John Paulson is unassuming, as far as hedge fund managers go: His demeanor is quiet; his suits are somber; his offices are understated. His nerve, however, is formidable. Convinced that subprime mortgages would falter, the event-driven specialist did extensive research, hired staff with necessary expertise and in April 2005 began making a big bet, using credit default swaps to short the asset class. His timing was superb. Even as hedge funds with subprime exposure began imploding the Paulson funds exploded, with one-year returns three times those of the benchmark for the Paulson Partners Fund and six times the index return for the leveraged version of the merger arbitrage fund.
Paulson & Co.’s merger arbitrage/event-driven focus derived from Mr. Paulson’s early experience as an investment banker. After a first job with Odyssey Partners, his career went into high gear when he joined the mergers and acquisition practice at Bear Stearns Cos. Inc. Prior to founding Paulson & Co. in 1995, he was a general partner of Gruss Partners LP, a merger arbitrage specialist. In the course of his career, Mr. Paulson has dealt with a wide range of company transactions, including both friendly and hostile tender offers, mergers, divestitures, recapitalizations and other company reorganizations and financings.
What induced you to move into money management? When I in was in M&A at Bear Stearns, one of our clients was Marty Gruss. He ran a very successful risk arbitrage firm, Gruss Partners. … It was a small partnership and very profitable. Bears Stearns also was a partnership at the time and also very profitable. But it didn’t really compare to the type of profits that could be made in principal investing, investing your own money and earning the returns, rather than earning fees. I realized that there’s a limitation on what you can earn from fees and that the highest rewards would come from investing your own money, where there are no limitations on your earnings. That’s when I decided to move from investment banking to money management, and I became a general partner of Gruss Partners.
Describe your investment philosophy. I really picked up my investment philosophy from Marty and his father, Joseph Gruss. He had two sayings that guided me going forward.
The first was: Watch the downside, the upside will take care of itself. That’s been a very important guiding philosophy for me. Our goal is to preserve principal, not to lose money. Our investors will forgive us if our returns don’t beat the S&P in a given year, but we are not forgiven if we have significant drawdowns.
The other saying really drives the same point from a different angle: Risk arbitrage is not about making money, it’s about not losing money. If you can minimize the downside, you get to keep all your earnings and that helps performance.
Would you say that your investment style is concentrated? Yes and no. No, when you look at most activist funds, they tend to have five or 10 positions and that’s 100% of their portfolio. Some have only five positions. We’re much more diversified; our average position size is just 2.5%. However, when we do feel strongly about a position, we will take that up to 12% in our merger fund and 10% in our event fund. That is (higher) than some funds. We feel it’s important to have the flexibility to go to 10% because in order to outperform, you have to be able to allocate a sizable position to what you think could be a high-return investment. It’s only when you have a substantial allocation to a high-return (security) that you can influence the overall portfolio.
Are you tired of talking about subprime mortgages yet? No, I’m still excited about it. I think we’ve got a winner with this. It’s been a very profitable investment for us, but we think we have only realized 25% of the (potential) that we expect to make in this area. The investment is very much consistent with our overall philosophy that if you watch the downside, the upside will take care of itself.
What attracted us to this particular position is that overall, we feel that we are in a credit bubble. We feel that there is too much risk going long (in) credit instruments since spreads are so tight. So we concluded that the best opportunities were on the short side.
The beauty of shorting a bond is that the maximum you can lose is the spread over the benchmark; yet if the bond defaults, you can potentially make more. So it’s an asymmetrical risk-return tradeoff. In the case of subprime securities, we targeted the triple-B bonds, which are the lowest tranches in the subprime securitization.
In a typical securitization, you have 18 to 20 different tranches with the lowest … taking the first loss. The triple-B bond has about 5% subordination, meaning that if the loss is greater than 5%, the bond will be impaired. And if it’s more than 6%, the bond will be extinguished. The yield was only 1% over LIBOR (the London interbank offered rate) so by shorting this particular bond, if I was wrong, I could lose 1%, but if I was right, I could make 100%. The downside was very limited but it had very substantial upside, and we like those types of investments.
We felt the exuberance in the credit markets and the massive liquidity was severely mispricing these securities. The more we analyzed the underlying quality of these loans, we thought it was highly probable that the losses in these pools would be more than 5%, that the bonds would be impaired and in many instances, extinguished. We thought it was a terrific risk-return tradeoff where you can risk 1% and make 100%.
We decided to put that investment either as a hedge or an absolute-return investment in all of our funds with the amount and the specific security depending on the nature of the funds. But generally, in our merger funds we agreed to spend about 1.5% on the short position and then we set up separate credit funds where we took a more concentrated position for investors who wanted that.
Ultimately in 2007, initially in January, but then in February, the market re-evaluated the risk of these securities. People paid more attention to the underlying credit quality of these securities and the potential losses that could occur. That caused the securities to fall materially in value and for the spreads to widen resulting in margin calls on these funds.
Are you still committed to subprime? Yes. The performance of these pools will not be decided over one month or two months. They will be decided over the next three years. Our investment (commitment is not based on) looking at what these bonds trade at today or tomorrow, but what the losses in these pools will be two or three years from now. Our estimates are that the losses will be well in excess of 6% or 7% and that as time goes on and these losses are realized, the bonds will be downgraded and they will fall much further.
Have you considered going public? For us, we don’t really need to. I think it would be premature (at this point) in our evolution to consider selling the firm or a piece of it. Our goal is to continue to focus on performance and building our capabilities, building … the investment platform. I’d like the firm to exist without me and (that requires) a developed infrastructure. So at some point in the future, going public or selling part of the firm will be issues we will have to think about. But it’s not on our radar screen now.