Paulson tries to bounce back

Paulson & Co. Inc. is on track to survive a reversal of fortune that sources say very few other hedge fund managers could withstand.

Assets declined $17 billion — 44.9% — to $21 billion as of June 30, down from a peak of $38.1 billion in February 2011. Much of the loss is the result of poor performance over the past year of the New York-based company's flagship Advantage event-driven arbitrage strategy, although there have been modest investor redemptions, sources said.

The offshore version of Paulson Advantage Plus Ltd., which uses mild leverage, was down 35% in 2011 and 17.7% year-to-date June 30. The non-leveraged version of the strategy, Paulson Advantage Ltd., was down 36% last year and fell 11.61% in the first half of 2012.

But the firm has a saving grace: About 60%, or $12.6 billion of June 30 assets are from employees. Observers said it is impossible to know how much of that employee asset pool belongs to John Paulson, the firm's founder and president, but they speculate it is the vast majority. (By contrast, about 31% or 32% of Paulson & Co.'s assets are from institutional investors.)

One source said the hedge fund manager's size at its peak — before the performance decline — combined with the high percentage of employee capital have insulated Paulson from the crippling impacts that performance declines of this size and client redemptions would wreak on other firms.

“It's impossible for any other hedge fund firm to lose $17 billion and still be in business,” said the source, who asked for anonymity.

“The firm will not fall apart because of this. Just John (Paulson's) money alone is enough to keep the firm in business. But he is not going anywhere. There are absolutely no signs that John Paulson intends to do anything other than manage his way out of this.”

Mr. Paulson and other executives at the firm declined to comment, said Armel Leslie, a spokesman.

Another positive for Paulson is that two-thirds of assets are managed in three other strategies — merger arbitrage, credit and distressed equities — that have produced positive returns for the first half of 2012, according to an industry expert who asked not to be identified.

The fifth and smallest strategy, Paulson Gold, was down sharply in the first half of 2012; the offshore fund lost 23.03% and the onshore fund was down 23.23%.

At the peak in February 2011, the breakdown of Paulson's assets by strategy was event arbitrage, 50.5%; credit, 24%; merger arbitrage, 15.5%; distressed equities, 7.5%; and gold, 2.5%.

As of June 30, the breakdown shifted to event arbitrage, 30.5%; credit, 26%; merger arbitrage, 32%; distressed equities, 7.5%; and gold, 4%.

The company has experienced modest redemptions since the performance decline last year: about 8% of total assets were pulled out during the final redemption period in 2011. Redemptions are in the low single digits so far this year, mostly from the Paulson Advantage strategies, sources said.

The firm's biggest outflows came at the end of 2008, when investors were rebalancing portfolios or seeking liquidity after the financial crisis, said the industry expert.

While some institutional investors have redeemed their Paulson Advantage assets in the past year or so — among them the $11.9 billion Public Employees Retirement Association of New Mexico and the $4.7 billion Philadelphia Board of Pensions — observers familiar with the company said many investors remain invested, albeit cautiously.

A consultant who requested anonymity said one institutional client in the Paulson Advantage fund knew “Paulson was directional and volatile, but didn't want to bail at just the wrong time and miss the upside. They still are waiting for that upside.”

Still, institutional investors and consultants are watching Mr. Paulson and his event-driven arbitrage investment team very closely.

Charles B. Krusen, CEO of Krusen Capital Management LLC, New York, an alternative investment consulting firm, said: “Paulson has shifted from using an event-driven approach to more of a global macro approach, and the question is whether the portfolio managers, including John Paulson, have the right training, skill set and methodology to perform in this space.”

“John tends to be less nimble than some managers because he is so binary: Either the investment will work or it won't,” Mr. Krusen added. “He takes big bets when he is sure something will work and he is willing to tolerate a lot of volatility while waiting for that investment” to come to fruition.

“Many investors have trouble stomaching that level of volatility,” he said.