John Paulson’s Very Bad Year

By Sheelah Kolhatkar


John Paulson, the founder of Paulson & Co., one of the world’s largest hedge funds, has close-cut black hair, dark eyes, and a soft voice. There’s a fuss when he arrives, befitting a man who made one of the biggest fortunes in Wall Street history, as his general counsel and PR consultant jostle for seats next to him. Paulson’s decision to buy credit-default insurance against billions of dollars of subprime mortgages before the market collapsed in 2007 earned him almost $4 billion personally and transformed him from an obscure money manager into a financial legend. Then came the kind of disastrous run that can unmake a career. In 2011 he lost billions.

“We clearly stumbled last year,” Paulson says. “We became overconfident as to the direction of the economy and took a lot of risk.”

On this June afternoon, Paulson, 56, sits in his midtown Manhattan offices, surrounded by his dozen or so Alexander Calder watercolors, which serve as a kind of millionaires’ wallpaper in primary colors. The space is not the high-tech cockpit one imagines for a financial wizard at the levers of the world’s money flow. Rather than wall-to-wall monitors and global heat maps, it’s all cream carpeting and beige walls and looks like it could belong to any boutique real estate firm or law office, albeit one with a compulsive neat freak at the helm. Relatively speaking, it’s a soothing place to confront questions about the incredible power and wealth one can amass on Wall Street, even as the rest of the economy struggles; the controversial means sometimes used to achieve it; and how it’s possible to lose so much money so quickly.

Persuading Paulson to discuss these issues is not easy. “I avoid the media,” he says, which is an understatement. While many people beyond finance have heard his name, he has never given a television interview, and he says people rarely recognize him on the street, which he appreciates. Although, he adds, “I’m not sure that actually helps me. Not participating might make the media more interested.”

After his success in 2007, the amount of money in his funds grew to more than $30 billion. Things went swimmingly until 2011 came along. His two largest funds, Paulson Advantage and Advantage Plus, lost 36 percent and 52 percent that year, and the red streak has continued into 2012, with Advantage and Advantage Plus down 6.3 percent and 9.3 percent as of the end of May.

Paulson is trying to project optimism. “I think we’re back on track,” he says, “and I’m actually quite excited about our portfolio.”

Flanked by his jumpy colleagues, Paulson drums his fingers frantically on the table as he talks, suggesting someone who feels his time would be better spent doing pretty much anything else. He sits back in his seat and stops drumming and banging for a second. “Sometimes it’s difficult to interpret the markets, so we’re not going to play a winning hand every day. Our goal is not to outperform all the time — that’s not possible. We want to outperform over time.”

Not everyone is willing to wait. One institutional investor, whose firm withdrew its money from Paulson’s funds in 2011, says that most hedge funds follow a familiar developmental pattern. During the first stage, funds often improve quickly, but they’re also small and therefore difficult for large institutions to invest in. The second stage is when the fund’s managers are working hard and have shown some success; that’s when the upward curve is steepest, and the most astute investors get in. Stage three, which the institutional investor called “cresting,” usually comes after the fund has become quite large and performance starts to drop off. “By stage four, they are starting to buy baseball teams and those kinds of things,” says the investor, who asked not to be identified because it might affect his company’s relationships with other fund managers. “It’s not always the case, but we found that with those stages, performance is usually not as good as it was earlier.” The investor adds, “I think for us that was a danger. We consider them a three or four — we knew they definitely weren’t a one or two.”

Paulson acknowledges that he and his firm made mistakes, underestimating the crisis in Europe and trying to ride an economic rebound that never came rather than maintaining the more conservative strategy he was previously known for. He says that he’s turning things around and that people who are giving up on him are making a mistake. “We had built up a great track record — in 18 years, we only had two down years, one of which was last year,” Paulson says. “That drawdown was disappointing, but you can’t think about the past. You have to think about the future.”

In the early days, the hedge fund industry was a cul-de-sac of nerds and misfits who didn’t care for the sclerotic politics of the big investment banks. Hedge funds are investment pools that cater to the wealthy and typically charge 1 percent or 2 percent of assets as a management fee and 20 percent of the annual profits. The moneymaking potential can be enormous. As Sebastian Mallaby points out in More Money Than God: Hedge Funds and the Making of a New Elite, Goldman Sachs paid its chief executive officer, Lloyd Blankfein, $54 million in 2006, which seems crazy enough. But the same year the lowest earner on Alpha magazine’s top-25 hedge fund list made $240 million. Many funds that began as mini-rogue states in the 1990s, whose managers wore flip-flops to work, have grown into slick multibillion-dollar operations that resemble the same investment banks they broke from.

After a middle-class upbringing in Queens, a degree from New York University, and a distinguished showing at Harvard Business School — he was a Baker Scholar, in the top 5 percent of his class — Paulson set out to join the ranks of the incredibly rich. He worked briefly at Boston Consulting Group and then with a firm called Odyssey Partners, where he helped assemble leveraged buyouts. In 1984 he took a job at Bear Stearns as an investment banker, then four years later left for investment firm Gruss & Co. By 1994, Paulson had enough money to go out on his own.

He started Paulson & Co. with $2 million of his own and family and friends’ capital. His focus was risk arbitrage — the plodding, almost dorky, method of betting on the shares of merging companies. Arbitrageurs are a group of opportunists generally resented by company managements, and their strategy is simple: Wait until one company announces that it’s buying another, rush to purchase the target company’s shares, short the acquirer’s stock (unless it’s a cash deal), and then earn the differential between the two share prices when the merger closes. It is one of the most conservative investment strategies, where profits and losses have little to do with the rest of the market. There are no derivatives and no fancy computer programs involved. Sometimes the amount earned is as little as 10¢ a share, but if done enough times and with leverage, it can add up to something respectable, if not spectacular. The risk is that a deal might not actually happen as expected, because of some regulatory hurdle or the poor performance of one of the companies. If a merger falls apart, the two companies’ stock prices usually move away from each other, potentially creating massive losses.

Paulson became known as one of the more aggressive of the “arbs,” trying to ferret out deals that were likely to escalate into bidding wars or even divine which companies might get taken over. When his small firm was one of a dozen or so tucked inside 277 Park Ave. in New York City, where I used to work at the hedge fund next door, he tended to charm and crack jokes when encountered in the hallway. At the same time, he was known to deal poorly with disappointment: On occasion, after a particularly difficult day in the market — when cigar smoke could be detected coming from the short-only fund across the hall — you could hear Paulson yelling at one of his analysts for blowing a trade.

His fund did well, growing to $300 million in assets by 2003. He married his assistant Jenny, had two daughters, and raised more money. When asked today what he thinks made him so successful, Paulson says that it was a “secret sauce” of “experience, focus, smarts, and desire.” That and his ability to find what he and his marketing folks like to call “asymmetrical trades,” where there is great profit potential and little risk.

Over the course of 2005, 2006, and into 2007, at the urging of an analyst named Paolo Pellegrini, Paulson looked into shorting the inflated national real estate market. Pellegrini crunched data and educated himself and his boss about credit-default swaps, then an obscure contract one could buy to insure the value of bonds, which presented one of the few ways to

profit from a potential decline in housing prices. Paulson fended off skepticism and even hostility from investors who were confused about what he was up to as he built up huge positions against billions of dollars worth of mortgage bonds, a play that formed the basis of the book, The Greatest Trade Ever, by Gregory Zuckerman. It took some time before the crumbling real estate market translated into hard profits, but it finally did: In 2007 the firm earned approximately $15 billion across all of its funds, 20 percent of which Paulson got to keep for himself and his employees.

It was a performance one would be hard-pressed to repeat. “We were only able to do that because it was a very asymmetrical return, so we could take a very large position, and if we were right it could produce extraordinary profits, but if we were wrong, we’d barely notice the cost of the premium,” Paulson says now. “Those types of investments don’t come around very often.”

Paulson may have a rare analytical gift, but he is either unwilling or incapable of turning it on himself. When asked what it was like to go from being an unknown investor to a semi-celebrity, he pauses for what feels like a long time. He then starts banging his hands loudly on the table in front of him and lets out a huge sigh. “How would you answer that?” he says, turning to the two men next to him.

“I don’t think you’ve changed or the firm’s changed,” his PR consultant says hesitantly.

Paulson pauses again. “I’m not sure how the visibility felt,” he says, “but achieving our investment goals for ourselves and our investors felt great.”

The fund continued to make money in 2008 and 2009 as Paulson bought up distressed debt in financial companies and bank and insurance stocks. Resentment also started to build around him. He was asked to appear before Congress with other hedge fund managers, where members of the House Committee on Oversight and Government Reform demanded to know how he had made so much money as the economy was falling apart: “You make a billion dollars, yet your [tax] rate can be as low as 15 percent,” said Representative Elijah Cummings (D-Md.) at one point. “Do you think that’s fair?” Paulson, looking annoyed with his arms crossed defensively, said, “I believe our tax situation is fair,” before suggesting that teachers and plumbers could buy stocks and enjoy the same lower long-term tax rates that he does.

By 2010, Paulson’s was one of the largest hedge funds in the world, with $32 billion spread across five strategies. In part this was the result of a rush of new investors, but it was also because of the growth of the firm’s own employees’ money — including Paulson’s — which he says now makes up almost 60 percent of the assets under management.

Size can be a handicap, as Warren Buffett seems to note every year in his annual letter. “Clearly, the bigger you get, the harder it is to generate alpha,” says Jim Liew, a professor of hedge fund strategies at New York University’s Stern School of Business, referring to the ability of a fund to outperform the market as a whole. “If you look at the largest 10 hedge funds, five of them won’t be there in 10 years. It’s that difficult to stay at the top.” Steven Cohen, the head of the giant hedge fund SAC Capital Advisors, acknowledged as much in a 2010 article in Vanity Fair when he said, “We’re not going to generate those larger numbers now that we are bigger.” Paulson counters that his fund had more than $30 billion from 2008 through 2010, some of its best years. “I don’t think it makes any difference at our current size,” he says.

On April 16, 2010, the Securities and Exchange Commission brought a suit against Goldman Sachs over the way that it had marketed a collateralized-debt obligation called Abacus that was tied to a group of subprime residential mortgages. In 2007, the SEC alleged, Paulson had suggested mortgage securities he felt were likely to experience “credit events,” and Goldman had bundled them together and sold them to other investors without telling them that Paulson had helped select the securities or that he had done so to profit from their decline. Paulson paid Goldman $15 million for putting the deal together, and investors such as foreign banks IKB Deutsche Industriebank and ABN Amro and New York insurance company ACA Financial Guaranty allegedly lost a total of $1 billion. (Goldman paid $550 million to settle the claims and said that it should have disclosed Paulson’s involvement to investors, according to an SEC press release.) Paulson and his firm were never accused of any wrongdoing, but the case did little to help his profile. According to a person familiar with Paulson’s thinking at the time who asked not to be identified, Paulson and his team were incensed over being implicated in the SEC’s case at all. “Paulson is not the subject of this complaint, made no representations, and is not the subject of any charges,” Paulson said in a statement at the time. “Paulson did not sponsor or initiate Goldman’s Abacus program.”

Paulson himself entered 2011 feeling sure of himself. He boasted in an investor letter about generating $8.4 billion in gains, before fees, for investors in the previous year, and he was dashing off op-eds telling the world what it should do to fix its economic problems (“Europe needs a firewall to stabilise markets,” read one exhortation in the Financial Times). He felt that he was within reach of his lifelong goal of becoming one of the greatest Wall Street moneymakers of all time.

Paulson had made his fortune through clever yet limited investments. But now he started making riskier gambles. His funds built up large holdings of bank stocks, such as Bank of America, Wells Fargo, JPMorgan Chase, and Capital One; gold mining stocks, which were expected to increase in value in the face of inflation; and bonds of either the high-yield or distressed variety. One snapshot of the firm’s growing presence in the debt markets came in Paulson & Co.’s 2010 year-end report, which identified newly promoted partner Brad Rosenberg, global head of fixed-income trading, as having traded over $100 billion of fixed-income securities. But most of the firm’s big “macro” investments performed poorly as the market gyrated and the European economic crisis worsened.

Paulson’s investment in Sino-Forest, a Chinese timber company that traded on the Toronto Stock Exchange, was a herald of disaster. According to a June 2011 memo Paulson sent to his investors, he became interested in Sino-Forest in 2007 after reading a Bloomberg News article suggesting that the company might be taken over. There was no dipping his wingtip in: By May of 2011, Paulson’s Advantage funds were the largest shareholders in Sino-Forest, with 31 million shares, or 12.5 percent of the company. In June, Carson Block, a short-seller who runs a firm called Muddy Waters Research, issued a negative research report on Sino-Forest, questioning the company’s financial statements and accusing it of pretending to own forest lands in China that it didn’t. Sino-Forest denied the allegations. The stock plummeted.

Paulson scrambled to get out of his entire position that month, and the fund realized a loss of C$106 million (about the equivalent in U.S. dollars). In May 2012, the Ontario Securities Commission, Canada’s primary financial regulator, filed fraud charges against Sino-Forest. A former Paulson investor named Hugh Culverhouse Jr. has since filed a lawsuit in U.S. District Court in Miami, alleging that Paulson & Co. did not conduct proper due diligence before making the investment. “We firmly believe that the lawsuit is completely without merit and that there is no basis in law or fact for the action,” Paulson’s firm said in response.

A number of Paulson’s investors who had piled into the fund after 2007 have liquidated their holdings, including the Public Employees Retirement Association of New Mexico, the nonprofit Ascension Health, the Philadelphia Board of Pensions and Retirement, and several hedge funds that invest in other hedge funds. “We know that about investing with John Paulson. He makes macroeconomic calls,” says Joelle Mevi, the chief investment officer of the New Mexico PERA. “[But] we started to notice a consistent underperformance of the fund, and we were noticing a bit of style drift” — investor-speak for getting into areas outside one’s expertise. And, Mevi says, “The Sino-Forest issue was notable.”

“If you’re going to come in and then leave, come in and leave, I don’t think you’ll reap the benefits of investing with us,” Paulson says. “Investors that do the best, and have done the best, are those that stay and compound at above-average rates over the long term.”

As 2011 ground on, millions of Americans lost their homes, and debates about economic inequality and the paychecks of Wall Street speculators simmered across the country. Paulson, who had accumulated a $24.5 million house in Aspen in 2010 and a $41 million spread in Southampton in 2008, became a symbol of the much maligned 1 Percent — more like 0.001 Percent, in his case. Last fall his 28,500-square-foot Upper East Side townhouse on East 86th Street, which he purchased for $14.7 million in 2004, was visited by Occupy Wall Street, which included him on a list of targets along with News Corp. Chairman Rupert Murdoch, Koch Industries head David Koch, and JPMorgan Chase CEO Jamie Dimon.

When he’s asked what it was like to have his townhouse picketed, Paulson displays more emotion than at any other time during our talk. “I think it’s somewhat misguided,” he says, growing agitated. “We pay a lot of taxes, especially living in New York — there’s an almost 13 percent city and state tax rate. ... Most jurisdictions would want to have successful companies like ours located there. I’m sure if we wanted to go to Singapore, they’d roll out the red carpet to attract us.” He goes on, “We choose to stay here and then, you know, get yelled at. I think that’s misdirecting their anger at the wrong place.”

The Paulson funds ended the year in the red. It is difficult to identify the exact amount of money lost, but according to Paulson’s investor reports, his funds had $13.2 billion less in assets at the end of 2011 than at the end of 2010. But while Paulson experienced one of the worst dollar-losses in hedge fund history, his fund’s $22.6 billion gain over its lifespan was still the third-highest for investors, according to LCH Investments. According to Forbes, Paulson’s net worth is $12.5 billion, down from a peak of $16 billion in March 2011.

The 101-page report that Paulson sent to his investors at the end of the year took a humble tone. The firm had made four major mistakes, according to Paulson, “overweighting long event equity,” underestimating Europe’s debt crisis, overestimating the U.S. economy, and some plain-old terrible stock picking. “Our performance in 2011 was clearly unacceptable,” he wrote. “However, we believe 2011 will be an aberration in our long-term performance.”

On May 16, Paulson appeared for the first time at the Ira Sohn investment conference, an annual ritual in which celebrated fund managers present ideas for the sake of a children’s charity. In rock concert style, the agenda tends to be backloaded, with the best-known acts coming on later — thus Paulson was almost last, at 5 p.m. The crowd at Avery Fisher Hall in Manhattan’s Lincoln Center noticeably thickened before he took the stage, which he finally did in a gray suit. In his quiet, even voice, he walked the audience through several investments.

One was Caesars Entertainment, a casino owner in which Paulson is the second-largest shareholder, with 9.87 percent of the shares outstanding. Another was CVR Energy, a gas-refining company in which Paulson built up a 9.9 percent stake before it was bought out by Carl Icahn. The third investment was AngloGold Ashanti, a global gold mining company in which Paulson is the largest single shareholder, with 33 million shares. “The stock has not been a good performer,” he conceded at the conference, before urging everyone in attendance to buy in. “The share price hasn’t correlated with the gold price.”

Gold is Paulson’s biggest, boldest — and most simplistic — idea in several years: The wild volatility of many gold stocks is part of the reason for the continuing slide in several Paulson funds. In addition to the Paulson Gold Funds, launched in 2010, almost a which were launched in 2010, almost a quarter of the Advantage funds were invested in “gold event” in 2012, according to investor communications. When Morgan Stanley Smith Barney sent an internal memo to its financial advisers on April 17 announcing that it would not accept any more investments for the Paulson Advantage funds through its HedgePremier platform, gold was cited as an area of concern. “During 2011 and into 2012 ... the Manager has made a number of market timing errors,” the memo read. It added that the fund seemed far too concentrated in gold-mining stocks: “The Funds’ near-term performance is largely dependent upon a single sector that has generated negative results throughout 2011, and again in 2012. ... There does not appear to be an obvious catalyst for reversal in the near term.”

“We view gold as a currency, not a commodity,” Paulson says. “Its importance as a currency will continue to increase as the major central banks around the world continue to print money.” He adds that as the market keeps shuddering, demand for gold will stay high, and soon enough all of his depressed gold holdings should shoot up. He also thinks that anyone in Greece, Italy, and France should pull all their money out of the banking system and purchase gold bars before the Continent collapses.

Paulson says he’s trying to get out of the fortune-telling business and that his funds are now much less dependent on reading the economic future: “We’ve gone back to our traditional strategy, which is operating with smaller amounts of net exposure, and hedges in the portfolio.” There are hints that it may be working. After a brutal April, the downswing in his funds leveled off in May, although his gold fund continued to slide. His general views on the U.S. economy would seem to echo what some investors may be feeling about their Paulson holdings: It’s “doing OK, but it’s not as strong as people would like.”

Now that he does indeed have more money than God, Paulson is casting about, trying to figure out how to best deploy his influence. Like many a Wall Street billionaire before him, he is wading into politics: He and his employees have been contributing heavily to House Speaker John Boehner, and in 2011 he personally donated $1 million to the pro-Mitt Romney super PAC Restore Our Future. On April 26, Paulson hosted a fundraiser for the GOP presidential candidate at his New York townhouse.

Less than two weeks later, media outlets reported that he’d spent $49 million purchasing two more properties in Aspen from a Saudi prince, including a 90-acre plot with a 15-bedroom, 16-bathroom palace on it. The 56,000-square-foot main building, which Paulson says he plans to downsize, is larger than the White House and includes horse stables and a water-treatment plant. At one point it had been considered the most expensive private residence for sale in the country, but Paulson acquired it well below its original $135 million asking price.

He’s ruled out the possibility of a Paulson & Co. initial public offering any time soon — “I don’t think hedge funds belong as public companies” — but he says he’d be “very happy” to see the firm continue after he retires. Which won’t be anytime soon, by the way. “I’m still relatively young, you know, being 56,” he says. “If you look at Soros — he’s 81, I think. Buffett, he’s 81. ... How old is Icahn?” Even though he could easily stop working, he can’t imagine it. “Some people like playing chess, some like backgammon. This is like a game, and playing games is fun,” he says, dispensing with any niceties about serving his clients. “It’s more fun when you win.”


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