John Paulson began his career at Boston Consulting Group before leaving to join Odyssey Partners, working under Leon Levy. He later worked in the mergers and acquisitions group at Bear Stearns. Prior to founding his own firm, he was a partner at mergers and acquisitions firm Gruss Partners LP. In 1994, he founded his own hedge fund with $2 million and two employees (himself and an assistant).
Paulson & Co., Inc. had assets under management (as of June 1, 2007) of $12.5 billion (95% from institutions), which leapt to $36 billion as of November 2008. [2] Under his direction, Paulson & Co has capitalized on the problems in the foreclosure and mortgage backed securities (MBS) markets. In 2008 he decided to start a new fund that would capitalize on Wall Street's capital problems by lending money to investment banks and other hedge funds currently feeling the pressure of the more than $345 billion of write downs resulting from under-performing assets linked to the housing market..
John Paulson’s investment philosophy and methodologies can be found in interviews he gave in the past.
According to "Excellent timing: Face to Face with John Paulson," by Pensions & Investments). John Paulson discussed his investment Philosophy and style:
And in the 2003 Interview with Hedge Fund News, he revealed some details on how he approaches risk arbitrage, his research process, and how he manages risks
GuruFocus is going to review John Paulson's equity holding portfolio in the next article.
Paulson & Co., Inc. had assets under management (as of June 1, 2007) of $12.5 billion (95% from institutions), which leapt to $36 billion as of November 2008. [2] Under his direction, Paulson & Co has capitalized on the problems in the foreclosure and mortgage backed securities (MBS) markets. In 2008 he decided to start a new fund that would capitalize on Wall Street's capital problems by lending money to investment banks and other hedge funds currently feeling the pressure of the more than $345 billion of write downs resulting from under-performing assets linked to the housing market..
John Paulson’s investment philosophy and methodologies can be found in interviews he gave in the past.
According to "Excellent timing: Face to Face with John Paulson," by Pensions & Investments). John Paulson discussed his investment Philosophy and style:
Describe your investment philosophy. I really picked up my investment philosophy from Marty and his father, Joseph Gruss. He had two sayings that guided me going forward.
The first was: Watch the downside, the upside will take care of itself. That’s been a very important guiding philosophy for me. Our goal is to preserve principal, not to lose money. Our investors will forgive us if our returns don’t beat the S&P in a given year, but we are not forgiven if we have significant drawdowns.
The other saying really drives the same point from a different angle: Risk arbitrage is not about making money, it’s about not losing money. If you can minimize the downside, you get to keep all your earnings and that helps performance.
Would you say that your investment style is concentrated? Yes and no. No, when you look at most activist funds, they tend to have five or 10 positions and that’s 100% of their portfolio. Some have only five positions. We’re much more diversified; our average position size is just 2.5%. However, when we do feel strongly about a position, we will take that up to 12% in our merger fund and 10% in our event fund. That is (higher) than some funds. We feel it’s important to have the flexibility to go to 10% because in order to outperform, you have to be able to allocate a sizable position to what you think could be a high-return investment. It’s only when you have a substantial allocation to a high-return (security) that you can influence the overall portfolio.
And in the 2003 Interview with Hedge Fund News, he revealed some details on how he approaches risk arbitrage, his research process, and how he manages risks
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 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. 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.
GuruFocus is going to review John Paulson's equity holding portfolio in the next article.
