Paulson & Company

Paulson & Co. Inc., an employee owned hedge fund sponsor, was founded by John Alfred Paulson in 1994 in New York City. Previous to its launch into the limelight in 2007 when its bets against the subprime mortgage bubble paid off handsomely, the hedge fund had approximately 2 billion dollars under management and Mr. Paulson carried a personal net worth of 100 million dollars.

After the hedge fund’s huge gains in 2007, followed by steadily positive returns through 2010, and then double digit losses in 2011, the assets under management were 22.7 billion dollars as of first end of quarter in 2012 and the net worth of Mr. Paulson was at a still very impressive 12.5 billion dollars.

While the media is now focused on each and every move of Mr. Paulson (only in the hedge fund universe you can manage 2 billion dollars and have a net worth of 100 million dollars and be classified as an average Joe unworthy of finance news), in reality most of the information is fragmented and does not dig deep enough into what are the various hedge funds under the umbrella of Paulson & Co., and how they perform differently.

Only the returns of his so called flagship fund Paulson Advantage and Paulson Advantage Plus are quoted, although these two funds constituted over a third of his total assets under management, granting that that happened after the losses in 2011. (Not to mention that the media often confused Mr. Paulson with the former treasury secretary with the same last name and sometimes even put his picture on articles referencing Paulson & Co. — really.)

The complexities of his strategies have been reduced to easily digestible bullet points: Prior to 2007 a nobody, starting 2007 a super genius, and by end of 2011 one wonders if his bet against the subprime mortgage was a fluke. In reality, all the funds of Paulson & Co. were up year-to-date as of March 2012. To set the record straight, we have to first understand the different strategies of the different funds and the different share classes recently created by Paulson & Co.

The hedge funds come under five broad categories: Merger Funds: 4.6 billion dollars AUM, Event Funds: 8.3 billion dollars AUM, Credit Funds: 6.8 billion dollars AUM, Recovery Funds: 1.8 billion dollars AUM, and Gold Funds: 1.2 billion dollars AUM. This adds to the above mentioned AUM of 22.7 billion dollars.

The Paulson Merger Funds:

Under the Merger Funds, there are essentially two types. The Paulson Partners which was the original fund when Paulson & Co. was founded, and the Paulson Enhanced which was added in 2001. Both of these funds follow the same strategies, the difference being that the Paulson Enhanced has a 2x exposure. (Technically, there are four funds as each fund has a domestic and international structure, but the strategies are the same and returns vary slightly because of structural difference and fees.)

As the name implies, the Merger Funds explore the inefficiencies in the M&A universe. Akin to many arbitrage funds, they seek absolute returns while engaging in low volatility and low correlation to the equity and bond markets. While they conduct traditional merger arbitrage, they seek to enhance the returns further by eschewing mergers they deem to be breakable and over-weighting the mergers where they believe the chance of receiving superior counter bids are higher. Also, part of their strategy is to analyze the global markets for potential deals that have not been announced yet. Last, they participate in exchange offerings conducted by bankruptcy reorganizations.

The unlevered Merger Fund, i.e. Paulson Partner, has had a solid performance since its inception in 1994. Besides losing about 10% in 2011, the only other negative year it ever had was in 1998 – and that too a loss of under 5%. During the recession of early 2000s after the internet bubble burst, it returned 22% in 2000, and about 5% both in 2001 and 2002. In the year 2007, when Paulson & Co. bet against subprime, this fund returned about 51% — indeed a great return, but not the kind needed to make the kind of money they made.

Overall, the fund has returned an annual compounded rate of over 14% since its inception (through end of 2011) and outperformed the merger arbitrage index which returned 8% for the same period. This translates to the following differences per initial 100 dollar investment: Paulson Partner at $1034, good old S&P 500 at $398, Merger Index at $393, and Hedge Fund index at $439.

The levered Merger Fund, i.e. Paulson Enhance, has annually compounded at 24% since its inception in 2001 compared to 6% merger index returns for the same time period. Because it was founded after the unlevered fund, the year 2011 was the first time it lost money, about 20% (as expected 2x of the unlevered fund). On the brighter side, the leverage helped it attain a return of 118% in 2007.

The Paulson Credit Opportunities Funds:

This is where Paulson & Co. deploys its debt strategies, using both long and short positions in the whole universe of the credit markets: from the highest rated bonds to high yield, from credit default swaps to sovereign debt, convertible bonds and preferred securities across the whole range of ratings going all the way down to post-bankruptcy reorganized bonds. Although there are three funds in this category, they are only different structurally, and their returns are more or less the same.

The fund does not adhere to a predefined allocation to the types of securities, instead opting to be long and short flexibly in accordance with their assessment of the environment. For instance, they were short Mortgage Backed Securities and Collateralized Debt Obligations (through Credit Default Swap transactions to enjoy the leverage) through late 2006. In 2007, they started realizing the gains from these shorts and closed their positions in mid-2008. As the economy chugged through the recession in 2009, they built long positions in High Yield, Mortgage Backed Securities, Bank Loans (levered), and Defaulted Debt, which they started monetizing in 2009 itself and project to keep closing them through 2013. Again, between 2009 and 2011, they built long positions in two new types of securities: Post Re-Org securities (including equity) and Convertible Bonds which they have already started monetizing. In 2012, they opened a long position in Interest Rate Hedges to protect their long positions.

The credit opportunity funds were created in mid-2006, specifically for the purpose of benefiting from the impending mortgage crisis. In the first six months of its existence, the fund returned a solid 20%. But in the month of February of 2007, it returned over 66% — some investors thought this was a typo. The fund went on to achieve a gain of 591% for the whole of 2007. The following three years it had again solid returns of 18%, 35% and 19%. In 2011, akin to other funds in Paulson & Co., it suffered a loss of 18%. Overall, though, it has managed a total return of 1232% through end of 2011, in contrast to a paltry 19% of the Hedge Funds Research Distressed Index.

Event Funds:

These — the Paulson Advantage Funds — are often quoted as the flagship funds of Paulson & Co. Currently they represent a little over a third of the whole assets under management of all the funds combined. They have a full mandate to invest in any of the other funds’ strategies that are event driven. That means any special situations, bankruptcies, M&A, and exposure to all kinds of sectors (the latter often through direct equity stakes).

There are two types: the Paulson Advantage and the Paulson Advantage Plus. Akin to the merger funds, the difference is in leverage, except that the Advantage Plus takes on a more moderate 1.5x exposure.

It is in these funds that Paulson & Co. took their biggest hits in 2011, for various missteps such as concentration in financial stocks and complacency about the crisis of Euro sovereign debt. Their analysis that a decent recovery was pending led to a loss of 36% for the unlevered fund and a dramatic 52% for the levered one.

The Advantage Funds were introduced in 2004 and 2005. The performance was somewhat steady in the initial stages, but once again they returned outsized gains in 2007 as all funds across Paulson & Co. bet against the looming mortgage meltdown. This meant a return of 100% for Advantage and 163% for Advantage Plus. The returns for the following three years were solid also: 24%, 13%, and 11% for advantage, and 38%, 21% and 17% for Advantage Plus.

Overall, since their inception the Advantage Fund has compounded at an annualized average rate of 13% (unlevered) and 17% (levered) and the S&P 500 has returned 2.6% (for time period of levered fund) and 3.5% (for time period of unlevered one).

Recovery Funds:

As the name indicates palpably, the Paulson Recovery Funds were established in anticipation of an economic recovery following the financial crisis of 2008 that launched the US into the Great Recession. Most interestingly, this fund was started in the panicked environment of October 2008.

The intent was to invest in the equity shares of solid companies that were in the most ravaged industries. That meant anything to do with finance — banks, insurance, and investment management outfits — and real estate including hospitality, and other industrials which would benefit from an overall economic recovery. To balance the long positions, short positions could be adopted in companies where the it was analyzed that the recovery would not lift their earnings.

Simply stated, this is a traditional long-short value play of seeking good companies at steeply discounted valuation (and vice-versa for shorts) by Paulson & Co. — the main difference being that they were making a macro bet, so a top-down analysis rather than a traditional bottom-up value investing paradigm.

While the strategy produced flat returns for the last quarter of 2008, the following two years it produced gains of 25% and 24% for 2009 and 2010 respectively. Similar to other funds, though, the fund lost in 2011: it was down a significant 28%. To accommodate for a possibility of double-dip recession and mounting Euro zone crisis, they restructured the portfolio to have a net equity exposure of 63% by the end of 2011.

Gold Funds:

The Gold Fund was launched in January 2010 and the mandate of this fund is not simply to own gold or gold mining stocks, but to outperform the price of gold. Paulson & Co. believes that this will play out very well for the next five years or so because they anticipate rising gold prices due to the quantitative easing coming from the fed that could lead to depreciation of the US dollar and that gold would also be a good hedge against any turbulence coming from the ongoing Euro crisis.

While the fund does use derivatives to get exposure to gold, it invests significantly in individual gold miners such as AngloGold as these companies can have significant financial leverage when the gold price moves upwards. But in 2011 there was a lot of volatility in the spot price (many double digit monthly swings), which left the investors of the gold mining stocks nervous and heading to the exits. Paulson & Co. believes this disparity between the gold miners and the gold commodity price will narrow as the earnings are digested by investors. So while in its first year of 2010 the fund gained about 35%, it ended 2011 with an 11% loss.

A Note on Gold Shares:

In April of 2009, Paulson & Co. started offering gold-denominated shares for its Merger Funds, Event Funds, Credit Funds and Recovery Funds. This was in line with thinking behind the Gold Fund: namely that widespread quantitative easing will lead to depreciation of US dollars and possibly other fiat currencies.

The strategy was executed by borrowing against the current funds and using that money to purchase gold derivatives. While this was not a wash-trade, by using leverage from the derivatives a small outlay could expose the fund to about 80% to 90% to gold. In short, the gold-denominated shares do not only benefit from any gains that the underlying strategies produce, but also enjoy higher performance as long as gold moves upwards.

For the years of 2009, 2010, and 2011, the gold-denominated shares have significantly outperformed the USD-denominated shares. In 2010 specifically, the gold-denominated return 2x to 3x of the regular shares. In 2011, the gold-denominated shares dampened all the losses by about 1000 basis points.

Manager Background:

Prior to founding Paulson & Co. in 1994, Mr. Paulson was in the position of a General Partner at Gruss Partners from 1988 to 1992. From 1984 to 1988, he worked in the Mergers and Acquisitions division of Bear Stearns as a of Managing Director. From 1982 to 1984 he trained as an Associate at Odyssey Partners, prior to which he was Management Consultant at Boston Consulting for two years.

Mr. Paulson earned an MBA with the distinguished title of a Baker Scholar at the Harvard Business School in 1980. In 1978, He also majored with summa cum laude in Finance at New York University’s College of Business and Public Administration.

QUOTES

“Do not forget that we have experienced the worst recession since the Great Depression. This necessitated the use of unconventional means to avoid economic collapse. In this sense, the monetary stimulus and fiscal stimulus provided by the government have been very useful to help get the economy get back on track. The problem is that the quantitative recovery is not without consequences and creates the potential for inflation. Currently we have no inflation because we still have overcapacity. But the risk exists. It is undeniable that this monetary expansion is equivalent to running the printing press. It remains to be seen whether the Fed will reduce the recovery before it becomes inflationary.”

“Over time, the price of gold will rise in proportion to the creation of paper dollars. In an inflationary environment where the demand for protection increases, the price of gold can rise even further. Historically, gold has always been a safe haven against inflation and a safe haven in times of political instability. Today we face both risks.”

“Initially, the Obama administration attempted to increase taxes, the traditional Democratic approach. They are doing a step back today to further support the private sector to foster job creation. Barack Obama has changed its policy and granted aggressive tax incentives to boost investment and stimulate growth. The weak point remains the financial reform. With a little hope, there will be changes to eliminate the negative aspects of this reform.”