Paulson & Co PROFILE

John Paulson Wiki Entry

Paulson & Co. is a New York-headquartered investment management firm, founded in 1994 by American fund manager John Alfred Paulson. Before founding the firm with $2 million of his own money, Paulson was a general partner with Gruss Partners, working as mergers arbitrageur from 1988 to 1994. A native of Queens in NY, Paulson went to New York University’s College of Business and Public Administration after high school and obtained his MBA from Harvard Business School as a Baker Scholar. His father was a CFO with Ruder & Finn while his maternal grandfather – Arthur Boklan, was a Wall Street banker. After having a brief stint with the Boston Consulting Group as a management consultant, he moved to the Odyssey Partners – a private equity and a hedge fund, as an associate. Later he joined Bear Sterns and became a managing director of the mergers and acquisitions division.

In 1996 – two years after launching Paulson Partners LP, an offshore companion fund – Paulson International Ltd., was launched. The firm launched a leveraged version of its funds in 2001. Paulson slowly built his track record by making careful investment choices and gained prominence during the tech bubble by betting on M&A deals, shorting firms, and most importantly, managing to preserve clients’ capital. Assets under management swelled to $600 million in four years between 1999 and 2003. However, Paulson’s reputation beyond the hedge fund community grew when the housing market crashed in 2007. During 2005, sentiments in the US mortgage market were high and investors were pouring money in CDOs while the prices of credit-default swaps (CDS) were significantly low. Sensing opportunity, Paulson invested heavily in CDS and shorted CDOs. After suffering initial losses, his funds grew by a staggering 600% in 2007 when the markets crashed while fund managers were left counting losses.

Paulson’s hedge funds essentially follow the multi-strategy investment style. The firm operates on a global basis with a focus on the US, Europe and Canada, and hold diversified portfolios with an aim to produce average returns with low volatility. Paulson & Co. manages merger arbitrage/event driven (both overseas and domestic) funds for individual and institutional investors and aims to outperform the merger arbitrage index by going long on deals that could receive higher bids, or by focusing on unique deal structures which has the potential for higher returns, and by occasionally shorting transactions deemed weak.

A major focus remains on anticipating M&A deals that are likely to receive another offer, and subsequently realigning portfolios accordingly. The strategy has been a key value driver for the firm over the years. The firm targets arbitrage deals that have low correlation with the market and historical correlation with the S&P 500 had remained 0.07 between 1994 and 2003.

Paulson currently manages eight hedge funds, including the flagship Paulson Advantage Fund, the Paulson Advantage Plus Fund, the Gold Fund, the Credit Opportunities Fund, the Paulson Recovery and the Paulson Real Estate Recovery Fund. Launched in 2009, the Paulson Real Estate Recovery Fund follows the private-equity investment style and invests in distressed real-estate opportunities. The Paulson Gold fund was launched in January 2010 and invests in bullion-based derivatives and mining companies. The company opened its second office in Hong Kong in March 2011.

Paulson’s firm employs proprietary screens to evaluate a potential deal. Analysts review the sales growth, EBITDA, net income and EPS trends, and looks at the size of the acquirer and the target, and the premium paid. In the second stage, the firm participates in management conference calls, assesses merger agreements, SEC filings and Wall Street research. The company basically looks for strong merger agreements with nominal conditions. The company seeks the opinion of anti-trust counsels and lawyers to look at legal issues that may affect a deal and tries to eliminate deals that have lower chances of succeeding.

For risk mitigation, the firm looks at both deal risk and portfolio risk. Deal risk is further divided in macro and micro risks, and macro risks like major market or interest rate movements are simulated (stress-tested) to measure the impact on performance. To minimize market risk impact, merger arbitrage positions are fully hedged. Micro risks includes transaction specific issues like earnings stability of the target, funding clauses, taxes, market timing and potential legal issues. The firm maintains specific risk guidelines on a real time basis for all the portfolios.

Despite being a star fund manager, Paulson had his share of controversies and was called by the Senate along with four leading other trader managers to testify before the House Oversight Committee investigating the housing market collapse.

Although John Paulson made $5 billion in 2010, the performance of his funds in 2011 has been disappointing. The Paulson Advantage fund slipped more than 32% during the first three quarters while the leveraged Advantage Plus fund was down nearly 47%. When the stock markets rallied briefly in October, Paulson missed the rally as he scaled back risk.

Quotes:

Quote 1: (On risk arbitrage) – “We operate on a global basis which includes the U.S., Canada and Europe and have a diversified portfolio of merger arbitrage positions. Our goal is to produce above average returns with low volatility and low correlation with the equity markets. We seek to outperform the merger arb-index by minimizing drawdowns from deals that break, by weighting the portfolio to deals that could receive higher bids, by focusing on unique deal structures which offer the potential for higher returns and by occasionally shorting the weaker transactions. A major focus of our proprietary research is to anticipate which deals may receive another bid and then to weight the portfolio toward those deals. We have a good track record in that area and that has been a key driver of our performance. We avoid event-type arbitrage deals, such as spin-offs, recapitalizations, announced sales or restructurings, as those types of deals tend to have more market correlation. Our correlation with the S&P 500 since 1994 has been 0.07.”

Quote: (On changes in risk-arbitrage trading over the years) – “Over the past ten years the Hennessee Merger Arbitrage Index has produced 11.6% compound annual returns with a standard deviation of 3.8% and a R¿ vs the S&P 500 of 0.26. While the returns over the period are enviable, returns in any given year can fluctuate. Generally, risk arbitrage returns are a function of deal activity, the supply of arbitrage capital, and the level of interest rates. In 1999 and 2000, for example, when merger activity was at its peak, spreads were very wide and returns averaged in the high teens. The above average returns attracted large capital inflows from tertiary sources, such as macro funds and investment banks. However, when deal activity fell, in 2001 and 2002 the influx of capital overwhelmed the supply of deals causing spreads to compress. Returns from the Hennessee Merger Arb Index fell from 17.5% in 2000 to 3.8% in 2001 and a negative 1.2% in 2002. The lower returns caused capital to leave resulting in less competition for arbitrage deals. First to leave were the macro funds, second, the proprietary desks at investment banks and third the multi-arb funds which today allocate a very small portion of capital to risk arbitrage. The reduction in capital combined with the stabilization of deal activity has caused returns to improve in 2003. For the first 6 months of this year, the Hennessee Merger Arb Index is up 5% net, or 10% annualized, not far from the ten year average return and quite favorable when compared to the risk free rate.

“One area that has become more active recently is what we call bond merger arbitrage. We don’t consider ourselves distressed players but there has been an increasing number of acquisitions of bankrupt companies. When a firm exchange offer is made to acquire a firm in bankruptcy, we can set it up as a spread, buying the bonds instead of the stock and exchanging them for cash or a package of cash, stock and other forms of consideration. Last year there was a record number of bankruptcies in the U.S. This year, many of those companies are coming out of bankruptcy pursuant to reorganizations or acquisitions by third parties. This has been a very profitable, albeit small, part of our portfolio.”

Quote 3: (On funds becoming large and less competitive) – “(Investors often) ask if our large asset base impedes our ability to maintain high levels of performance. Although that may be the case in the future, we have not reached that point yet (in 2008).”