Dondero Still Slays Bears at Highland With New Leveraged Loans

Even in an industry full of risk takers, James Dondero stands out.

At 49, the 6-foot-5-inch money manager has taken up wakesurfing, a daredevil form of water-skiing that involves riding a boat’s wake just 8 feet from the spinning propellers. Without a towrope. In October, he stalked brown bears in Alaska’s rugged Aleutian Islands, bagging a 9-foot-6-inch, 800- pound behemoth.

One risk Dondero took with his Dallas-based debt-investing firm, Highland Capital Management LP, almost cost him his reputation along with billions of dollars, Bloomberg Markets magazine reports in its March issue.

He gambled that Highland could do with a hedge fund what it had done with the firm’s specialty -- packaging high-yield bank loans into securities in the form of collateralized loan obligations (CLOs).

The bet backfired along with the economy during the credit crisis. By Jan. 1, Highland’s total assets under management had shrunk to $23 billion, down from $39 billion at the end of 2007. For Dondero, the low point came in 2008, when Highland suspended investor withdrawals from two ailing hedge funds.

“Our name was mud,” he says.

Now, Dondero is back on the road, pitching new investment strategies to attract investors, including a distressed debt fund and two revamped -- and smaller -- hedge funds. In recent months, Dondero and Highland’s co-founder, Mark Okada, 49, say they’ve managed to repair the firm’s reputation.

Photographer: Brent Humphreys/Bloomberg Markets via Bloomberg

James Dondero, co-founder and president of Highland Capital Management LP, took on a risky bet with his Dallas-based debt-investing firm, which cost him his reputation along with billions of dollars. Close

James Dondero, co-founder and president of Highland Capital Management LP, took on a... Read More

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Photographer: Brent Humphreys/Bloomberg Markets via Bloomberg

James Dondero, co-founder and president of Highland Capital Management LP, took on a risky bet with his Dallas-based debt-investing firm, which cost him his reputation along with billions of dollars.

Infrastructure Projects

They settled investor lawsuits; hired new investor and institutional relations managers; and in September, opened an office in Seoul to work with institutional investors in South Korea and Asia. In October, after raising $163 million, they closed their first joint-venture oil-and-gas fund to new investors.

In January, they spun off a $3 billion retail unit comprising 21 mutual funds. All told, Highland says, it had a net increase of $1.4 billion in assets in 2011.

In December, they teamed up with three Sao Paulo-based asset managers: Plural Capital Ltda., Quata Investimentos and Banco Pine SA (PINE4)’s investment arm. Highland is calculating that Brazil will need to fund major infrastructure projects for soccer’s 2014 World Cup and the 2016 Olympics in Rio de Janeiro.

“No one bailed us out,” Dondero says. “We had to work through the issues, good and bad.”

With so much distressed debt around after the financial crisis, Highland is concentrating once again on the core business Dondero and Okada built before they strayed into hedge funds in the early 2000s and had their brush with disaster.

Photographer: Brent Humphreys/Bloomberg Markets via Bloomberg

Mark Okada, co-founder and chief investment officer of Highland Capital Management LP, is photographed at the company's office in Dallas. Highland focuses on buying secured loans from banks and packaging them into CLOs. Close

Mark Okada, co-founder and chief investment officer of Highland Capital Management LP,... Read More

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Photographer: Brent Humphreys/Bloomberg Markets via Bloomberg

Mark Okada, co-founder and chief investment officer of Highland Capital Management LP, is photographed at the company's office in Dallas. Highland focuses on buying secured loans from banks and packaging them into CLOs.

Largest CLO Manager

Highland is the largest CLO manager in the U.S. by dollar amount, according to Moody’s Investors Service (MCO), and this part of Highland’s business has done well. Since 1996, the equity portion of Highland’s CLOs has generated average annualized returns of 19 percent.

Highland focuses on buying secured loans from banks or on the secondary market and packaging them into CLOs, which are backed by the pool of corporate loans. The firm sells the higher-rated portions to investors. Highland itself invests in the nether reaches of CLOs, the so-called equity tranche, which is typically unrated and gets wiped out if a CLO goes bust.

In cases where debt hasn’t been repaid, Highland has taken a stake in the borrowers, including American HomePatient Inc. (AHOM) and Metro-Goldwyn-Mayer Studios Inc. If the CLO stays healthy, Highland’s payoff is an average return of 170 percent of the original investment after five to seven years.

Comeback Strategy

Lee Partridge, chief investment officer of Salient Partners LP in Houston, says he’s favorably impressed by Highland’s comeback strategy after the hedge-fund debacle. “Considering the circumstances, they actually navigated that environment very well,” he says.

In 2010, Partridge recommended a Highland oil-and-gas joint-venture fund with PetroCap Inc., a Dallas energy investment firm, to his clients at the San Diego County Employees Retirement Association, which had $8.2 billion in assets as of Nov. 30, 2011.

Britt Harris, chief investment officer of the $101 billion Teacher Retirement System of Texas, is more cautious. He says Highland’s strengths in distressed debt are relevant to some things -- “not to everything in the world.”

After earning double the returns of the benchmark index, TRS took its money out of Highland in 2010. Harris says TRS may reinvest with Highland only when it sees more-attractive opportunities in the credit markets.

The two men in charge of Highland have an odd-couple partnership. Dondero towers over the diminutive Japanese- American Okada, who’s at least 8 inches shorter.

Giraffe Rug

Dondero, a New Jersey native who took up hunting when he moved to Texas, decorates his office with trophies, including a boar, a giraffe rug and stuffed pheasants.

Okada’s office features a somewhat tamer collection of basketball bric-a-brac and electric guitars. He jokes about the origins of the name of a band he once played in, Subprime: “Because nothing was good about our band.”

Okada’s leisure-time pursuits are more serious in nature. Last summer, he carted his family off to a Christian missionary project in Brazil, where his five kids scrubbed toilets and performed other menial chores.

The pair hooked up in 1990. At the time, Okada was at Hibernia National Bank in New Orleans, and Dondero was working in Los Angeles as chief investment officer of a unit of Protective Life Corp. (PL), a Birmingham, Alabama-based insurance firm. Dondero bought a package of commercial loans from Okada as an investment.

Forming Highland

Okada, who was raised in Orange County and graduated with degrees in economics and psychology from the University of California, Los Angeles, wanted to get back to California. He joined Dondero at Protective Life as a credit analyst in July of that year.

“Jim was smart at everything I wasn’t,” Okada says.

Three years later, Okada and Dondero carved off their operation, formed a joint venture with Protective that would become Highland and moved to Dallas. In 1997, they bought out Protective.

Highland was one of the earliest packagers of corporate loans into CLOs. To this day, CLOs remain largely unscathed compared with collateralized debt obligations, which packaged subprime-mortgage-backed loans and imploded during the credit crunch.

“The CLO market was well governed before the financial crisis, and that is why it performed relatively well,” says Houman Shadab, an associate professor of law at New York Law School.

Keeping CLOs Solvent

Trey Parker, Highland’s co-head of research, says that to keep its CLOs solvent, the firm buys debt only after delving deep into a company’s financials. Parker cites Highland’s role last year in funding Rank Group Ltd.’s $950 million purchase of Autoparts Holdings Ltd. from Honeywell International Inc. (HON)

While Highland’s 25-page analysis was positive about Autoparts’ brands, including Prestone antifreeze and Autolite spark plugs, it was cautious about risks such as the price volatility of ethylene glycol, the main chemical in antifreeze.

Highland’s foray into hedge funds started off well. Dondero and Okada launched the Highland Crusader Fund in 2000 as a vehicle to invest in troubled loans.

Credit Crisis

The Crusader fund produced returns as high as 50.6 percent in 2004 and had down years in 2002 and 2007, according to a performance review sent to investors. Net assets peaked at $3.12 billion in 2007, with the fund leveraged at 1.5 to 2 times equity.

The following year, Highland got slammed by the credit crisis. Dondero says market prices for assets in the hedge fund collapsed, potential bidders dried up and counterparties who had provided leverage to the fund demanded additional cash collateral or yanked their backing entirely.

By October 2008, the fund’s assets had shrunk to $1.3 billion. Highland sent a letter to investors announcing that it was suspending withdrawals by investors in order to preserve the fund’s value by waiting for markets to stabilize so the assets could be sold.

Highland had to convince 400 investors to accept the firm’s plan to distribute the assets of Crusader and the smaller Highland Credit Strategies Fund, which had about $200 million.

The firm spent almost the next three years negotiating with investors over a plan to return their money and persuading them to wait until asset prices or liquidity recovered.

Lawsuits

“People realized we had saved them from themselves,” Dondero says. In the case of the Crusader fund, the firm said in July that it would return $350 million in cash immediately and the remaining $1.3 billion during the next three years.

Over the years, at least eight investors sued Highland on grounds that the firm deceived them about the health of the hedge funds and the rate of redemptions. The plaintiffs included the Houston Municipal Employees Pension System and the Mary E. Bivins Foundation, an Amarillo, Texas-based senior citizens charity.

Most of the lawsuits have been settled or dismissed. Highland says it paid no compensation.

Highland, in turn, filed lawsuits against banks it said were compounding the firm’s problems by seizing collateral that Highland had used to back the leverage in its hedge funds; it accused some of the banks of selling collateral and others of transferring it internally for their own gain.

Fighting Banks

Highland traded litigation with Barclays Plc (BARC), Deutsche Bank AG (DBK), Royal Bank of Scotland Group Plc (RBS) and UBS AG. (UBSN) “The attitude among many big banks in the crisis was, ‘We’re going to do things to survive and pay money in litigation later,’” Dondero says. Some of those cases have been settled; others are still in court.

With many borrowers unable to pay off their loans, Highland was left running a number of companies.

In 2008, the firm took control of bankrupt Marcal Paper Mills Inc. after Highland agreed to convert $121.6 million in debt into a controlling stake in the maker of paper towels, toilet paper, tissues and napkins.

Highland installed a new management team and repositioned the company as a marketer of green products, touting Marcal’s use of recycled materials.

Highland also controls American HomePatient (AHOM), a provider of medical supplies such as feeding tubes, oxygen supplies, wheelchairs and beds to hospitals through a network of 280 health-care centers in 33 states.

Hollywood

Highland began buying American HomePatient’s debt on the secondary market in 2001 before the company tumbled into bankruptcy in 2002. Highland acquired more of the company’s debt and equity before taking the entire company private in 2010.

Highland’s most high-profile move was to take control of 12 percent of Metro-Goldwyn-Mayer, owner of the iconic Hollywood movie studio that produced such classics as “The Wizard of Oz” and “Gone With the Wind” as well as the James Bond series and 2012’s “The Hobbit”.

Once one of Hollywood’s grandest studios, MGM ran into trouble after a $5 billion leveraged buyout in 2005 by private- equity firms including Providence Equity Partners Inc. and Texas Pacific Group.

Highland and other owners of MGM debt, including Anchorage Capital Group LLC and Solus Alternative Asset Management LP, converted their debt to equity after MGM filed for bankruptcy in November 2010. They appointed Gary Barber and Roger Birnbaum, the co-founders of Spyglass Entertainment Group Inc., to run the studio.

Marble Pillars

The new team’s first money-saving move was to get MGM out of its luxurious Century City office tower, where MGM’s design flourishes included marble pillars and a grand spiral staircase.

Barber says he and Highland share an appreciation for keeping expenses to a minimum. No one at Highland flies in anything except coach unless they pay for the upgrade on their own. That includes Dondero.

“We’re both very tough on costs,” says Barber, whose Spyglass Entertainment produced supernatural thriller “The Sixth Sense” and co-produced the 2009 movie version of “Star Trek”. “We don’t like to see things getting wasted.”

Now that Dondero and Okada have pulled Highland out of its nose dive, they say they’re eager to break with the past. Among other things, Highland earned an unhelpful reputation as a magnet for lawsuits.

One, filed by Shawn Carter, the rapper who performs as Jay- Z, accused Highland and co-defendant NexBank SSB of trying to “bleed” from him more money than he had agreed to invest in connection with a boutique hotel development project in Manhattan’s Chelsea neighborhood.

New Offices

Highland denied the allegations and said they resold the building at a profit.

In what Highland Chief Operating Officer Patrick Boyce says is a deliberate re-branding effort, the firm scheduled a move in late February from the northern suburbs to new offices closer to Dallas’s downtown financial district.

“It made sense to really have a rebirth of Highland,” Boyce, 40, says. “We want to make sure the world almost sees us as a new firm.”

Boyce says the new setup will be more modern, with white walls and glass. That means Dondero’s office will lose its big- game hunter look as Highland repositions itself. According to Boyce, Dondero won’t be taking with him his coveted collection of trophies that for years adorned his private lair.

To contact the reporter on this story: Seth Lubove in Los Angeles at slubove@bloomberg.net

To contact the editor responsible for this story: Laura Colby in New York at lcolby@bloomberg.net

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