Best hedge fund

PAULSON & CO: Paulson’s success is no flash in the pan but based on a rigorously researched devotion to merger arbitrage, distressed and other event-driven strategies

“The better hedge fund managers will survive and ultimately the industry will recover and return to growth” John Paulson, Paulson & Co

The hedge fund industry suffered its worst year on record in 2008, with the average fund losing 18.3%. Not so for John Paulson. In 2007, his credit opportunities fund returned 590% on sub-prime plays, and the industry wondered if he had just got lucky. But the performance in 2008 quieted the naysayers: Paulson’s Advantage Plus fund returned 37.6% net of fees, and all six Paulson funds returned more than 7.9%. Into 2009, the positive streak has continued. The firm now manages about $27 billion in assets. In the Advantage Plus fund, Paulson’s strategy was to short financials. Paulson says: “While 2007 saw a shutdown of the structured finance area and a collapse in the prices of many asset-backed securities, 2008 saw the crisis spread to the financial institutions most involved in those troubled assets and then to the broader economy. The problems in the financial sector were very apparent to us and we just followed the progression as they started with sub-prime mortgages and then eventually spread throughout the financial system.” Eight of the top 10 financial institutions highlighted by Paulson for shorting either failed, were recapitalized by the government, or were sold off to other banks as part of government-backed transactions. Among those were Freddie Mac and Fannie Mae, and short positions in HBOS, Lloyds TSB, Barclays and Royal Bank of Scotland were also disclosed over the year.

Although in 2008 the credit fund did not come near the 590% return of 2007, it did achieve 18.8%. By comparison, the HFRI credit arbitrage index, which measures the average return of a strategy, lost more than 6%. In Paulson’s end-of-year letter to investors, he says the best decision the firm made was to resist the temptation to go long any type of credit investment for most of the year. Instead, the firm remained short credit by purchasing CDS protection on various financial institutions and by allowing its remaining sub-prime positions to fall in value. As spreads widened and the prices of underlying securities fell, Paulson’s fund realized gains on its CDS positions.

Over 2009, Paulson has remained short financials and has also been focusing on long distressed opportunities in mortgages, bankrupt debt, distressed debt and capital restructurings, as well as having a slight short exposure to equity markets.

Paulson’s continued bearish views are contrarian to many in the market who feel that the crisis has bottomed, and that markets are now recovering. But, he explains: “[While] the massive US fiscal and monetary stimulus will prevent the US from sinking into a deeper recession, these policies will likely create other problems with deficits, borrowing limitations, higher taxes and potential future inflation. Ultimately, the deleveraging process the US must go through will likely lead to a decade of slower growth and reduced economic influence in the world.”

Just how Paulson seems to be the only hedge fund manager making money has onlookers perplexed. Paulson attributes the firm’s success to its focus on a small area of the market, namely merger arbitrage, distressed and other forms of event investing. Paulson’s background is in mergers and acquisitions, a speciality he pursued at both Bear Stearns and Gruss Partners. With little activity in M&A last year, it was harder to make a merger arbitrage strategy work. However, on one deal Paulson had the largest profit he’d ever earned on a spread deal in history. “The spread in InBev’s $70 per share all-cash acquisition of Anheuser Busch widened in October to over a 90% annualized rate. The market had mispriced the risk of the transaction, creating a strong buying opportunity,” explains Paulson to investors. The firm aggressively added to its position in October, with its funds becoming the largest shareholder of Anheuser Busch. When the merger closed in November at an agreed price of $70, Paulson took its profits.

While other funds have broadened into strategies unfamiliar to them, it is perhaps Paulson’s focus on his specialist areas of expertise that has kept his funds well and truly in the game. Paulson himself is modest and attributes the firm’s success to the research edge developed by its employees.

“We also have a broad-based ownership structure where almost all employees share in the success of the firm, creating a strong team culture where our interests are all mutually aligned,” he says.

With few competitors now in the hedge fund industry able to match his success, questions abound about the future of so-called alpha-generating funds. Paulson disagrees that the industry is doomed. “It is going through a correction, as are all segments of the financial industry,” he says. “However, there are many talented, highly capable, managers out there who have proven themselves over time. While the industry is consolidating, the better managers will survive and ultimately the industry will recover and return to growth. Hedge funds provide a valuable alternative to long-only strategies and for that reason I believe they will be a permanent part of the investment landscape.”