After most of his clients have fled, billionaire John Paulson has embarked on a strategy to raise assets and generate big fees at the risk of losing his own capital.
Paulson & Co. signed up last year with the three main providers of so-called first-loss funds to pursue the wagers, according to a March regulatory filing. These deals with Topwater Capital, Prelude Capital Management and Boothbay Fund Management allow Paulson to lever-up his own capital many times over after he squandered much of it on wrong-way bets.
Here’s how first-loss works: Managers like Paulson put their own money into an account within a first-loss fund, and any of the three firms contribute nine times as much from their investors. Managers get to keep about 55 percent of the trading profits, more than double the standard industry cut. But should the strategy go awry, all of the losses come out of their invested capital until it’s gone.
“The upside, if you do well, is good,” said Karl Cole-Frieman, whose law firm advises hedge funds on seeding deals and other structuring issues. “The downside, if you do poorly, is disastrous.”
Paulson, 62, is making the highly levered wagers after suffering years of losses and redemptions, bringing his firm’s assets down to about $9 billion from $38 billion in 2011. He trades at least some of the first-loss assets through his Pure Spread strategy, according to a person familiar with the matter. Merger arbitrage has been a traditional strength for Paulson and he’s using it to refocus his New York-based firm.
Paulson, Topwater and Boothbay declined to comment.
First-loss funds were pioneered by Norwalk, Connecticut-based Topwater, which was co-founded in 2002 by Bryan Borgia and Travis Taylor in an 800 square-foot space above a pizzeria. Gavin Saitowitz helped start Prelude in New York eight years later after running a first-loss strategy with Topwater, now a division of Leucadia Asset Management.
Attracting Veterans
First-loss firms have traditionally catered to startups that lacked the cache to attract conventional institutions. The deals gained traction starting in 2011 as alternatives to seed funding, which often requires new managers to surrender equity in their firms.
Now the field is attracting veteran managers, many of whom are under pressure to lower fees as investors flock to cheaper passive products. First-loss accounts offer a way to pay the bills for firms such as Paulson & Co. that no longer have many fee-paying clients.
Paulson and at least nine other hedge funds with assets of $100 million or more signed up last year to run first-loss accounts on behalf of Prelude, according to filings. They include Kyle Bass’s Hayman Capital Management and Chicago Equity Partners, which reported about $9 billion of gross assets at the end of 2017. Hayman and Chicago Equity declined to comment.
Few Losses
While Prelude and its two peers supply most of the capital in first-loss strategies, they almost never lose any of it. That’s because they can shut down an account once most of the hedge fund manager’s capital is gone. First-loss providers also generally prefer to back strategies whose assets can be easily sold should the trades sour.
“Believe me, Prelude and Topwater never get a loss,” said Cole-Frieman, a partner at Cole-Frieman & Mallon. “They are watching close.”
Institutional investors like first-loss funds because they offer steady returns and little downside. Pensions are increasingly investing with Prelude, Boothbay and Topwater, helping to push their combined gross assets to $5.9 billion from $3.7 billion in two years, filings show. Prelude, with $3.5 billion in gross assets at the end of February, is the biggest player.
“If someone is willing to take the loss on the first 10 percent, it makes the other 90 percent far less risky,” said Keith Danko, the managing member of Witherspoon Partners, a strategic consultant to hedge funds.
Paulson’s Strategy
Managers who run first-loss accounts tend to have extensive risk controls and low-volatility strategies since they’re first in line to absorb losses. Paulson is managing his accounts with the same merger-arbitrage strategy used by his Pure Spread, which started in 2016 for investors who want a traditional approach for betting on announced deals.
Pure Spread returned 12 percent last year. Paulson Partners, the riskier strategy, bets on potential mergers as well as announced ones, and has suffered heavy losses during the past several years.
Pure Spread had about $80 million of gross assets at the end of last year. When capital in the first-loss accounts is included, the total managed by the strategy comes to several hundred million dollars, the person said.
“We look forward to a long-term partnership with the firm,” Saitowitz, Prelude’s chief executive officer, said about Paulson. “We are excited about the level of deal activity and believe the portfolio is well positioned to continue profiting from the current environment.”
This article was provided by Bloomberg News.
