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There are Calders everywhere. One Calder canvas anchors the west wall, one the east; a bronze Calder sculpture guards the windows facing north, high above midtown Manhattan. The south side could hold a Calder, too, but instead is dedicated to a glory wall of lucite deal toys and dusty pictures of the host and friends. The pictures invariably feature men who were, at the time of the photograph, more famous than the host. That is no longer true.
The host does not rush into the room. He saunters purposefully, if that’s possible. He is slight of stature, indulging in none of the weight that afflicts so many of his peers. His mien is dark: dark shoes, dark socks, dark suit, dark tie, dark hair, dark circles—although not as deep as they often seem on camera—under his dark, but not unfriendly, eyes.
The host shakes hands softly and alights upon a white couch under one of his Calders. He leans back, crossing his left leg over his right. He does not fidget. He seems neither happy to be here nor particularly annoyed. He takes a sip of bottled water, poured into a glass.
“So, let’s start,” John Paulson says slowly, because Paulson—the man who made billions in what arguably is the single most lucrative bet in financial history—wants to get this over with quickly.
What exactly “this” is remains a mystery. Unlike Dan Loeb (of Third Point) or Bill Ackman (of Pershing Square), Paulson’s hedge fund—the eponymous Paulson & Co.—does not rely on the media megaphone to move stock prices in its favor. If there were a spectrum of hedge-fund loudmouth-ness, Loeb, Ackman, and Carl Icahn would be on one end. Paulson would be on the other. And where Pershing Square and Third Point are really just legal entities for their founder’s egos, Paulson & Co. occupies a nebulous middle ground. It’s not an asset management firm in name alone, but neither is it an enterprise—like Ray Dalio’s Bridgewater Associates—that seems saddled with a legacy and intent on surviving indefinitely.
So why is John Paulson—quiet billionaire, legend—now opening his doors to the outside world?
“There are two different questions there,” Paulson begins, having sipped his water a second time and re-crossed his legs. “One is about reticence in terms of publicity, and the second is about our strategy for longevity. Let me deal with the second question. We’re structured as a partnership. The partnership is the best organizational format for long-term survivability of a money management firm. The reason is that, if you’re a partnership, 100% of the reward goes to the partners. My share goes down every year as the others’ go up, and when I’m ready to retire, the existing partnership management will already be in place, and they can assume the firm going forward.”
He does not address the publicity argument—now or ever. John Paulson, after all, did not become one of the greatest traders of all time by being an easy read.
Like any piece of art, however, the provenance of John Paulson is important to establish—and, luckily, that is far easier to decipher than his current motivations.
He was born in the New York suburb Queens, the third child of an immigrant from Ecuador who fought in the Second World War. His affection for assets showed itself early, as Gregory Zuckerman revealed in The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History. According to the author, Paulson’s father took him “to a local supermarket to show the 6-year-old where to buy a pack of Charms for eight cents, trying to instill an appreciation of math and numbers in him. John broke up the pack and sold the candies individually for five cents each, a tactic that investor Warren Buffett employed in his own youth with packs of chewing gum.” While not exactly an academic prodigy, Paulson was an eager student of subjects beyond his grade-level—at least until he entered New York University (NYU).
At NYU, where he focused his initial efforts in the arts, Paulson lost his way as well as “his early interest in money,” according to Zuckerman. A trip to South America and contact with a vibrant uncle changed that, and he returned to university with a renewed interest in finance. He was eventually named valedictorian of his class. Harvard Business School followed—with top honors—as did a move to Wall Street.
“The most profitable aspect of investment banking was the proprietary trading desk,” Paulson now says. “When I was at NYU, I took a course, taught by John Whitehead—chairman of Goldman Sachs at the time—and he brought in Bob Rubin, who at that time headed risk arbitrage. He was the star; he was rumored to be the next senior partner, and ran the most profitable part of Goldman. So I became very interested in risk arbitrage from college, and decided to pursue a career that developed the skills to manage a risk arbitrage portfolio.” His interest, post-Harvard, took him not to Goldman but to Boston Consulting Group, Odyssey Partners, Bear Stearns, and then merger-arbitrage stalwart Gruss Partners. In 1994, he left Gruss to start his own hedge fund—armed, he believed, with a specific skill set that would unlock riches.
“I developed an expertise in shorting bonds in the late 1980s at Gruss, and [at the time] we went through a financial crisis, and we started to short the bonds of bank-holding companies,” he explains. “When the banks were downgraded, those bonds would fall more than the bonds of the operating company. We would go long the operating-company bonds and short the holding company’s.- If they failed, the operating company assets would hold their value. The holding bonds would often get zero.”
Despite his confidence, however, it is here that his tale slows its pace—for Paulson got rich the way most people go poor: slowly, then all at once. While hedge funds were not as large in the 1990s as they are now, Paulson & Co. was small, even for the times. Despite solid returns, assets did not flood in the doors. It took a decade to amass a respectable, if not immense, pool of capital. But as Paulson now argues, it helped set the stage for his greatest act to date.
“The first stage of growth was from 2002 to 2006,” he says. “We went from $300 million to about $6 billion.” They staffed up appropriately, he explains—and then “it” happened. With the help of then-analyst Paolo Pellegrini, Paulson came to believe that the housing market was historically overpriced. He then started to act on this belief by shorting the market.
“We became familiar with [the trade] in June 2005,” he says. “We put some size on in December 2005, and then they came out with the index—the MBS index—which provided a lot of liquidity. We used 2006 to build up our position size. The market first cracked in January 2007, but the major crack in the market—when our thesis was proven correct—was when New Century filed for bankruptcy. They were the largest subprime lender in the country, and they filed because the underlying performance of the securities deteriorated so rapidly. And that’s when people first understood what was going on, and the market weakened.”
By the end of 2007, Paulson’s total assets under management came to $28 billion. Like most hedge funds, this capital was spread over a number of pools with nuanced mandates. Investors lucky or smart enough to be invested in John Paulson’s Credit Opportunities Fund—initially established to focus on the mortgage-short position—reaped the benefits of the best 12 months a major hedge fund has ever had. After fees, it brought some investors a 591% return on their capital.
In a world without schadenfreude, Paulson would be hailed as hero—but this is Wall Street.
Upon the revelation of Paulson’s historic year, everyone had an opinion, not all of them favorable. Paulson had grown rich on the backs of America’s poor; he was lucky, not skillful; he’d actually helped foster the bubble by getting Goldman Sachs and others to create structured products designed to fail: “It’s like being the Miami Heat and playing the Chicago Bulls—but being able to pick the Bulls’ starting lineup from the crowd,” according to one investor. Perhaps the most common critique, however, was more mundane: Paulson had stepped outside his historical mandate and skill set, and thus his success was likely an aberration.
Paulson disagrees vehemently with this final accusation. “It was within the purview,” he now says. “One of the advantages of a hedge fund is to be correctly positioned if market goes up or goes down. We can position ourselves to be short.” The 2007 success, he says, was just a very good example of that. “We weren’t really shorting housing. We were short weak bonds that were mortgage-related and that we thought in a weakening of a housing market could fall.”
Instead, Paulson’s argument is that the success of 2007 was the result of 30 years’ work. “I’ve been shorting bonds since the late 1980s,” he says. “We always liked the risk/return nature of bond shorts, but it’s a challenge to find the right opportunity. It’s a tool we developed and periodically used. In 2006, it was the ideal opportunity to use that tool because we felt the credit markets were in a bubble, [the markets] were mispricing risk, and that there was a terrific opportunity on the short side. And when we looked at all the credit markets, we found that mortgages were most mispriced, and within that, the most mispriced were subprime.”
Another critique whispered behind Paulson’s back was that he was entirely run-of-the-mill before his big trade—and that he would soon revert back to this category. And while even Paulson would admit another 600% year is unlikely, his supporters take offense at the suggestion of relative mediocrity.
“That’s BS. He was not run-of-the-mill,” says Jeff Tarrant, co-founder of hedge fund-of-funds Protégé Partners and an investor in, friend of, and tennis partner to Paulson. “He’s just misunderstood. John is an incredibly cerebral guy. Some call him spacey—it can seem that he goes off into another world when you’re talking to him. But he’s not. His mind is just moving about 100 miles per hour. He’s thinking deliberately about the question, or the situation, and he’s trying to come up with an answer.”
In the case of the mortgage short, Tarrant—who was one of the earliest investors in the Credit Opportunities vehicle—is adamant that Paulson was unique long before 2007. “Look at his risk arbitrage track record. He’s always been one of the best in the business. And he wasn’t one of these guys with 80 positions on the book. He had 20 positions because he was pretty sure about his analysis.”
Of the trade, Tarrant says, “Others laughed at him or said he was simply wrong, but he was right. You need someone from outside the industry to peer in through the smoke and mirrors, and find out that, in the Land of Oz, there might be some guy behind the curtain. It took a lot of guts, but he knew his stuff.”
Was the mortgage short about guts? Paulson pauses for perhaps 10 seconds when asked. “I would say it was obvious, risk-averse, and a fair amount of gutsy,” he finally says. “What today is so obvious was that the collateral was awful. It was risk-averse in that they only traded at a 1% spread to treasurys. If we were wrong, we would lose 1% a year for three years; if we were right, we could make 100%. The risk/return nature of the trade was exceedingly attractive. We sized it so it wasn’t too big—it was 2% to 2.5% in the Advantage Fund. If we were wrong, you wouldn’t even notice it; if we were right, we’d be up over 100%.”
Before considering the gutsy part, he pauses again. “The ‘gutsy’ part was understanding the situation so well that we notionally took a very large size. If we were correct, the trade would produce very high gains.” It did—and as Paulson points out, these gains persisted for a number of years. “We were one of the few funds to make money in 2008, and were very profitable in 2009. When we reached our peak, almost all the money we were managing was from compounded returns as opposed to capital raising. Many of our investors had become very rich.”
But nothing lasts forever. By the time the crisis reached its zenith and the markets their nadir, Paulson’s historic trade had paid off, and he’d repositioned his portfolios to take advantage of an eventual recovery. He was, as it turns out, too early.
“We had a difficult 2011,” he admits. “That year, we became overly optimistic on the direction of the US economy, and as such took on too much leverage in our funds. And when the economy grew at a much weaker level and we had concerns about Europe, the markets had a lot of volatility and caused some drawdowns.” He also hedged inflation concerns with his famous gold bet—perhaps the greatest point of glee for his detractors—and 2011 saw losses of up to 50%. The following year wasn’t much better. Through redemptions and losses, what had been $32 billion in assets fell significantly. Total firm assets now sit at $19 billion across a number of portfolios, only 35% of which belongs to external limited partners.
John Paulson didn’t become John Paulson by being an easy read. He also didn’t get there by fooling himself.
“The fact that we lost money twice shows that we’re not perfect,” he says.
He’s not losing money anymore, however—and therein lies a clue as to why, after a quiet period, Paulson is re-engaging with the outside world. Indeed, according to cache of documents obtained by aiCIO, 2013 has been an exceptional year for Paulson by almost any standard.
Paulson & Co. capital is largely spread over four funds: Merger, Advantage, Credit Opportunities, and Recovery. (Paulson’s gold fund, although much commented upon, is smaller than the others by a factor of 10, as is his private-equity focused Real Estate Recovery Fund.) As of the end of October, all the major funds were up between 12% and 45%, net of fees. While the much-maligned gold trade continues to be a drag on some of the portfolios, stellar investing elsewhere all but eclipses that issue. His overriding bet—recovery—is now paying off handsomely. If that bet continues to work, Paulson will be the rarest of beasts: a man who became rich as America fell, and richer still as it rose.
Paulson seems as nonplussed about his recent rebound as he does about his 2011 drawdown. “We’ve been a top-performing fund since inception,” he says. “We got notoriety because of our success in subprime, but we have a certain expertise in risk arbitrage, and we’ve always operated in the top quartile. [Data for Merger Enhanced shows] we’ve been the number one performer in this group this year, for five years, ten years, and in the life of fund.”
Paulson’s ambition didn’t disappear when he went from millionaire to billionaire in record time. “We’re nowhere near one of the largest hedge funds out there,” he says when asked about his goals for Paulson & Co. “You know how big Dalio and [Oaktree Capital’s Howard] Marks are, how big certain other firms are. Blackstone is $250 billion in assets; we’re at $19 billion.”
But why bother? Carl Icahn, among others, famously closed shop to outside investors when regulation and demanding clients became too much. So why doesn’t Paulson simply rid himself of external money, never attend another investment conference, and happily go about his knitting as a family office surrounded by his Calders?
Paulson smiles at the question. “I guess you can ask that question of Fidelity, Blackstone, BlackRock. Our business is money management,” he says. “That’s the business I started in; that’s the business we’re in. That includes managing money for outsiders for a fee. I don’t know why we’d want to close a business that’s successful—in most business, if they succeed, they want to grow and expand the business.” (“That’s a non-answer,” chuckles Tarrant when informed of Paulson’s response.)
Further harvesting of Paulson’s mind bears no fruit. “I’m 57,” is all he says. “Our goal is to continue to build wealth for clients, to survive past me, and continue to be one of the top-performing event arbitrageurs.”
John Paulson is happy to reveal two major bets playing out right now. One is financial: He believes, and has for some time, in the resilience of the American economy. The other is less tangible, but no less important to him: He believes in his firm’s ability to persist after the sole name on the masthead is gone. He’s all in with both bets, and the world is watching.
What Paulson does not reveal is something more primal. Invariably, a certain cadre of hedge fund investors are asked whether they think they are, or can be, the world’s best at what they do. Paulson, unsurprisingly, will have none of that. As he sits below his Calders, in his office high above Manhattan, he smiles at the idea and moves on.
His friend and tennis partner Tarrant, however, is willing to venture a guess as to Paulson’s ambition to be the best ever. “I think so, yeah. I think he looks at others—Howard Marks at Oaktree, for example—that have built something that went from the investment fund business to the asset management business. And why not?”
And while he was discussing tennis, not investing, Tarrant’s assessment of his partner’s game might be the best explanation of what Paulson ultimately wants in life: “He has a wicked forehand,” Tarrant says. “And a serve, when it’s on, that’s just as wicked. He likes to win, and he enjoys the game.”