Canyon Parlays Harvard-Drexel Roots Into Problematic Dealmaking
The head winds grew so intense during the 508-mile race through California’s Mojave Desert and Death Valley that Joshua Friedman told his teammates he thought he would be blown off his bike. Instead of tumbling down, the hedge-fund manager powered through his 86-mile leg of the Furnace Creek 508, showing little fatigue after he dismounted his bike.
“He said he was having a great time,” says David Garaffa, a personal trainer and one of Friedman’s teammates in 2007. “It was a morale booster for everybody else because we had two other guys who still had a leg to go.”
Friedman’s endurance carries through to the way he and his partner, Mitchell Julis, run Los Angeles-based Canyon Partners LLC, the $19 billion hedge fund. The two debt investors founded Canyon in 1990 and have built it into the 9th-most-profitable fund and the 17th-largest firm in the world, according to Bloomberg Markets magazine’s annual hedge-fund ranking in the February issue.
After Friedman and Julis graduated with both Harvard University law and business school degrees in the early 1980s, they went to work at Drexel Burnham Lambert Inc. It was the heyday for junk bonds, and Drexel used them to back corporate raiders such as Carl Icahn. Friedman, 54, and Julis, 55, have carried on the Drexel bloodline with their focus on troubled assets -- everything from bank loans and junk bonds to mortgage-backed securities and aircraft leases.
“Our basic business is finding markets and assets in disruption, where trading prices diverge from intrinsic value,” says Friedman in a sun-drenched conference room at Canyon’s headquarters.
A smaller part of Canyon’s operation -- real-estate lending and investing -- has stirred controversy. The firm has tangled in court with developers from New York to Nashville to Los Angeles who have defaulted on its loans. Canyon’s real estate funds often end up taking control of the underlying real estate or the assets they financed.
It now runs an ailing casino hotel on the north shore of Lake Tahoe once owned by Frank Sinatra. One of the firm’s opponents in court has called it a “vulture” and said it charges interest rates as high as 27.7 percent that border on usury.
A Canyon spokesman says the lawsuits are the exception. Few of the firm’s 240 commercial real-estate investments have ended up in court, and 94 percent of its loans have been paid back under the agreed-upon terms, the spokesman says.
“Aggressiveness is part of their DNA,” says Michael Rosen, chief investment officer of Angeles Investment Advisors LLC, a Santa Monica, California-based institutional-investment consultant that steers client money to Canyon. “My takeaway is they’re looking after my interests. I think it’s a highly ethical firm.”
The company’s flagship $9 billion Canyon Value Realization Fund LP has had only two down years since it began in 1995. The fund’s multistrategy investing technique allows managers to shift investments as market conditions change. After the flagship fund lost money in 2008, Friedman and Julis took advantage of the financial turmoil by investing in beaten-down bank loans and mortgage-backed securities.
Canyon Value Realization’s 11.5 percent return in the first 10 months of 2010 ranked it 51st in the list of the top 100 best-performing hedge funds managing $1 billion or more. The fund was up 14.4 percent for all of 2010.
The duo first honed their debt-investing skills at Drexel. After a brief stint as a bankruptcy attorney at Wachtell, Lipton, Rosen & Katz in New York, Julis moved to Beverly Hills, California, in 1983 to join Michael Milken’s expanding junk-bond empire, where he oversaw $500 million of distressed securities.
Friedman, who was working in Goldman, Sachs & Co.’s (GS) mergers and acquisitions department in New York, followed his friend a year later to Drexel’s California outpost and was eventually put in charge of structuring new issues. Both stayed at Drexel until its bankruptcy in 1990, brought on by the collapse of the junk-bond market and a securities-fraud scandal that sent Milken to prison for 22 months.
“They were among a number of Drexel alumni who have done reasonably well,” says G. Chris Andersen, a former head of investment banking at Drexel who now runs New York-based merchant bank G.C. Andersen Partners LLC.
Kenneth Moelis, who worked with Friedman and Julis at Drexel, says they are especially talented at navigating the complexities of corporate debt. While Julis is skilled at basic research and financial analysis, Friedman is an expert on the pecking order of creditors in the event of a default or liquidation and how their claims can affect debt holders.
“Josh knows where the bodies are buried,” says Moelis, founder of New York-based investment bank Moelis & Co. (MC), whose Los Angeles office is across the street from Canyon’s headquarters. “It’s a very good partnership. They play off each other.”
Friedman and Julis also strive to mitigate their fund’s exposure to potential macroeconomic outcomes, such as a slowdown in China. Friedman says the firm expects that anything affecting China’s meteoric industrial growth could impact companies and countries that depend on its demand for raw materials and commodities.
So the firm started investing in credit-default swaps on oil-and-gas-company debt beginning in April. The wager could pay off if China’s expansion slows, reducing demand for energy and making oil-and-gas-company debt riskier.
‘Freedom of Mandate’
Canyon also bought options on Australian interest-rate swaps. The firm expects that Australia’s raw material exports would drop if China hiccups, hurting the country’s expansion and spurring a decline in interest rates to stimulate the economy. The hedge is intended to protect against the impact of a China slowdown on the firm’s holdings of U.S. securities.
“We’re trying to focus on our freedom of mandate as a hedge fund to find those moments of dislocation where we can generate alpha, or excess return,” Friedman says.
Canyon’s office on the 11th floor of a glass-and-metal building in the Century City district is sparsely decorated in keeping with the firm’s low profile. The only works of art in the reception areas and halls are black-and-white photos of rocky canyons bought for $50 each.
The firm’s 215 employees are part of a culture that Julis says resembles a graduate school study group. The firm’s small library is spilling over with books. About six senior managers oversee investments, with input from the founders.
Mock SEC Audits
“What we don’t do is just allocate money to managers,” Friedman says. “Mitch and I are interacting with our senior analysts on positions so we can bring the best ideas to bear on each investment.”
The hedge fund hires outside consultants annually to audit each of its operating departments, says John Simpson, Canyon’s chief operating officer. The reviews include a full mock Securities and Exchange Commission audit every 12 to 18 months.
“If we don’t run our business as well as our best investor runs theirs, we shouldn’t take their money,” Simpson says.
Outside the headquarters, the founders appear only occasionally in public, attending local charity events and the annual Beverly Hills conference of their former mentor, Milken. Business leaders gather at the Milken Institute Global Conference to opine on everything from the future of the euro zone to nuclear nonproliferation.
Julis, a voracious reader, popped up in news headlines in October when he paid $25,250 at a San Francisco auction for a first edition of Benjamin Graham’s bible of value investing, The Intelligent Investor (Harper & Brothers, 1949). The book was signed by Warren Buffett, who said in a video tribute to Graham that it changed his investment philosophy and his life.
Friedman and Julis also keep quiet about their investments. In 2009, former Miami Vice star Don Johnson sued Hollywood film library Rysher Entertainment Inc., alleging it hadn’t paid him profits from his Nash Bridges TV series. During the case, defense lawyers told the actor’s attorneys that Canyon owned a majority of Qualia Rysher Co., which in turn controlled the film library.
“It was the defense that stood up and said we sued the wrong company,” says Johnson’s Los Angeles lawyer, Mark Holscher of Kirkland & Ellis LLP.
A California Superior Court jury in Los Angeles ordered the Canyon-controlled firm and another defendant to pay Johnson $23.2 million in damages, which the judge more than doubled in September to $51 million after adding interest. The defendants plan to appeal the decision, which applies to events that happened prior to Canyon’s ownership.
“Canyon is incredibly transparent to investors,” says Sandra Lelievre, a former Canyon vice president of investor services who left in July to join hedge-fund-software supplier Backstop Solutions Group LLC. Canyon, for instance, provides investors with detailed quarterly letters that include specific investments, returns and the firm’s outlook.
“That’s why they’ve done so well in attracting institutional investors, and that’s why they can afford to be so quiet,” Lelievre says.
In 2005, Julis gave a rare interview to Aish.com, a Jewish-themed website he funds. He said he became an observant Jew after the Canyon Value Realization Fund had its first negative year in 1998. Canyon’s investments in Russia took a nose dive when the country defaulted on its sovereign debt and devalued the ruble. The fund tumbled 15.8 percent in 1998.
“The market got shaken and I got shaken,” Julis said. “I knew I needed something beyond my hedge fund to ground me. Torah was the answer.”
‘A Simple Song’
Julis co-wrote a song about Israel in reaction to Jimmy Carter’s 2006 book equating the country’s treatment of Palestinians with South Africa’s apartheid regime, says Sam Glaser, a professional musician. Glaser helped author the tune and sings it on an Internet video featuring bucolic scenes of Arabs and Israelis. Patterned after the lyrics and melody of a “Simple Song of Freedom” by the late Bobby Darin, “A Simple Song for Israel” changes the chorus to “Israel stands for peace and not for war.”
Friedman and Julis had their second brush with disaster during the credit crisis in late 2008, when their flagship fund posted its worst-ever loss of 29.2 percent, according to reports to investors. Friedman says the meltdown had an impact on the firm even during its offsite meeting in September 2008, an annual event in which Canyon brings in financial experts to speak to its traders and analysts.
In the middle of a beach volleyball team-building exercise in Santa Barbara, employees suddenly brought the game to a halt to strategize about a momentary upturn in the market.
Canyon sent a 14-page mea culpa to investors in January 2009. The firm said managers got hurt by staying almost fully invested in high-quality assets while much of the rest of the market was indiscriminately selling, driving down the value of Canyon’s investments regardless of their underlying worth.
Canyon also said CDSs and other forms of investment insurance failed to prevent the free fall because banks and other counterparties were themselves in turmoil, making the hedges ineffective.
“We regret learning some harsh lessons at your expense, but we will make every effort in 2009 to put this learning to good use,” the letter said.
Canyon tempered its self-flagellation with enthusiasm about its market outlook. The letter noted once-in-a-generation opportunities for investments in senior bank debt, mortgage-backed securities, distressed debt, convertible bonds, direct loans to bankrupt companies and even securities backed by aircraft leases.
As the markets imploded in 2008, many of these lease securitizations lost their AAA debt ratings as the bond insurers that propped up the ratings were themselves downgraded. That prompted institutional investors to offload their holdings, driving down prices of the securities. Canyon scooped the securities up at a discount.
“Our team understands the valuation of and leasing market for the underlying aircraft and the credit quality of the airlines,” Friedman says.
At the time of the 2009 letter, bank debt made up 29 percent of assets in the flagship fund, followed by high-yield bonds, at 14 percent, and securitized assets, at 12 percent. The firm also said it planned to profit from the deluge of bankruptcies because of the recession.
Charter Communications Inc. (CHTR)’s $8 billion of senior debt -- most of which is typically recouped in a bankruptcy -- was producing profitable trades in anticipation of the impending Chapter 11 filing of the St. Louis-based cable operator.
The flagship fund rebounded in 2009, returning 55 percent, according to Canyon’s full-year letter to investors.
Some of Canyon’s real-estate investments, which comprise $2.5 billion of its total assets, were also battered during the financial crisis. The firm often provides high-interest loans secured by the underlying real estate, which sometimes results in legal battles when the borrower can’t make payments on Canyon’s loans.
In 2000, Canyon partner K. Robert Turner hooked up with Earvin “Magic” Johnson, the former Los Angeles Lakers star turned entrepreneur, to help the firm invest in urban revitalization projects. One of the Canyon Johnson funds provided $12.4 million in financing to a company run by New York developer Joel Schwartz in 2007 to construct a 130-unit, 6-story condominium building in Brooklyn’s Greenpoint neighborhood.
The company, 110 Green St. Development LLC, couldn’t complete the project by a 2008 deadline and defaulted on Canyon’s loan and a $41 million mortgage held by Bank of New York Mellon Corp. The company filed for Chapter 11 protection in February 2009.
Canyon has battled 110 Green St. in court ever since, claiming it filed for bankruptcy in bad faith as a way to frustrate the hedge fund’s efforts to collect its money. Schwartz’s lawyer, Kevin Nash of New York’s Goldberg Weprin Finkel Goldstein LLP, returned fire in a March 2009 filing, accusing Canyon of being a vulture fund that charged an interest rate of 21.7 percent that escalated to 27.7 percent when Schwartz defaulted. Nash also accused Canyon of having made the loan with the intention of taking ownership of the property.
“Life would be a lot easier if they were not sitting in that position as lenders,” Nash says.
In early December, Nash said in court papers that Schwartz’s company had a buyer who would pay $59 million for the condo building, which would return over $20 million to Canyon for its original $12.4 million loan.
10 Percent Returns
Canyon rejected the deal, calling it “illusory” in a filing. The firm says it has worked to preserve the value of the development, including helping to convert it into a fully leased rental property. Canyon also says that investors in all of the three Canyon Johnson funds have or will receive 100 percent of their capital back, with returns of more than 10 percent after fees for the first fund, and a smaller return in the second fund.
In 2009, Canyon took possession of the Cal Neva Resort, Spa & Casino -- a property that had once been owned by Frank Sinatra. In the early 1960s, Sinatra entertained his Rat Pack pals at the resort, which he sold after Nevada gaming authorities revoked his license because mobsters had been seen at the casino.
Four years ago, another Canyon fund, Canpartners Realty Holding Co. IV, extended a $25 million loan to the resort’s then-owner, Ezri Namvar of Los Angeles. He defaulted in late 2008 after his plans to convert the Cal Neva into a five-star hotel and condominium collapsed along with the luxury end of the market.
Namvar was separately indicted last September on federal charges of stealing about $23 million from clients. He pleaded not guilty to the charges.
While Canyon says it rescued the hotel from a complete closure under Namvar, it’s a long way today from the time when Ol’ Blue Eyes crooned in the Frank Sinatra Celebrity Showroom and Marilyn Monroe spent one of her last days at the hotel before her death in 1962.
On a weekday evening in November, the hotel, which has about 200 rooms, was almost deserted. One person was eating in the restaurant where Sinatra once held court. The barmaid at the Circle Bar, which had only two customers, said business plummeted as soon as Canyon closed the Cal Neva casino last March.
It expects to reopen the casino by February. Until then, the only regular entertainment is a $10 tour of the subterranean tunnels that the hotel says Sinatra used to get around his resort, along with an endless loop of the crooner’s hits playing over the hotel’s speakers.
The Crystal Bay Club Casino, not far from the Cal Neva’s almost-empty parking lot, and the Tahoe Biltmore Lodge & Casino across the street were busier on the same late-November afternoon.
Canyon tried and failed to sell the hotel in 2009. In September, Canyon Capital Realty Advisors LLC announced that the Cal Neva was part of a larger strategy to increase its investments in hotels, which already include the Washington Hilton, Hotel 71 in Chicago and the W Austin in Texas.
While Friedman and Julis used the expertise first honed at Drexel to navigate through the turbulence of the debt markets, their smaller real-estate investments have sometimes brought court battles. As the founders add to their real-estate holdings, they’ll likely spur more controversy with borrowers and generate the very publicity they seek to avoid.
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