Appaloosa Management

Appaloosa Management was founded in 1993 by David Tepper. Since its inception, Appaloosa has netted investors 30% annual compounded returns and grossed the firm 40% yearly.

Akin to many prosperous hedge fund managers, Mr. Tepper had successfully kept a discrete profile for many years. Yet, since his remarkable performance in 2009 that brought him into the limelight as the highest paid hedge fund manager for that year, he has become a little more media accessible.

The man behind the outlandish returns, however, is not your stereotypical fund manager with sophisticated investment philosophizing and jargon-heavy macro talk, but instead a straightforward, often profane, down-to-earth guy who sums his investment philosophy with the phrase “it is what it is”. In an interview, when asked to elaborate more on his investment process, he quipped, “I am the animal at the head of the pack… I either get eaten, or I get the good grass.”

The location of the firm is also indicative of Mr. Tepper’s unusual approach. Originally, the firm was headquartered in Chatham, New Jersey, west of New York City, and had a starting capital of 57 million dollars. Today Appaloosa manages over 14 billion dollars, yet continues to operate from New Jersey in the small town of Short Hills with a staff of 23 people, away from New York City and Boston where Mr. Tepper honed his investment skills earlier.

Mr. Tepper, the self-described “regular upper-middle-class guy who happens to be a billionaire”, was born and brought up in Stanton Heights, the east side of Pittsburgh, and went to Peabody High School where he started to trade penny stocks along with his father who was an accountant. He went to University of Pittsburgh and graduated with a degree in economics.

His first job was as a credit analyst in the treasury department of Equibank. Not finding the job stimulating enough, he went back to school for two years at Carnegie Mellon’s business school to pursue an MBA (technically offered as a Master of Science in Industrial Administration back then). While there he attended options classes taught by Professor Dean Kenneth and formulated his own options trading model to supplement his expenses.

In 1982, his next job was as a finance analyst at the treasury of Republic Steel Corp based out of Ohio. The company was suffering financially and this provided Mr. Tepper with an inside glance at the credit structure of a distressed company. Two years later, he received his first exposure to money management when he joined Keystone Funds (now under Evergreen Funds) in Boston.

Only after spending a year in Boston, he got recruited by the then up-and-coming high yield desk at Goldman Sachs in New York City. Although he was hired as a credit analyst, within a couple of quarters he progressed towards the trading desk and his daring talent was noticed by the head of fixed income Robert Rubin. (They shared a good friendship for many years to come and Mr. Rubin is the closest person who comes to being a mentor to Mr. Tepper. Although Mr. Tepper has never said that, his investment style is reminiscent of Rubin’s articulation of investment philosophy.)

After another six months, in 1986, Mr. Tepper became the head of the high yield desk, where he primarily concentrated on special situations such as distressed companies and bankruptcies. For the following three years, the junk bond market enjoyed good returns and his desk consistently amplified those returns so much so that his desk became one of the highest money makers in Goldman Sachs. Even when the high yield market crashed in 1989 and many junk bond trader and dealers were wiped out, Mr. Tepper skillfully tempered the ripple effects which allowed his desk to endure through the turmoil. Additionally, in the same year, he persisted in buying seemingly hopeless bank debt for cents on the dollars, only to be rewarded by soaring returns when the banks went through bankruptcies and the markets recovered overall.

Despite his exceptional performance at Goldman Sachs, he was never offered a partnership there. His name came up as a potential partner three times during his tenure there, but each time was rejected. It was part politics (he only listened to Rubin and apparently did not waste time building relationships with more higher-ups) and part his crude character that did not always sit well with the elitist culture of Goldman Sachs.

When his prospects for a partnership were rejected for the third time in December 1992, he left Goldman Sachs. Mr. Tepper successfully sought out the mutual fund manager Michael Price (who at the time was a client of Goldman Sachs) so he can have access to a trading desk. Using his own funds, Mr. Tepper set out to trade at his best in order to increase his account enough to be able to start his own fund. After a quick succession of profitable trades by mid-1993, he founded Appaloosa Management with a total of 57 million dollars with a partial cash infusion from his former colleague Jack Walton who also was a bond trader at Goldman Sachs. (Mr. Walton has since retired from the firm.)

The stated objective of the fund was to indeed capitalize on Mr. Tepper’s expertise by emphasizing investments in distressed special situations through a 70-30 debt-equity allocation in global publicly traded markets. Beyond these loose restrictions of the mandate, however, Mr. Tepper was ready to be sector agnostic, event-driven, and bring his trade-oriented style into full play. Since he is not too attached to computer screens and software filters, but simply believes in keeping one’s eyes open for opportunities, a history of his major trades best elaborates his investment philosophy and the attendant (often nerve-wrecking) volatility.

Appaloosa’s first six months in 1993 delivered a 57% gain. Not surprisingly, one of his first investments was in a distressed steel company. The steel company was Algoma Steel which was then going through the bankruptcy court. Digging deep into the prospectus, Mr. Tepper uncovered the significance of the company’s preferred shares. Instead of regular preferred shares, which are normally secondary to secured and unsecured debt of a company, Algoma Steel’s preferred shares were essentially first mortgage bonds on the real estate of the company’s plants and headquarters (one can guess that the company did not want to directly increase its debt when it issued the preferred shares and that the initial investors yet wanted an asset backing their cash infusion). Since this buried fact was ignored by the current investors in the company, the preferred shares were trading at approximately 20 cents on the dollar. After building a position at that price, Mr. Tepper unloaded the shares at an average of 70 cents over the course of one year.

Mr. Tepper continued to make wagers on turnarounds, expanding its investment universe from companies to countries.

In 1995, when the investors in sovereign debt of Argentina were heading for the exit doors, he saw an opportunity in the panic as the increase in bank deposits in Argentina indicated an economy that was already in a recovery mode. Once again, he bought the debt significantly below face value, and returned 42% to his investors that year.

In 1997, when the markets were embroiled in the Asian financial crisis, Mr. Tepper saw an opportunity in the first-world country South Korea. As investors were painting whole of Asia with the same brush, the Korean currency had declined by more than 50% although the dynamics of its economy was quite distinct from the rest of the region. By buying highly discounted futures on the currency and Korean sovereign debt, he managed a 30% return.

In 1998, as the Russian government was having troubles with its increasing debt level, he saw an opportunity by reasoning that while Russia might devalue its currency it would not default on its debt. Of course, Russia went on to shock the global markets by defaulting in the same year. This misguided trade cost Appaloosa 30%. But Mr. Tepper re-analyzed the situation and persisted in buying the debt as it was bid further down. This prescient persistence helped him gain 60% in the following year.

In early 2000, as the internet bubble sped to its NASDAQ peak, Mr. Tepper placed a daring short on the index itself. As this was a somewhat different trade from his earlier ones, and was naturally losing money as the tech companies were still on their (soon-to-end) roar, Mr. Tepper’s investors panicked and protested so strongly that he undid the short position. Of course, only in a matter of couple of months NASDAQ started its reckless downward spiral, and had he held on to the position that might have actually been one his best trades ever. It is said that Mr. Tepper resolved then to never pay attention to the nervousness of his investors regardless of what kind of trade he was executing.

By 2002, as the US economy was in the throes of a recession, the high yield market underwent another substantial downturn and Appaloosa lost 25%. But, as always, Mr. Tepper was picking the hidden gems in the ravages left by uninformed and fearful traders. He purchased the debentures of three (what used to be) large cap companies while they were sorting out their bankruptcies; namely, Enron, WorldCom, and Conseco. He also built a position in the senior bonds of Marconi Corp which according to his analysis were cheaper than the company’s cash position itself. Lastly, he found some opportunities in distressed utility companies such as Williams Company. All this astute positioning added to a 148% gain in 2003.

For the following four years, from 2004 to 2007, as the US emerged out of the recession and both equity and debt markets reflected the perceived prosperity, his returns were sideways at best for lack of distressed opportunities. In early 2008, though, he went long large cap stocks in anticipation that they would rally from the levels they had been pulled down by the growing malaise of the sub-prime market. Surely this bet did not pan out and this cost his fund 25% by the second quarter. Further, in a much publicized deal, he led the syndication of a debt package to rescue the largest US auto part supplier Delphi from bankruptcy. The deal was botched and cost his fund around 200 million dollars.

While his long bet on the large caps rallying and his syndicated Delphi rescue plan did not pan out, this was to be made up (and much, much more) by his profits from his selective pickings from the post-Lehman devastation of the financial companies. After the collapse of Lehman Brothers in late 2008, he aggressively purchased preferred shares of Wachovia and Washington Mutual for 20 cents on the dollar. These helped him stabilize the fund in the last quarter of 2008 as both the companies were bought out by larger banks in a deal engineered by the US Treasury.

By early 2009, the financial crisis had only gotten worse and most money managers were dealing with high level of redemptions by panicked investors (not to mention that many money managers were panicked themselves). Mr. Tepper found himself in a large cash position (as he had quickly unwound his wager on large caps from last year) and sought turnaround situations in the wreckage.

As a first mover he was already establishing positions in financials. His impetus to go all-in only came in February when the US Treasury printed a publicly-available white paper detailing its Financial Stability Plan to help the ailing banks. Most specifically, the white paper expounded the terms for the banks that were utilizing the Capital Assistance Plan for cash infusion into their balance sheets — the trades were being executed by the government by buying preferred shares that would be convertible into common equity at prices that were far above the current market prices.

Although the markets were still anxious about the possibility that this could lead to the nationalization of the banks, Mr. Tepper perceived a government-backed opportunity to buy the common and preferred shares and debt of the financials and started building his tactical exposure. Things continued to get worse and by March Appaloosa was down over 10% which translated into about 600 million dollars. He persevered in his buying spree, grabbing the preferred shares of big financials such as Bank of America (12 cents on the dollar) and junior debt of Citigroup (19 cents on the dollar). He also bought a tranche at a 91% discount of a billion dollars of face value of commercial mortgage backed securities floated by AIG. All in all, he had over 30% exposure to financials at the depressed valuations.

As things stabilized in 2009, his concentrated allocation to financials reaped rewards beyond anything Appaloosa had seen. The fund provided investors a 120% net-of-fees return and although Mr. Tepper’s investors had seen such percentage gains before, this time it was the quantum of assets that amplified the returns – that was a succulent 7 billion dollars for the investors and a 4 billion dollar payday for Mr. Tepper himself.

A Note on the Name of Funds:

Appaloosa is a high breed horse with a pattern of distinct jaguar-like spots on the skin that was popularized by Marlon Brando in the movie by the same name. In the movie his horse Appaloosa is abducted by bandits and mistreated. Marlon Brando gets the horse back at the end by single-handedly taking on all he bandits and they ride across the border to start a new life. Mr. Tepper has not commented on why his flagship fund was named such.

In any case, the equine theme is prevalent in his other two funds: Palomino and Thoroughbred. The latter denotes a breed known for its nimbleness, swiftness and spirit, along with being hot-blooded. It does not take much imagination to guess the reference in here.

QUOTES

“It’s nice when you can buy cash when it’s cheaper than cash.”

“The key is to wait. Sometimes the hardest thing to do is to do nothing.”

“GM will do what’s best for GM, and Delphi should do what’s good for them.”

“It’s our contention that equity may be in the money, depending on where the liabilities lie.”

“Would you pick that up? [referring to a 20 dollar note he throws down when he is arguing to build a position]”

“We lead he herd. The Street follows us, we don’t follow the Street.”

“We’re consistently inconsistent. It’s one of the cornerstones of our success.”

“It was easy [referring to his trade in financials in 2009].The government told you what they were going to do.”

“On the way to work this morning, I got a headache because I was listening to one guy talking about how there’s gonna be hyperinflation. And then after him there was some guy telling me there’s going to be a depression and deflation. Neither—neither—is most likely going to happen. The point is, markets adapt, people adapt. Don’t listen to all the crap out there.”

“The PIIGs [Portugal, Ireland, Italy, Greece, and Spain] are considered to be the most troubled European economies – every single one has a deficit-reduction plan! The ECB—the Bundesbank—bought back government bonds! It’s like the chastity belt is off, and the girl is starting to play.”

“I think when it comes to decisions, I try not to be emotional. To drown out the noise and look at the important facts.”