The Richest Hedge Funds: John Paulson Strikes Again

The man who called the subprime mortgage crisis is back, with four of the top 20 funds -- as his firm's bets against banks pay off big.

By Richard Teitelbaum
Bloomberg Markets, January 2009

There's not a lot of light in Paulson & Co.'s 28th- floor headquarters on a drizzly November afternoon. The Alexander Calder sculpture and multicolored prints have been shipped to the firm's new offices six blocks south. Darkness envelops the New York skyline.

The Dow Industrials have lost a total of 929 points over two days, and the jobless rate is poised to hit 6.5 percent. And John Paulson, who oversees $36 billion in hedge fund assets, isn't exactly Mr. Sunshine either.

"You have deterioration in almost every asset class," Paulson says. "You're looking at declines in housing prices, the health of manufacturers and the earnings of various companies. There are rising delinquencies in auto loans and commercial real estate."

Paulson, 52, peers over his tortoiseshell glasses. "There's more to come," he warns.

Paulson doesn't smile as he says this, even though with each new calamity his bottom line grows. Paulson & Co. funds generated profits of more than $3 billion for the firm in 2007, mostly by betting the housing bubble, swollen with subprime mortgages, would burst.

As that year ended, he set his analysts poring over the balance sheets of overstretched financial institutions, including many in the U.K. "We focused on those banks with lots of mortgages," Paulson says. "After those companies fell, we expanded our focus not just to mortgage assets, but to all credit classes."

The payoff: Four of Paulson's funds were among the 20 best-performing, and the 20 most profitable, hedge funds for the first nine months of 2008, according to data compiled by Bloomberg, other hedge fund research firms and investors.

$1.05 Billion Profit

The Paulson funds' gains ranged from 15 percent to nearly 25 percent. Based on those returns, they were on track on Sept. 30 to furnish Paulson & Co. with $1.05 billion in profits.

Paulson's performance was a striking success in a disastrous 2008 for hedge funds. The industry is reeling from convulsing markets, fleeing investors and the most serious credit squeeze since the 1930s.

Through September, the average fund lost 10.8 percent, according to data compiled by Chicago-based Hedge Fund Research Inc., putting the hedge fund industry on course to record its worst returns since at least 1990, the year HFR began compiling data. October saw another 6.3 percent decline.

HFR says hedge fund closures at midyear were 15 percent ahead of 2007. And that may be only the beginning for the world's 10,000 funds.

"It's pretty simple," says John Siciliano, a managing partner at Grail Partners LLC, a merchant bank that serves asset management firms. "The number of hedge funds is going to be cut in half in the next two quarters. You're going to see capital calls like you can't believe."

Long-Shorts Lose

Classic long-short equity funds -- the biggest category by assets -- were down 16.0 percent for 2008 through September. Such funds often wager that one group of stocks will rise and then hedge the bet by shorting a second set of stocks. In a short sale, an investor borrows shares of a company and sells them immediately, hoping to repay the lender later with shares bought at a lower price, pocketing the difference.

"Event-driven" funds, which bet on takeovers, restructurings or other company developments, were off 10.3 percent for the first nine months of 2008. Convertible arbitrage funds fell 19.4 percent. In their simplest transactions, managers make money by buying convertible bonds -- which can be converted to stock at a certain price -- and then hedging the investment by shorting the underlying stock. Convertible arb funds typically employ large amounts of leverage.

"What we're going through is what differentiates talent from luck," says Carrie McCabe, founder of New York-based Lasair Capital LLC, which invests in multiple hedge funds for large institutions. "Leverage kills you if you only use it to speculate."

Medallion is No. 1

The highest return in the Bloomberg ranking was scored by the Medallion Fund, run by Jim Simons's Renaissance Technologies LLC. The fund, which has an estimated $8 billion in assets, according to Bloomberg, racked up a gain in excess of 58 percent. That translates into firm profits of $1.43 billion for the quantitative juggernaut.

Simons, 70, is a former military code breaker and ex- chairman of the State University of New York at Stony Brook's math department.

Paulson's $13 billion Advantage Plus fund, which is designed to bet on takeovers, restructurings and other corporate events, was the second-best performer for the nine months ended on Sept. 30, with a 24.6 percent gain, according to Bloomberg data.

Waxman Hearing

Amid the torrents of red ink, hedge funds face the threat of government sanctions and regulation. In November, Representative Henry Waxman, chairman of the U.S. House Committee on Oversight and Government Reform, called hedge fund managers, including Paulson and Simons, to Washington to answer questions about their responsibility for the country's financial meltdown.

President-elect Barack Obama's economic advisers may recommend new capital requirements for hedge funds, according to a person familiar with the matter.

Casualties of the crash include some of the hedge fund industry's biggest names. Kenneth Griffin's Chicago-based Citadel Investment Group LLC is one victim. Its largest hedge fund, Kensington Global Strategies, was down 38 percent in 2008 through Nov. 4. A sour bet on Deutsche Boerse AG thrashed David Slager's Atticus European Fund, which plunged 43.5 percent through September. And William Browder's Hermitage Fund, which trades Russian stocks, lost 65.7 percent as of Oct. 31.

Medallion Siblings Fall

Even two of Simons's Medallion siblings took hits. Renaissance Institutional Equities Fund and Renaissance Institutional Futures Fund were down 14.8 percent and 15.6 percent for the year as of Oct. 31, according to investors.

Some big funds have called it quits. Drake Capital Management LLC, founded by veterans of BlackRock Inc., told investors in April that it was winding down its Global Opportunities Fund. In October, it delisted three other funds that traded on the Irish Stock Exchange. Ospraie Management LLC, run by commodities trader Dwight Anderson, decided to shutter its flagship fund in September.

Investors are running, not walking, to the exits. TrimTabs Investment Research of Sausalito, California, estimates that September and October redemptions totaled $87.5 billion. Total industry assets, which peaked at $1.93 trillion in the second quarter of 2008, declined 11 percent to $1.72 trillion at the end of the third, according to HFR.

Methodology

The ranking of best-performing funds is based on figures taken from a variety of sources, including data compiled by Bloomberg, hedge fund research firms, investors and the fund firms themselves. To derive the profits for funds, a 20 percent performance fee was used if fee information wasn't available. Some fund firms keep such a low profile that returns for their major funds couldn't be found. Those firms include D.E. Shaw & Co. and Farallon Capital Management LLC.

Paulson, sporting a French-cuffed shirt and patterned tie, looks every bit the investment banker he was when he worked for Bear Stearns Cos. in the 1980s. He says his firm's 2008 performance benefited from market hedging -- balancing out short positions with long ones.

British regulatory filings show that Paulson funds made short-selling bets totaling more than $1 billion against Barclays Plc, HBOS Plc, Lloyds TSB Group Plc and Royal Bank of Scotland Group Plc. On average, the shares of those banks lost more than half their value in the nine months through September.

Unforgivable

The billionaire points out that his funds also went long in sectors likely to do well in a recession, including health care, utilities and tobacco. Paulson says he's at a loss to explain why other funds were not hedged like he was. "Investors will forgive you if your returns are below average for a period," he says. "They won't forgive you if you lose money."

Paulson's returns have catapulted the soft-spoken native of Queens, New York, into the spotlight of the investing world. "This is rock star status," says Sol Waksman, founder of Barclay Hedge Ltd., a Fairfield, Iowa- based firm that tracks and invests in hedge funds.

At a March 2008 fund of hedge funds awards dinner at New York's Pierre hotel, Paulson & Co.'s performance was the buzz of the evening, with many of the winning managers having invested in its funds.

"Almost everyone who received an award thanked Paulson," says one person who attended.

Paulson keeps a low profile, even by hedge fund standards. Raised in the waterside neighborhood of Beechhurst, he's the third of four children of Alfred and Jacqueline Paulson. He credits the New York public schools, with their programs for gifted children, with giving him a leg up.

"I always had reading and math skills four or five years ahead of my grade," he says.

Summa Cum Laude

After graduating from Bayside High School in Queens, he went to New York University, where he earned a bachelor's degree in finance, summa cum laude, in 1978. As valedictorian, Paulson gave a graduation speech on corporate responsibility.

He went on to earn an MBA at Harvard Business School in 1980, finishing in the top 5 percent of his class. At the time, he says, banking jobs were scarce. He settled for a spot at Boston Consulting Group Inc.

Two years later, he landed an associate position at New York-based Odyssey Partners, an investment firm run by Leon Levy and Jack Nash. An Odyssey specialty was risk arbitrage, in which traders typically buy the stock of takeover targets and short that of the acquirer.

Paulson says Levy and Nash, both now deceased, taught him about risk arbitrage, real estate investing and how to profit from bankruptcies.

Levy a Mentor

"Leon was brilliant," Paulson says. "A lot of what I know about deals today, I learned from them."

Paulson left Odyssey to join Bear Stearns's mergers and acquisitions department in 1984, rising in just four years to managing director.

After Bear sold shares in 1985, Paulson says, he decided he didn't want to work for a publicly traded company and in 1988 joined privately held Gruss Partners, another risk arbitrage firm. Founder Joseph Gruss taught Paulson an important lesson.

"Joseph Gruss used to say, 'Risk arbitrage is not about making money; it's about not losing money,'" Paulson says.

Paulson & Co, which he founded in 1994, also started as a risk arbitrage firm. Over the years, Paulson launched new funds to exploit market trends.

"We always operated with a lot of hedges," he says. "We try to minimize market correlations. If you don't, you're going to be exposed when a market event happens."

600 Percent Gain

He started the Paulson Credit Opportunities and Credit Opportunities II funds in 2006 after anticipating a shock in the housing and mortgage markets. In 2007, the funds racked up gains of more than 600 percent. They're in the top 20 funds of the 2008 Bloomberg rankings for both performance and profits.

Paulson said in mid-November that more than 50 percent of the assets he managed were in cash and that the money he had invested was equally weighted between short and long positions.

"You have to get to the corner to see around the corner," he says. "We haven't gotten to the corner."

He expects 2009 to reward those who invest in restructurings, strategic acquisitions and distressed credits. In November, Paulson began buying bonds backed by home mortgages, according to an investor. Spokesman Armel Leslie declined to comment. In making his investments, Paulson focuses on straightforward themes.

"You have to be simple to have a clear strategy," Paulson says.

Quant Strategies

Don't tell that to Simons, who has earned billions for his firm through often-complex quantitatively driven trading strategies. Simons helped start Medallion in 1988 and continues to oversee the fund from Renaissance's gated headquarters in East Setauket on New York's Long Island.

Medallion assesses Renaissance employee-investors what may be the highest fees in the hedge fund business: a 5 percent management fee and 36 percent of profits.

Medallion has thrived in volatile times. In 1994, when the U.S. Federal Reserve raised its fed funds target rate six times to 5.5 percent from 3 percent, Medallion returned 71 percent. In 2000, when the Standard & Poor's 500 Index fell 10.1 percent, Medallion returned 98.5 percent net of fees. In 2007, when markets began melting down, it gained more than 70 percent.

Today, Medallion is almost exclusively owned by Renaissance employees, who include mathematicians, astrophysicists, statisticians and computer programmers. They search for patterns and correlations that can divine a market's direction. The fund spreads its bets around the world, trading everything from soybean futures to French government bonds.

Skating Along

Simons told Congress in November that Medallion, like Paulson & Co., was long and short equal amounts of equity. "By and large our business is not highly correlated with the stock market," he said. "And so that is how we have skated along here."

Medallion is just one of many funds that used mathematical models to profit in the first nine months of 2008. Of the 20 best performers in the Bloomberg ranking, at least six employed such strategies. One was Man AHL Diversified, No. 20 in the Bloomberg best-performance ranking, returning 7.7 percent. That gain means manager Tim Wong was on track to earn London-based Man Group Plc $72.5 million through the third quarter, according to Bloomberg data.

Man AHL typically uses computer-designed models to invest based on market trends. Fund managers that follow this path are known as commodity trading advisers, or CTAs, though their funds don't necessarily invest solely in commodities.

The CTAs Rule

Many of these funds trace their intellectual roots back to Adam, Harding & Lueck Ltd., or AHL, a pioneering London-based CTA-run firm founded in 1987 by Michael Adam, David Harding and Martin Lueck. In 1997, Adam, 47, and Lueck, 47, went on to help found London-based Aspect Capital Ltd., whose Aspect Diversified Fund rounds off Bloomberg's list of the top 20 profit generators.

Also in 1997, Harding, 47, founded London-based Winton Capital Management Ltd., whose Winton Futures Fund ranks No. 18 for performance and No. 9 on the moneymakers list, generating $146.6 million in profits. AHL itself was wholly acquired by publicly listed Man Group Plc in 1994 and carries on as the investment manager of Man AHL Diversified.

Despite the success of Man AHL, Man Group's stock was hit hard by the market downturn, losing 56 percent for 2008 through Dec. 1.

Trends tracked by CTAs can last a few hours, a few days or a few months. "We are trying to capture crowd behavior in different broad markets, around the world, 24 hours a day, five days a week," says Anthony Todd, the Oxford-trained physicist and AHL alumnus who co-founded Aspect.

Trend Following

In the first nine months of 2008, Aspect Diversified benefited from following trends in short-term interest rates, energy markets and stock indexes, Todd says.

CTAs and their ilk put their faith in formulas. "We're seen as annoying, geeky, black-box people," Harding says. "We're all scientists who are excluded from having opinions -- which are by their nature vanities."

One way Colm O'Shea made money in 2008 was by having an opinion on how bond yield curves would move. O'Shea, 38, is founder of London-based Comac Capital LLP and manager of the Comac Global Macro Fund. The fund, with $1.3 billion in assets, returned 19.2 percent for the first nine months of 2008, earning it the No. 4 position on the Bloomberg list of top performers.

Late in 2007, O'Shea and his team predicted that as the U.S. economy deteriorated the yield curve between short- and long-term bonds would steepen, as central banks lowered short-term rates. Comac began buying U.S. fed- funds-rate futures and short-term Treasuries, among other instruments.

Obvious Trades

At the same time, O'Shea was shorting longer-term bonds such as 10-year Treasuries. When the Fed lowered interest rates, he profited.

"Many of the best trades we do, people say afterwards, 'That was obvious,' but people didn't think it was obvious beforehand," says O'Shea, a native of Oxford, England, whose parents were born in County Kerry, Ireland. "A lot of it is just thinking through logically the implications and repercussions of things that we already know."

In March, as the economic outlook improved, O'Shea felt the trade had run out of steam and quit Comac's positions. In September, as the market started to crumple and the economic outlook worsened, Comac jumped back in.

"This year has not been about your economic view, it's been about being able to be flexible," O'Shea says of 2008.

He founded Comac Capital in 2006, after managing money for Citigroup Inc., Balyasny Asset Management LP and Soros Fund Management LLC, where he was senior macro portfolio manager.

Brevan Howard No. 3

Brevan Howard Master Fund Ltd., No. 3 on the list of most-profitable funds, also wagered on economic trends. In the first nine months of 2008, the Master Fund returned 14.1 percent, generating estimated earnings for Brevan Howard Asset Management LLP of $489.3 million.

With $26.2 billion in assets, Brevan Howard is the largest hedge fund firm in Europe. Its secretive co- founder, Alan Howard, trades from his London headquarters and sits at the center of a network of 400 employees in offices as far flung as Hong Kong, Mumbai and Tel Aviv. Howard seldom talks to the media and declined to be interviewed.

Ian Plenderleith, by contrast, was happy to talk. He's the chairman of BH Macro Ltd., a London-listed closed-end fund whose sole investment is the Brevan Howard Master Fund. "Their macro approach is not based on a wing and a prayer," he says in a thick South African accent. "It's based on substantial fundamental economic analysis."

Balancing Strategies

Brevan Howard employs a stable of 14 economists who craft outlooks for various world markets and work with more than 70 traders devising strategies to profit from them. A September BH Macro shareholder report said the Master Fund made money from its wagers on foreign exchange and market volatility and lost money on bond, stock and commodity investments.

As of mid-October, Brevan Howard had adopted a dominant strategy: Head for the exits. The fund at that point was 80 percent in cash, according to an investor letter from Howard.

For every successful strategy in 2008 there were four that failed -- and some funds took both roads. The No. 5 fund in the Bloomberg ranking of best-performing funds, Clarium LP, managed by PayPal Inc. co-founder Peter Thiel, 41, chalked up an estimated gain of 18.9 percent through Sept. 30, according to an investor letter from San Francisco-based Clarium Capital Management LLC.

Clarium's Ups, Downs

However, at midyear, the fund had been up 58 percent. It then gave back its remaining gains and more in October, when it plunged 18.3 percent after bets went bad on the prospect bond spreads would widen, according to an investor. In the nine-month period, the fund also gained from a bearish bet on commodities prices and lost on a bullish wager on U.S. stocks.

As President-elect Obama prepared to take office, hedge fund managers everywhere were in a defensive crouch, with Washington politicians demanding to know whether they contributed to the market meltdown.

At Rep. Waxman's Nov. 13 hearing, Paulson, Simons, Griffin, George Soros and Philip Falcone of Harbinger Capital Partners were all on the firing line, as congressmen queried them about their trading strategies, tax status and the need for government regulation.

Paulson impressed. Responding to questions, he found fault with Treasury Secretary Henry Paulson's Troubled Asset Relief Program, saying the Treasury gave banks overly generous terms on the preferred shares it bought from them. He said the government should be getting 10 percent yields, not 5 percent, and that banks should have suspended dividends on their common stock so long as they were being bailed out by the Treasury.

Paulson vs. Paulson

Democratic Representative John Tierney of Massachusetts said, "I was thinking we probably had the wrong Paulson handing out the TARP money here."

As was made clear at the hearing, hedge funds will face greater scrutiny. "There's enough blame to go around, but that doesn't help politicians," says Barclay Hedge's Waksman. "They want scapegoats."

At the very least, U.S. hedge funds are likely to see changes in their tax treatment, Lasair's McCabe says. Performance, or "incentive," fees -- the 20 percent or more of profits that hedge funds pocket -- that are held more than a year are currently treated as long-term capital gains and taxed at a rate of 15 percent. "That's a lower tax rate than many schoolteachers, firefighters or plumbers pay," Rep. Waxman said in his opening statement to the hearing.

Also on the chopping block: the tax break hedge funds get by domiciling their funds offshore, which allows a fund's performance fee to grow on a tax-deferred basis until it is repatriated.

Fees Will Fall

Change lies ahead for hedge funds even without government intervention. Underperformers will be forced to bring their steep fund fees down, Siciliano says. The lockup periods that many funds demand from their investors will also fall, he says.

Hedge funds typically market themselves as being able to deliver positive returns in good times and bad. They've done that over the years: From 1990 through 2007, the HFRI Fund Weighted Composite Index registered just a single down year, 2002, when the industry lost 1.45 percent. And in that year, the S&P 500 lost 22.1 percent.

From 1990 through 2007, the HFR Index has delivered an average annual return of 14.2 percent.

That kind of performance attracted a flood of money from university endowments and corporate and public pension funds. Their managers were eager to earn back the money they had lost in the bursting of the Internet bubble. Those and other investors poured an additional $658 billion into hedge funds between year-end 2000 and year-end 2007, according to HFR.

Following the Herd

Investors may wonder whether they got what they paid for. Goldman Sachs Group Inc. has created what it calls the Very Important Position basket, which tracks a roster of 50 stocks -- including such companies as Anadarko Petroleum Corp., General Electric Co. and Google Inc. -- that most frequently appear among the top 10 holdings of hedge funds.

When fund firms scrambled to raise cash in September, those stocks were pummeled worst of all. The VIP fell 19 percent in that month.

A companion basket of stocks least likely to appear among hedge funds' top 10 holdings fell just 2 percent.

The upshot is that investors who were paying 2 percent of assets and 20 percent of profit -- as opposed to the 1 percent or less they might have paid a plain-vanilla money manager -- now realize they were running with the herd.

A Premium Price

"The entire premise for the hedge fund industry is that you were paying a premium price for low correlations with the markets," says Daniel Celeghin, a director at investment management consultant Casey, Quirk & Associates LLC in Darien, Connecticut.

Managers like Paulson zigged while others zagged. That means new money by the billions is likely to come their way. Paulson managed just $7 billion in late 2006, an amount that has grown fivefold.

"Even after the trillions of dollars that have been lost, there is still a tremendous amount of money lying about," says Barclay Hedge's Waksman. "There is more money than there are good places to put it. Good managers are scarce."

That, in the end, may be the most important lesson to be learned from the 2008 market rout.

Richard Teitelbaum is a senior writer at Bloomberg News in New York, rteitelbaum1@bloomberg.net.

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