Hedge fund of the year: Paulson & Co

Risk awards 2011

New York-based Paulson & Co became one of the most famous hedge funds in the world in 2007, when a canny short position in US subprime mortgages netted the firm a whopping $15 billion return – dubbed the greatest trade ever. Since then, market participants have watched Paulson’s every move with interest. After taking a long position in distressed credit at the end of 2008 and into 2009, last year saw a transition into the equity of firms facing bankruptcy or restructuring. But the result has been the same – strong returns for its flagship funds.

The $9 billion Advantage Plus fund, which employs an event arbitrage strategy specialising in merger arbitrage, distressed, bankruptcy and other forms of corporate reorganisation investing, had climbed by 14.3% in the year to December 20. The firm’s Credit Opportunities fund increased by 16.5%, while the Recovery fund had risen by 19.4%

“As high-yield bonds trade above par, any further gain in the enterprise value of the company has to accrue to the equity. So right now, the majority of our focus is on restructuring equities. In 2010, we made more than 40 investments totalling more than $20 billion in various corporate restructurings,” John Paulson, founder and president of the firm, which has $33 billion in assets under management, tells Risk.

Another coup for Paulson was the decision to create a gold share class for its funds in 2009 – and these have traded at a significant premium above the dollar share class. The gold share class for the Advantage Plus and Recovery funds climbed by 33% and 38.5%, respectively, in the year to December 20. The decision to open a gold share class came in response to the start of quantitative easing by the US Federal Reserve, and Paulson’s belief this posed a strong inflationary threat.

“We are very concerned about the effect of quantitative easing on the future value of the dollar,” explains Paulson. “When the Federal Reserve completes its new $600 billion quantitative easing (QE) project, the monetary base in the US will have increased about 200% above what it was prior to the failure of Lehman. Although the Fed is confident it can withdraw that stimulus before it becomes inflationary, there is the risk the money that has been printed finds its way into the money supply, which could lead to higher inflation in the future. When the Fed announced its initial QE programme in March last year, I became concerned that I could do well in dollar terms but lose money on a real purchasing power basis. We therefore looked for another currency in which to denominate our investments, and felt gold was the best alternative to hedge against paper currency depreciation. So we created a gold share class for all our funds.”

The firm also created a dedicated gold fund in January 2010, which is invested in physical gold, equities and options strategies, with the aim of outperforming the gold price. The fund has managed to raise approximately $1 billion in assets and delivered a 35% performance as of December 20 last year.

Paulson has a reputation for moving early and making some big, contrarian calls. The biggest was the decision to short subprime mortgages in 2007, at a time when other investors and dealers were still piling into the sector.

“Our strategy in 2007, where we were way ahead of the curve, was being short credit. We came out of the last recession in 2002 with our usual focus on bankruptcy investing, but bankrupt bonds were trading above par by 2005, so we felt the credit markets were mis-pricing risk. Neither the ratings nor the price of securities made sense, and we focused our research on searching for the most mis-priced securities,” explains Paulson. “We found that in the BBB layers of subprime mortgage securities. The BBBs were yielding only one point more than Treasury bonds, yet according to our analysis they had a high probability of default. So the downside was 1% and the upside, if they defaulted, was 100%. This purchase of BBB protection drove our returns in 2007, as these securities fell from par to an average of 20 cents by the end of the year.”

This short credit strategy hit headlines again last year – but this time, in relation to a lawsuit against Goldman Sachs filed by the Securities and Exchange Commission (SEC) in April. The suit centred on a synthetic collateralised debt obligation (CDO) called Abacus 2007-AC1, arranged by Goldman Sachs in 2007. The SEC alleged Goldman had not disclosed to the portfolio manager and other investors that Paulson, the sponsor of the CDO, had played a part in selecting the reference portfolio, and intended to short many of the constituent names (Risk May 2010, pages 14–15).

The lawsuit claimed Paulson & Co pocketed a $1 billion profit from the trade, while the investors in the CDO, Düsseldorf-based IKB Deutsche Industriebank and ABN Amro, lost $150 million and $840.91 million, respectively. Goldman eventually settled with the SEC for $550 million last July.

“There was certainly a lot of headline risk, but we were not a party to the suit,” says Paulson. “We didn’t sell any securities and we didn’t make any misrepresentations. The only thing we did in this transaction was buy protection. We were very clear that was what we wanted to do at the outset. The SEC has nothing against people buying or selling protection in the credit derivatives markets – that is the nature of the transactions. However, the SEC does have issues as to whether or not proper disclosures are made when selling securities.”

But the firm still had to grapple with the reputational risk of being associated with the trade. Paulson says his investors were not unduly concerned – they ultimately understood the firm was not implicated in the lawsuit and would not be materially affected, he adds: “The issue was relatively short-lived and, importantly, the filing did not result in any material client redemptions from our funds.”

The hedge fund sector knows all about redemptions, though, having seen a wave of requests from investors wanting to withdraw their cash during the worst of the crisis in the fourth quarter of 2008 and early 2009. Many hedge funds responded by putting gates in place and hastily modifying liquidity and redemption rules. In contrast, Paulson & Co took the decision not to refuse investor redemption requests.

“We never restricted withdrawals in our funds or imposed gates. Any investor who wanted to redeem could do so with no questions asked, and our investors were very appreciative of that. Far too many hedge funds had deviated from their original strategies and invested in securities with longer durations or more illiquid types of investments they weren’t able to liquidate in good time. The lesson for funds is that you have to match the liquidity of investments with the terms of the fund,” says Paulson.

Counterparty credit risk also became a key concern in the aftermath of the crisis, with some end-users wary of trading with certain bank counterparties. Paulson says the current environment is a lot different to 2008.

“Most of our counterparties are major and well-capitalised banks and I don’t feel there is much risk in dealing with them,” explains Paulson. “We’ve always been concerned about counterparty risk, but we believe that risk has lessened. Banks are much better capitalised, have higher levels of equity and have reduced the riskiness of the assets they own. However, that is not to say one should be complacent about counterparty risk. You need to know who you’re dealing with and ascertain creditworthiness.”