental elements of which have remained constant over almost 18 years.”

When Loeb started Third Point, he had a strong background in high-yield credit, distressed debt, and risk arbitrage, but necessity pushed him to expand his areas of expertise. “We’ve never defined ourselves as one kind of firm,” he says, “and we’ve never really deviated from that kind of flexible approach. Instead, we’ve deepened our research process, and hired people who brought us expertise in different geographies, different industries, and different asset classes. Our philosophy is to be opportunistic all the way across the capital structure from debt to equity, across industries and different geographies. We invest wherever we see some kind of special situation element, an event that will either help create the investment opportunity or help to realize the opportunity.”

In finding these opportunities, Loeb begins with an investment framework, a financial point of view that helps define patterns of events that have consistently produced outsized returns. “The hedge fund world is full of people who specialize in these so-called event-driven situations,” he says. “There was a time when people didn’t really look at them or understand them. We start with that at the center of what we do, and we’ve done a better job making judgments regarding valuations.” Since 2008, Loeb says, Third Point has added a focus on public policy. “Changes in financial regulations, health care reform, and a variety of industry regulations could have massive impact on the valuations of public companies. We try to anticipate the repercussions. These create opportunities, both long and short.”

Loeb says that Third Point also develops top-down theses about sectors, industries, and economic trends. He gives an example: “In the 1990s, we recognized that the growth of the Internet would have a huge impact, but instead of focusing just on new internet companies, we bought a bunch of old-line companies that had internet companies embedded within them and we did quite well without taking the risk attendant in purchasing shares of high-flying overpriced internet companies. More recently, we bought U.S. and European companies that had large emerging market components, such as Swatch, Volkswagen, and Mercedes, and got emerging markets growth with domestic market valuations.”

Loeb also manages exposure by keeping a handle on leverage. Third Point uses a modest amount of leverage, with net equity exposure fluctuating between 30 and 70 percent. “We operate in that range,” says Loeb. “Any incremental leverage we have on top of that is in less volatile credit securities. Overall, our gross long exposure is maybe a little over 110 or 120 long percent less 20, 30, or 40 percent in short exposure, which gets us to an all-in adjusted net exposure of about 70. But gross long plus short is generally under 150 percent.”

The practice Third Point studiously avoids is using leverage on individual positions to tease a good return out of a mediocre investment. “The brilliant investor Howard Marks makes the point by saying something like, ‘Don’t confuse adding leverage to an existing investment with increasing your return,’” says Loeb. “If you take a 10 percent return in security and lever it up four times and after financing costs generate 15 or 20 percent returns, you haven’t increased your returns. You’ve just increased your leverage and significantly increased your risk. But you’ve also got a 20, 25 percent downside threat, so if the trade goes against you, you’ve lost 100 percent of your capital. Look at all the supposedly low volatility leveraged funds that blew up in 2008—due to too much leverage. We don’t leverage anything. We look at everything on an unlevered basis.”

During Third Point’s first seven years in business, the fund returned over 15 percent net every year except one, where it returned 6.6 percent with banner years of 52.1 percent, 44.3 percent, 42.2 percent, and 37.0 percent. These returns got him noticed and the fund grew as investors sought out Third Point for its stellar returns. Along the way, Loeb made a name for himself in single-name short-selling, finding both value plays and specializing in what he calls the “Three Fs: fads, frauds, and failures.” As the tech bubble burst, Loeb was correctly positioned short and made a killing. In 2000, he beat the Standard & Poor’s (S&P) by 26.2 percent. In 2001, he beat the S&P by 26.8 percent. Today, Third Point has a dedicated team of short sellers who consistently generate alpha regardless of market conditions. Unlike many hedge funds that use shorting only as a method of hedging, Loeb instills the discipline of the art of alpha-generating short-selling in each of his team members and this approach has given the firm an important means of profit making throughout the years.

Coming off the high of correctly shorting the tech bubble, in 2002 Loeb saw the chance to return to his roots as a distressed debt investor and “load the boat” with broken credits stemming from the recession of 2001. In 2003, Third Point’s main fund made 51.5 percent for its investors and in 2004 followed with 30.2 percent gains, all on the heels of these savvy investments in distressed paper and the post-reorganization securities stemming from these bankruptcy processes.