Elliott Associates' aggression captures low-risk returns
Elliott Associates' founder Paul Singer learnt the hard way that good investment returns can only be achieved consistently if hedging is rigorously applied and opportunities to add value ruthlessly pursued. Felix Salmon reports.
NEWS CLIPPINGS ABOUT Elliott Associates suggest that it is a super-aggressive vulture investor. It picks fights with major corporations (Procter & Gamble), US federal court judges (in a high-profile asbestos case), and even entire nations (Peru). Anne Krueger, the first deputy managing director of the IMF, has denounced the fund, alleging that it has undermined the entire structure of sovereign finance.
Ask its investors about Elliott, though, and you'll get a very different story. Over the course of its 27 years of managing money, Elliott has never returned more than 25% in any given year; its compound annual return is a respectable 14.1%. The fund is so cautious that some investors left during the stock market bubble, seeking higher returns from more aggressive managers. They generally returned, chastened, after the bubble burst.
Sophisticated investors tend to be particularly impressed by Elliott, whose proudest achievement is that over the course of its history it has outperformed the S&P500 by 130 basis points, while having only one-third of the index's volatility. It's an extremely impressive low-risk, moderate-return fund. Larry Simon, the founder of Ivy Asset Management and a very early investor in Elliott, says that Paul Singer, Elliott's founder, "is in the pantheon of risk-adjusted investment managers that I know of".
That said, the headlines aren't necessarily wrong about the fund's aggressive approach. Elliott is a highly conservative hedge fund, but it does seek out situations where it can make money by pursuing legal strategies in markets worldwide.
Like a professional limit poker player, its ability to make relatively modest but consistent returns is a direct consequence of its fearlessness in situations where it has a great deal of experience and expertise.
Singer rarely grants interviews. He is a cautious and private man, and was very concerned that this story be about Elliott rather than about him personally – he was adamant that he did not want his photograph taken. In truth, though, there are few, if any, differences between Elliott and Singer. The company is born of the man, and the man was born of the brutal bear market from 1968 to 1974.
Singer graduated from Harvard Law School in 1969 with a strong interest in the markets. He read a lot of books, was open to investment ideas, and tried out various investment strategies while pursuing a career as a lawyer. None of them worked. It was just as well he had a day job: he lost a lot of money, both for himself and for his family.
It was an expensive, yet effective, education. "From 1968 to 1974, investors were run over by a series of unpredictable moves culminating in a crushing bear market," he says. "Risk consciousness was seared into my mind as a result of my experience during that period."
Pioneer of market-neutral investing The entire philosophy and history of Elliott Associates was, in a sense, written before it was even founded. Singer will never forget how gruesome markets can get, and one of the few places that his name can be found in the public domain is as the author of a chapter on risk control and risk management in an Institutional Investor book on hedge fund strategies.
He looks carefully at every kind of risk a hedge fund manager faces, from obvious ones such as leverage to much less obvious ones like hubris. Since September 11, Singer has been ever more attuned to large event risk: the kind of thing that is incredibly difficult to hedge.
The experience of the bear market led Singer to seek out trades that made money no matter what the rest of the market was doing. Virtually all hedge funds call themselves "market-neutral", of course, but Singer was one of the very first to actively hedge his positions on behalf of investors.
It all started with the publication of a couple of books on convertible arbitrage in the mid-1970s. Singer was working as a lawyer at Donaldson Lufkin & Jenrette Real Estate at the time, and managing his family's money on the side in his spare time. He started buying convertible bonds while shorting the underlying stock, and found that it really worked: he was making money in up markets and in down – nothing spectacular, but certainly a good steady income.
This was at the very beginning of the options market, when no-one really knew how to value the securities that were being traded on the brand-new Chicago Board Options Exchange. "Markets were primitive; we were primitive," says Singer, with hindsight. But in fact he was ahead of the curve all the time.
At no point did Singer plan a career as a major hedge fund manager. He never went out and marketed his new fund at inception: it was born much more gently than that. Essentially, Singer, together with his first large client, negotiated some of the first short-sell rebates with such brokerages as Merrill Lynch and EF Hutton.
Before he came along, you could borrow stock from the brokerage, but when you sold it, you had to give the proceeds back to the bank as collateral, and they kept the interest on that cash. Singer was among the very first independent investors to persuade the banks to let him keep a chunk of the interest, thereby essentially giving birth to a whole new asset class.
"Elliott was formed because we were able to get that deal," says Singer: it was now possible to sell stock short as part of complex related-securities arbitrages, rather than simply as a bet on it going down.
Better than being a lawyer After that, the business maths was relatively easy – certainly easier than the Fischer Black options pricing model he was using. If he aggregated all the money that he was managing for his family, friends and clients anyway – it came to $1 million in total – Singer worked out that the management fee on those funds would roughly equal his salary as a lawyer. Since investing was always where his heart had been, he took the plunge and formed the company, giving it his middle name.
In 1977, you could set up a hedge fund with almost nothing in the way of expenses. At the beginning of his money management business, Singer's back office consisted of his mother reconciling tickets; Elliott's first full-time employee did not come on board until 1979.
Singer won't say directly how much he is worth, but he will say that he, his family and his employees are the largest single group of investors in the fund – and Elliott now manages some $3.8 billion. That's a big selling point: Ivy's Simon says that people invest in Elliott because of its "integrity, ethics, long track record, and the amount of personal capital that is invested alongside their own". Right from the beginning, Elliott has been by far the Singer family's greatest investment.
So from day one, Elliott was dedicated to making consistent, modest returns above all. It has always spent an inordinate amount of time and effort hedging positions, ensuring that anything that can go wrong won't hurt it too much. "We knock ourselves out for a lower return with a higher effort," Singer says.
The first 10 years were good ones for Elliott: consistently profitable, with four of those years seeing growth of more than 20%. But then came the event that turned Elliott from what was essentially a trading shop into something a lot more distinctive: the 1987 crash.
Singer remembers the experience vividly. "We lost only 3.5% that quarter, and were profitable for the year, but it was a pretty horrifying experience seeing how illiquid convertibles traded in a period of intense market adversity," he says. "To me it was a datapoint and a wake-up call."
It didn't happen overnight – nothing does in the world of Elliott – but Singer decided at that point that he was going to start moving out of trading operations and related-securities arbitrage (although those would remain a large part of what Elliott does) and into more of what he calls value-added investing.
"We like to create value rather than merely identify it," explains Singer. "If we just identify value, we can't make money unless the market moves the security in the predicted direction."
Instead, Singer and his team look for situations where they can roll up their shirtsleeves, do some hard work, and play an active role in creating money. These days, those situations often seem to be in the world of distressed debt, and it's as a distressed investor, much more than in the world of convertible arbitrage, that Singer and Elliott are best known.
Now that Elliott is solidly in the ranks of the largest hedge funds, it's more than capable of buying up significant chunks of companies' debt – thereby placing itself in a leadership role in the workout process – while still staying diversified.
Elliott's most famous distressed-debt investment is certainly Peru, but in fact emerging-market debt has never accounted for more than 2% of Elliott's portfolio. The firm is much more likely to be found in the US bankruptcy courts, fighting for bondholder rights in cases like that of WorldCom.
Even so, in many ways the Peru case is typical. Elliott bought $20 million face value of Peruvian bank debt for $11 million, and then stayed out of the country's Brady plan. Eventually, after long and arduous litigation costing many millions of dollars, and following numerous unsuccessful attempts by Elliott to settle at a discount, Elliott got paid just over $58 million.
Elliott was much criticized while the Peru case was going on for being a hold-out. While all of Peru's other creditors took a haircut and moved on, Elliott was said to have used the fact that its own remaining obligation was relatively small to force the country to pay it in full.
In fact, all sovereign debt restructurings, from Ecuador to Ukraine to Uruguay, have had hold-outs, and all of the holdouts have been paid in full: in that sense, Elliott was not exceptional. What distinguishes the Elliott case was the sheer amount of work that portfolio manager Jay Newman and attorney Michael Straus, of Straus & Boies, put into the investment.
Peruvian negotiations The work started back in 1995, when Newman heard that Peru was buying back its own defaulted debt and understating its true level of foreign exchange reserves. The team at Elliott examined the situation, determined that Peru was getting away with paying its banks rather less than it ought, and held out for a better deal. They also, of course, judged their chances of being able to win a court case against a sovereign. When Peru refused to talk to Elliott, the court case began.
Elliott started badly, especially when the fund was handed down a notorious district court judgment finding that the debt was unenforceable because of a provision of New York law based on the ancient doctrine of champerty. Elliott appealed, and won in the end, after important institutions such as the Emerging Market Traders Association changed their minds on which way the case should be decided.
Following that victory, Elliott hired New York University law professor Andreas Lowenfeld to explain why their pari passu clause meant that bondholders couldn't be paid if Peru was in default to Elliott. They lobbied in Albany for a change in New York State law so that they could collect interest on interest.
And once they finally got their judgment, they took legal action in Canada, Belgium, Germany, Luxembourg, the Netherlands, and the UK, trying to attach any payment on Peru's Brady bonds before it reached the bondholders.
As Singer says, for most distressed debt investors "active involvement is considered a cost of doing business. To us, it doesn't go that way. Active involvement is a primary driver for Elliott. We start by asking whether we can get involved and create value."
Elliott is often misrepresented in the press, especially with regard to its actions in Peru. A recent wire report about Argentina litigation, for instance, said that in Elliott vs Peru, "bondholder Elliott Associates forced Peru to settle after a Belgian court laid down a broad definition of pari passu, setting the stage for Elliott to delay the restructuring".
This is wrong on several counts. Elliott wasn't a bondholder: it held bank loans, which include much greater creditor protections than most bonds. Moreover, no Belgian court laid down the broad definition of pari passu; it was the US court that did that and gave Elliott the judgment.
But the accusation that annoys Elliott the most is that of holding up Peru's restructuring process, wherein bank loans were swapped for Brady bonds. Elliott did no such thing. Although it did not participate in the Brady exchange, it was more than happy to see all of Peru's banks take part. Indeed, Elliott's holdout strategy only works when everybody else has already restructured and settled.
More recently, Elliott has got involved in two other high-profile cases. The first is in Germany. As competition among hedge funds heats up in the US, Elliott has found itself increasingly looking to Europe for opportunities. It has a large office in London, with about 20 people (there are roughly 90 at the New York headquarters), which is run by Jon Pollock, Elliott's number two investment professional.
Elliott at this point is a very long way from being a one-man shop. Indeed, it's fair to say that not only do most people who deal with Elliott never come into contact with Singer; often, they never even know who he is.
Singer, 59, has no plans to retire in the near future, but he does want Elliott to have a life after him, and has set up a solid management structure.
At the top is a five-man management committee including three risk managers. That's followed by the senior portfolio managers, the portfolio managers, the traders and the analysts.
Still, for the time being Singer is keenly aware of exactly what's going on in all of Elliott's big positions. In Germany, for instance, Elliott bought a large chunk of the preferred (non-voting) shares of shampoo company Wella after Procter & Gamble announced an agreed $6.9 billion takeover bid. P&G paid a huge premium for voting over non-voting shares: e92.50 compared with e65, to be precise. Until that point, no-one had considered the ordinary (voting) shares to be more valuable: in fact, they traded at a discount for liquidity reasons, since most of them were held by the controlling family.
Taking fighting spirit to Europe Elliott is now the largest single holder of Wella shares apart from P&G, and is waging a battle – which Singer estimates is likely to last for years if P&G doesn't give in – to get value for minority shareholders.
The fact that Elliott is taking such an uncompromising stance seems to have gone down well among other Wella preferred shareholders: only 40% of them took P&G up on its offer, compared with substantially all of the ordinary shareholders. In a development that Singer finds heartening, among the holdouts is massive German pension fund Deka: a sign that big names are beginning to fight for shareholder rights.
Such battles are rare in Europe, which is one reason why Elliott likes to get involved in this kind of situation there. "We don't see very many people willing to step up to the plate and stand up for their rights," says Singer.
What is more, he has been around so long that other shareholders can have faith that he will not give up or cut a side deal with the company concerned. "If we cut and run, it's bad for the group," he says, which might benefit Elliott in the short term, but would damage its reputation enormously in the long term. "People are respectful of us because we do what we say we'll do."
In Italy, for instance, Elliott became the first fund manager to successfully sue Consob, the Italian equivalent of the SEC. Again it was an issue of minority shareholder rights: this time in Fondiaria, an Italian insurance company. And arrayed against Elliott was not only the notoriously conservative Italian legal system, but one of the best-connected companies in the country, Mediobanca.
Elliott essentially contended that Mediobanca had gained control of Fondiaria without making the mandatory bid for minority shareholders that Italian law demanded. It was far from clear that Elliott was going to win. As one of its advisers, Erik Bomans of corporate governance advisory firm Deminor, says: "You have so little case law that when you go to court it's like playing in a casino. In Europe there's less transparency than in the US, and regulators are much less active."
That, of course, is much of the reason why Elliott is in Europe in the first place. The company makes money from the combination of complexity and opacity, from venturing into situations where other funds might fear to tread.
"We've gone out of our way to exert ourselves in areas where other firms would not and have not," says Singer.
And few situations are more complex, opaque and fearsome than anything connected with asbestos in the US. Elliott is the single largest holder of the bank debt of Owens Corning, a company driven into bankruptcy in 2000 by massive asbestos litigation.
The bank debt has guarantees from valuable Owens Corning subsidiaries, but the asbestos claimants are trying to toss out those guarantees. The bank debt holders are contesting the size of the asbestos claims and the tangled affair has been given to Federal district judge Alfred Wolin to sort out.
Elliott was unhappy with the judge's choice of staff, however. It turns out that two of his key advisers represent asbestos claimants in other bankruptcy proceedings. So in an extremely unusual move, Elliott filed a recusal motion, asking the judge to remove himself from the case. The motion has already been up to the Third Circuit Court of Appeals and back down again, and could well end up in the appeals court again if Wolin decides that he wants to stay on the case.
And this is not all that Elliott is doing to maximize the chances that it will manage to gain some advantage over the asbestos claimants. The company has also invested a lot of time, effort and money in Washington, lobbying for tort reform laws that would help its case.
"In the summer, we saw that efforts to find a legislative solution to the asbestos litigation crisis were gaining traction," says Singer. "We helped to form a financial industry coalition to support these efforts. We've tried to be helpful and creative, and we've invested a good deal of effort in the endeavour."
An interest in politics Such lobbying activities are certainly aimed at improving Elliott's bottom line, but they also mesh well with Singer's personal politics. He is a major donor to the Republican Party, and is listed as one of Bush's "pioneers" – people who promise to raise at least $100,000 in individual chunks of no more than $2,000 at a time.
In fact, there seems almost nothing in the way of contradictions between Singer's professional, personal and political lives. He's a very conservative man – in all senses of the word – who takes everything he does extremely seriously.
Singer has very little in the way of ego: he's quiet and unassuming, and you would never guess that the man in the sober suit with the well-trimmed white beard (he bears a passing resemblance to the composer John Adams) is one of the world's longest-standing and most successful investors. And for all his personal wealth, he seems to be driven much more by what he can do for his investors than what he can make for himself.
What is more, although he genuinely loves what he does, he never allows himself to be self-indulgent. At one point, Euromoney asked whether the unpredictable ups and downs of the court cases Elliott gets involved in, while nerve-racking, might not also be a little fun.
A look of utter incomprehension and astonishment passes across Singer's face. "Fun?" he asks. "Skiing is fun. This is work."
| Elliott Associate's annual returns (1977-2003)
cumulative data and comparisons to stock and bond market returns and volatility
|Source: PerTrac 2000, Lehman Brothers and Standard & Poor's|