Looking for trouble
Richard Perry, hedge fund superstar, hasn't had a down year in his flagship fund in 14 years.
(Fortune Magazine) -- The swaggering, ultra-rich hedge fund manager, manager, an unloved species to begin with, is very possibly becoming endangered.
This is for good reason. Over the past two decades, growing numbers of hedge fund managers have been collecting "Supersize me" management fees for doing little more than basking in bull market returns and borrowing cheap money to make more money. They've become the tollbooth collectors of the financial world (though that may be a disservice to real-life toll workers, who have to cope with hazmats and Amber Alerts). But the just-buy-stocks-they'll-go-up party is over, replaced by a skittish economy, rising interest rates, record housing foreclosures, and one of the worst credit crunches in history. Hedge fund performance is down, and money is flowing out. By year's end, an estimated 987 funds will have launched, less than half the number started in 2005, the peak year for startups. Also by year's end, an estimated 679 funds will shut down - about 20% more than last year. Can hedge funds with tepid returns survive this? Should they?
Common or garden-variety hedge fund managers sit in offices a lot, staring at numbers. When they do venture out, it's to obtain "secret" stock picks at conferences in big hotels (AAPL, Fortune 500). They often fib about how hard they work, and they buy bad office art - Chinese tiger sculptures, renderings of Sufi whirling dervishes - to appear worldly, though many of them have never set foot in "Chindia," to use their smug locution.
What many have been secretly doing is ... shhhhh ... replicating an index fund, then labeling it "black box" or "long-short" (even though some don't actually engage in the somewhat risky business of shorting stocks). When they beat the S&P by a percentage point or two they like to say, "That's money, baby!" quoting actor Vince Vaughn. By besting the index, they can brag about "preservation of capital" and "low beta."
Of course, hedge fund managers are not all like that. There are some really good ones out there. And then there are the superstars, like Richard Cayne Perry.
If you've never heard of Perry, that's no accident. He's deeply secretive. At 53 he is one of the most successful investors of our time, but until now he has never been profiled in a major magazine. Yet Perry's consistently superb performance puts him in the league of well-known hedge gods like Paul Tudor Jones and Stanley Druckenmiller. In the 20 years since he started Perry Capital, fresh out of Goldman Sachs, his flagship fund - now with $14 billion in assets - has never had a down year. He's been up an average over that time of 15.4% annually after fees.
Perry was one of a few on Wall Street, for instance, to start betting against subprime mortgages in late 2006. "We could see there was a lot of bad behavior by financial institutions," he says. Perry Capital shorted $3 billion in subprime securities, a bet that yielded $1 billion last year. His fund was up 11.7% after fees, according to investors, more than double the S&P 500's 5.5% gain. (He charges a 1.5% management fee, less than the 2% charged by most hedge funds, and the typical 20% of profits.)
Perry, as you might imagine, is a complex guy. He has completed four triathlons, yet when he's away from the office he carries a white patent-leather murse (that's a man-purse) designed by his wife. He's a bit of a power broker - Caroline Kennedy and Barack Obama first met at a gathering in his home - and also a bit of a management guru (he oversees 250 egos at Perry Capital and consults with dozens of CEOs on their businesses).
Moreover, Perry represents a new breed of hedge fund manager. He fires on lots of investment cylinders, creating multiple revenue streams and reducing risk. He thrives in private equity and real estate investing. He uses his strong cash position (he averages only 1.15x leverage) to lend money at eye-popping rates to cash-strapped investors, now that banks won't. In other words, he has built a megafund along the lines of Kenneth C. Griffin's Citadel, which manages $16 billion, and Och-Ziff Capital Management, which has $33 billion under management. These funds are attracting the big inflows from pension funds, endowments, and charities. "The bulk of institutional clients don't have the time or staff to check out emerging talent. They're looking for a solid back office and stringent risk controls," says Mark Yusko, former chief investment officer of the University of North Carolina's endowment, who now runs a fund of funds. At the end of the second quarter, 89% of all hedge fund assets were managed by funds with $1 billion or more, and 63% were managed by funds with $5 billion or more, according to HFR, a Chicago hedge fund research group.
Says Perry: "Right now there are fantastic investments to be made. A wide variety of things are going to be distressed. Lots of markets are experiencing things that have never happened before." So he's rolling up his Thom Browne shirtsleeves and preparing to battle bankruptcy creditors.
Recently Perry has been investing in distressed credit - particularly bank debt issued by companies involved in leveraged buyouts that have had a hard time finding financing. And for the second time in two decades, 20% of his portfolio is in cash. "There's a false sense of security in the markets," Perry says, predicting that economic woes will get even worse. For other people.
In the 59 years since the hedge fund business was popularized by a Fortune writer named Alfred W. Jones, only a handful of managers have been considered kings and, in turn, kingmakers. One example would be Julian Robertson, founder of Tiger Management, which spawned stars including Maverick Capital's Lee Ainslie and Viking Global's Andreas Halvorsen. The Tiger alumni tend to take a fundamental, research-driven approach to investing.
Then there's George Soros, king of macro players. Macro investors typically bet on global currencies and interest rates. Famous macro investors today include Stanley Druckenmiller and Louis Bacon. The quant giants include James Simons, who heads Renaissance Technologies, and David E. Shaw of D.E. Shaw. These are math whizzes who do calculus for fun. They tend to use computers to execute complex trading programs.
And there is the former Goldman Sachs gang, in particular the ex-Rubin rookies - those who started their careers at Goldman's famed risk arbitrage desk under Robert Rubin, who ran it from the mid-'70s to the late '80s. They generally run multistrategy, value-oriented funds with a heavy emphasis on making money while limiting market exposure or risk. The group includes Eddie Lampert, who runs ESL Investments and is majority owner of Sears Holdings; Farallon Capital's Thomas Steyer; Och-Ziff's Daniel Och; and Eric Mindich, who runs Eton Park Capital Management. The Goldman arb desk spawned possibly the most elite group of hedge fund managers around.
One of them is Perry, who began his career at Goldman's options trading desk in the mid-1970s. He soon realized he preferred scouring companies' fundamentals, evaluating risk, gauging probabilities - in other words, investing - to trading. He moved over to the risk arbitrage desk, which invested in stocks involved in mergers. Rubin, who went on to become co-chairman of Goldman, Treasury Secretary under President Clinton, and head of the executive committee at Citigroup, was a fabulous teacher. It was a hectic, complex environment in which decisions often had to be made quickly, and the wrong one could cost the firm millions. "Rubin walked around with a slide rule. He was calculating odds constantly," Perry recalls. "He would say, 'Nothing ever needs to be a 100% probability.'" But the upside always had to outweigh the risk exponentially. Says Rubin: "From the time Richard started at Goldman, he was highly effective. He took on lots of responsibility even as a junior trader. It's no surprise he's built an enormously successful business."
At Goldman, Perry learned what continues to be his mantra: expected value analysis, or EVA. He describes it this way: "You take all the percentage probabilities of a situation and multiply them by [all the anticipated] prices of a security [if those probabilities were to occur]." Then he compares the expected value with the current market price to gauge whether to buy or sell. Simple, right? To Perry, it is - akin to the ease of, say, Mordecai "Three Finger" Brown pitching a curve ball. He admits, "Filling in the blanks is completely subjective. It's based on my fundamental view. It's what separates winners from losers." Also, he emphasizes that if you underestimate your downside, you're likely to be toast.
Perry likes to keep his name out of newspapers and magazines, but he doesn't exactly keep a low profile. He is a big Democrat, a former Hillary Clinton supporter who now backs Obama. He and his wife, Lisa, who have college-age twins, own a large collection of works by Warhol, Lichtenstein, and other '60s artists. Most of it is displayed in their New York mansion, formerly owned by Walter Annenberg's daughter and before that by socialites Winston and C.Z. Guest, on Manhattan's Sutton Place. "When you go to their house, they give you an art catalog and literally take you on a tour," a guest says. Perry, the value guy, picked the place up at a discount - $10.9 million, $4 million below its asking price, in 2000. The house, with sweeping views of the East River, was a bit of a white elephant - 17 rooms, two of them ornate ballrooms. The Perrys remodeled it into a pop art palace.
Perry Capital's headquarters are on two connecting floors of the General Motors Building in Manhattan, a swank edifice that also houses Thomas H. Lee Capital, Perella Weinberg, and, in the basement, an Apple Store. Perry doesn't have an office, though. He has a desk on the trading floor. The place has a feeling of self-denial, teamwork, and mentoring akin to his alma mater's. "I think Richard's been very successful in developing a very Goldman-esque culture," says Tye Schlegelmilch, a former Perry portfolio manager who left recently to start his own fund.
It's a Tuesday morning in April, and as soon as Perry walks into the conference room where we're meeting, he starts talking about what some outsiders are referring to as a shakeup at the firm. Four partners, including longtimer Carl Berg, and two managing directors in the U.S. equity area recently resigned. The reason: Perry Capital's U.S. equity business was the worst-performing sector in 2007 - it was down 1.7%, and it dipped almost 3% in the first quarter of this year. Some culprits: health-care stocks like Humana and Universal American Holdings, both insurers, and education lender Sallie Mae.
This kind of situation - almost an entire team departing - has occurred two or three times in the firm's 20 years, Perry says. When analysts are hired at Perry, there's an understanding that it's usually a two-year stint. "He lets portfolio managers be autonomous for the most part and create their own track records that are portable," says a former employee, adding, "That's very unusual in the hedge fund world." Perry's investment team is relatively small, with about 25 portfolio managers and traders.
But an issue that has irked senior people at Perry Capital is that few receive equity. Perry himself owns the majority of the firm, at least 75%, according to SEC filings. His longtime partner Paul Leff holds an undisclosed amount. Two years ago, Perry says, he started rewarding partners with equity. (Others often receive so-called phantom shares, which are a kind of virtual common stock: They track real shares' market value but don't carry voting or ownership rights.) Says Howard Kapiloff, editor of newsletter Hedge Fund Alert: "He's not generous with equity. So people leave and start their own firms. Still, it doesn't seem to hurt performance."
Perry moved from Chicago to Manhattan when he was 10. His mother, Merel, at one time ran a small import business. She is the sister of James Cayne, the former Bear Stearns CEO who became the face of the subprime crisis (see "The Rise and Fall of Jimmy Cayne"). Perry's father, Arnold, ran several firms, including a business-machine company and a book publisher. None of them was very successful. His parents divorced when he was 13. Money was a contentious issue, and Richard's relationship with his father became strained. Richard attended the all-boys Allen-Stevenson School in Manhattan, then went to Milton Academy in Milton, Mass., where he worked part-time in the finance office and ran a real estate investment trust as part of a school project. He caught the finance bug and went to the University of Pennsylvania's Wharton School as an undergraduate.
The family's finances were uneven, Perry says. After his freshman year at Wharton, his father cut him off financially. Perry worked as a movie theater usher at night and was promoted to chain manager. He says, "I always had a sense that I needed to provide for myself, that others weren't there to do it for me."
For a summer gig in 1975, he got a coveted job at Goldman through his dad, who played tennis with one of the partners, L. Jay Tenenbaum. After Wharton, Perry was hired at Goldman full-time. While there he earned an MBA, studying nights at NYU.
After joining Rubin's arb desk, Perry quickly became a favored protégé. One reason Rubin says he took to Perry: "Richard is very thoughtful. His interests go far beyond the business world." Perry babysat for Rubin's kids. Rubin sometimes went to watch Perry play softball in Central Park. Perry also became Rubin's teaching assistant at NYU's Stern School of Business, where Rubin was an adjunct professor.
By the late 1980s, Perry was flying high at Goldman. He had an urge to be an entrepreneur, though, and he also thought his compensation didn't measure up to his contributions to the firm. (In those days Goldman didn't tie traders' pay directly to the amount of money they brought in.) So Perry left and founded Perry Capital with Leff, in offices provided by his uncle Jimmy at Bear Stearns. He worked out of Bear's offices for about five years. For reasons Perry won't describe, he and Cayne have had an on-and-off relationship - there have been years when they didn't speak. "We tend to get along fine now," he says.
Perry has retained a tight relationship with Goldman. Along with billionaire Eli Broad, Perry recently injected $3 billion into Goldman's Global Opportunities Fund after the quant fund cratered 30%. Perry primarily trades through Goldman and is often approached by the firm about investment opportunities. Perry has also remained friends with Rubin and sits on the advisory council of the Hamilton Project, an economic policy group Rubin founded.
Perry learned early on the importance of being deeply involved with his investments. One of his first successes running Perry Capital was at FTD, the giant floral-delivery service. In 1994, FTD was a nonprofit cooperative, but it wanted a buyer to turn it into a for-profit business. Perry bought it for around $130 million, with $20 million of his own equity, around $10 million from Bain Capital and Bank of Boston, and the rest borrowed money. It was a contentious deal from the start. The CEO of FTD quit before it went through, wary of various terms. Then there were the angry florists: Many of the 25,000 or so were scared they would lose the power of the network they had depended on. FTD's board approved the deal, but Perry couldn't complete it unless more than half of the member florists were onboard. So Perry went state to state visiting florists, telling them about his plans to spend $12 million a year on advertising and make a big push to get more florists into the network. He got their vote. "It was the first time I'd won anything since I was student council president in the ninth grade," he says. Perry installed Meg Whitman, who later became CEO of eBay, as CEO of FTD (she was recommended by Bain, where she had worked previously). In 2004, Perry sold FTD for $450 million to a private equity firm, making a 28% annualized return on his initial $20 million investment. The FTD experience led Perry into trolling for struggling companies in which to invest in essence, creating his own opportunities.
Many investors and financial institutions are holding lots of credit they'd like to get out of," says Paul Leff. "They won't get out at prices where they want to get out, but where they have to get out." In other words, Perry Capital will be ready to pounce when credit opportunities become attractive. Right now, for instance, companies involved in LBOs are willing to pay premiums to investors to get deals done. Perry Capital's investments include First Data Corp., the merchant-services company that KKR took private last year, which has bank debt yielding 9%, and Harrah's, which went private in a leveraged buyout last year and issued bank debt yielding around 10%. Perry also holds Ford Motor debt, which has gone through a string of downgrades. Its most recent bond issues have been yielding around 13%.
Perry Capital generally avoids hostile situations, preferring to work on fixer-uppers with receptive management. But for two years it has been slugging it out with NEC Corp. subsidiary NEC Electronics, Japan's third-largest semiconductor company and the worst performer of the world's top ten chipmakers. Last July Perry, the third-largest shareholder, offered to increase its 6.03% stake to 25%, purchasing shares for $1.3 billion at a significant premium. The offer was rebuffed by NEC Corp., which Perry has accused of running the subsidiary for its own benefit, disregarding minority shareholders. This June, NEC told Perry in a letter that it was cutting costs and would improve operating profit margins.
Perry got into a battle with financier Carl Icahn over shareholder rights that gave him a bit of a black eye. In 2004, Mylan Laboratories was considering a takeover of smaller King Pharmaceuticals. Perry used a novel, controversial hedging tactic involving a swap trade with Goldman and Bear Stearns that made him the largest shareholder of Mylan, edging Icahn out of the top spot. Perry bought 26.6 million shares, or 9.89%, of Mylan, then borrowed the same number of shares from Goldman Sachs and Bear Stearns for a 30-day period in order to short them. The hedge not only made Perry temporarily the largest Mylan shareholder (Icahn held 9.8%), it was also essentially a risk-free situation because of the hedge. By being the largest shareholder, Perry ostensibly could have helped ensure that Mylan received enough shareholder votes to approve the takeover of King, in which Perry was also a large investor - and Perry would have made as much as $28 million on the deal, according to Securities and Exchange Commission documents. Icahn, who was trying to block the merger, sued Perry for $1 billion, alleging he had gamed the system. The takeover never went through, Perry sold his shares, and Icahn dropped the lawsuit. Still, in December 2005, the SEC issued a Wells Notice to Perry Capital meaning the regulator is considering bringing an enforcement action against it in connection with the Mylan trading for alleged violations.
The SEC, which doesn't comment on ongoing cases, has yet to take any action. Perry, while declining to discuss the case, says, "We've always prided ourselves on our honesty and transparency." He notes that Perry Capital was one of the first big hedge funds to voluntarily register with the SEC.
Perry is not investing solely in distressed securities. In 2005, along with Dan Och and Citadel's Griffin, he loaned billionaire Malcolm Glazer, owner of the Tampa Bay Buccaneers, $512 million to help finance the purchase of Manchester United, the British soccer team. Perry is also a large investor in Exclusive Resort - the members-only vacation club owned by former AOL Time Warner chairman Steve Case's company, Revolution. He's also a backer of Hollywood honchos Harvey and Bob Weinstein, who formed their own company, the Weinstein Co., in 2005. Perry even gave them the idea for a TV show: Battle of the Nutcrackers, in which ballet companies compete to put on the best performance.
But looking for trouble is what Perry does best. Some star investors are calling these times the "second Great Depression." Perry doesn't disagree. As some famous lyrics from his favorite band, the Kinks, go: "And those who are successful, be always on your guard. Success walks hand in hand with failure on Hollywood Boulevard." Or in this case, Wall Street. Yet Perry is forging ahead: "We're looking forward to taking advantage of a long-lasting distressed cycle."