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Thursday 4 December 2008

‘Don’t focus on what you can make, but on what you can lose’

David Craig, a pioneer of the British hedge-fund industry, recalls lessons learned from John Paulson, the New York investor who topped last year’s global earnings league

What I remember most of all is how John described, at that first meeting, the manner in which he viewed his careful approach to risk, learned when he worked for two other veteran merger traders, Marty Gruss and his father Joseph. John sold us on three key tenets he followed in the risk arbitrage business. First, it’s best to back takeover deals where you get paid in cash, not flaky securities. Their value is unpredictable, whereas cash offers certainty. Second, look for merger deals with a twist, such as a guaranteed ‘floor price’ hidden behind a share exchange, or where there may be more than one potential buyer around. You never know, there may be an auction contest that might swell your return. Third, don’t focus on what you can make, but on what you can lose if something goes wrong. This short series of pointers helped convince us to go ahead with our investment.

In 1998 the Greenwich, Connecticut-based fund Long-Term Capital Management blew up and every other hedge fund feared for its existence. Certainly most of the 15 or so funds in which we were invested had come under some form of pressure, sometimes extreme, and we could see that those which specialised in merger plays were being pounded as badly as any. I called John to see how he was doing. His icy tone gave some clue to the level of tension he felt, reporting to an investor whose money he had under his care. ‘David, we’re losing pretty big... close to 5 per cent,’ he sounded despondent. ‘I’m mostly in cash and I don’t intend to go down with those other guys.’ He was referring to LTCM, who did go down a few days later.

I responded to John’s assessment in a tone that signalled my delight and relief. ‘Five or even 8 per cent is nothing, John. You’re doing fine. Relax.’

‘Thank you for that, but it just doesn’t make me feel any better. Stay invested because the opportunity looms to make it all back and more,’ said the cool voice — then click. He was clearly not doing fine enough by the standards he set for himself. Paulson is generally very astute at managing risk: as much as anyone I have come across, he gives you the feeling your assets are safe on his watch.

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