Before he began his investment career, John Paulson accumulated academic distinctions
Before he began his investment career, John Paulson accumulated academic distinctions. He was Valedictorian of his class at New York University’s College of Business and Public Administration and received his MBA from Harvard Business School as a Baker Scholar, the school’s distinction for the class’ top students. After a stint as a management consultant with the Boston Consulting Group, he joined Odyssey Partners as an Associate and moved on to Bear Stearns in 1984 where he became a Managing Director in mergers and acquisitions. In 1988, he became a general partner of Gruss Partners. In 1994, he started Paulson Partners L.P., and in 1996, Paulson International Ltd., a companion offshore fund. In 2001, the firm launched a leveraged version of its funds. Based in New York, Paulson & Co. currently manages $700 million and is up over 12% net for the first six months of 2003. John Paulson spoke with HFN publisher, Antoine Bernheim in July 2003.
Profile of John Paulson
Born: New York City, 1955
Education: B.S. New York University, MBA Harvard University
Family: Recently married with a 10-month old daughter
Last vacation: Bel Air/Malibu, California
Last book read: “Roman” by Polanski
Hobbies: Art, Sports, Socializing
Favorite quote: “Never give up. Never give up. Never give up.” -Winston Churchill
How he best describes himself: Loving father, devoted husband.
Q. Could you describe your approach to risk arbitrage?
A. 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.
Q. Could you describe how trading opportunities in risk arbitrage have changed over the last ten years?
A. 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.
Q. Could you describe your research process?
A. First, one of our analysts screens the tape for any new deals that are announced. Once a deal is announced, we do a detailed financial analysis. We examine the performance of the company, its growth in sales, EBITDA, net income and earnings per share; we compute the merger multiples to EBITDA, EBIT and net income; we look at the size of the acquirer vis a vis the target, and the premium being paid. We then make an overall assessment of the financial merits of the deal. Generally, we look for healthy companies being purchased at reasonable multiples without excessive premiums. The second stage of our research is to participate in the management conference calls; review the Wall Street research, SEC filings and the merger agreement. In our review of the merger agreement, we look for any unusual conditions to the merger such as due diligence, financing, business or regulatory conditions. We are basically looking for solid merger agreements with minimal conditions. We also examine regulatory issues that could affect the timing or the ultimate approval of the transactions. We have very good outside antitrust counsel and we have a in-house lawyer to look at any legal issue that may affect the outcome of a transaction. Generally, the focus of our research is to eliminate deals that are riskier and have a lower probability of being completed. We look at the remaining lower risk deals on a return basis and we try to focus on deals with lower risk and higher potential returns.
Q. Could you describe the structure of your portfolio?
A. We diversify across cash deals, stock deals and cash-and- stock deals. We tend to be in about thirty to forty deals at any given time. In 1999, we invested in about 180 deals during the course of the year. Last year, it was about 125. Our average position size is around 3%, and for a low risk deal with higher potential returns, we may go up to 8% or 10%. We generally don’t use much leverage, which we define as longs to equity. On average, it has been one to one. During the past couple of years, it has been around 0.75 and it has been as high as 1.35 depending on the number and attractiveness of opportunities.
Q. What are your risk management tools?
A. We look at deal risk and portfolio risk. We divide deal risk into macro risk and micro risk. Macro risk would be how major market moves could impact the portfolio. For instance, if markets were to fall sharply or interest rates were to rise, we stress-test the portfolio to see what impact that could have on performance. Generally, we try to minimize the impact of market risk by being fully hedged on the merger arb positions and by eliminating deals that have financing contingencies, market-outs, walk-away clauses or other type of market related outs. The micro risks are those risks pertaining to any particular transaction that could affect the chance of a deal breaking. These could include the earnings stability of the target, financing, legal or regulatory hurdles, taxes, timing and potential accounting issues. We also look at the premium being paid and the potential downside in case the deal is not completed. Portfolio risk includes such things as average position size, top five or ten positions, number of positions, allocation between cash and stock deals, allocation between the US, Canada and Europe, allocation across different market capitalizations, currency exposure, liquidity issues, and sector concentration. We have specific guidelines on all our risk parameters that we maintain on a real time basis to manage the portfolio.
Q. What is your approach to cutting losses when a position goes against you?
A. Many arbitrage deals will experience some volatility in the spread from the point of announcement to the point of closing. The arbitrageur needs to evaluate why these spreads are widening and make a judgment as to whether it is a temporary overreaction or serious risk. Ninety percent of the times, those temporary fears are overblown, the issue is favorably resolved, the spread comes back in, and the deal closes. Our reaction would depend on our evaluation of the risk, the size of our position, and the potential downside. Generally, while it is important to reduce exposure or close out the deal if the risk is serious, it is equally important not to panic.
Q. In managing money for ten years, what have been your worst experiences and what have you learned from them?
A. The only year when we lost money over the past nine years was 1998 when we lost about 4%. We got caught in August 1998 in the Long Term Capital debacle when we had too great an exposure to event arbitrage situations. When we analyzed where we had losses, we found that most of the losses were confined to the event arbitrage portfolio. Since then, we have reduced or eliminated our event arbitrage portfolio as a way to reduce our correlation to market downturns and we have had much less volatility, and far greater protection of investor capital in market downturns. For example, we were profitable in each of 2000, 2001 and 2002 even though all the major market indices declined.
Q. Can you describe your organization?
A. We have nine people, including three analysts, a trader, a trader’s assistant , a controller, an office manager and a director of marketing. (Two of our analysts have M&A backgrounds, Andrew Hoine who came from JP Morgan and Michael Waldorf who came from CSFB.) We are contemplating hiring a compliance/risk management officer. Our goals are to continue to grow our asset base and remain focused on the merger arbitrage area. We think merger arbitrage is a very attractive long term alternative investment strategy and can produce good returns, with low volatility and minimal correlation. We want to be one of the top performers in our category. u