It has been nearly a decade since John Paulson achieved near-instant Wall Street fame - and his firm became one of the most sought-after venues for buy-side employment - thanks to a blockbuster subprime megatrade that earned him $4 billion.
After reaching a peak in 2011 of $38 billion in AUM, Paulson's fund has shrank to $9 billion of mostly his own capital (despite his insistence that he was not converting to a family office after returning some outside capital) all while laying off senior managers and traders.
But it's clear Paulson is desperate to revive his fortunes, which is one reason why he might've signed up last year with three providers of so-called "first-loss" funds, essentially allowing Paulson to jack up the leverage to 10x - a level rarely seen in the wake of the financial crisis - on what's left of his capital (that is, after he pays off his staggering ten-figure tax bill).
For Paulson, the upside is the potential to earn 50%+ fees on his winnings - that is, if he wins. Because if his positions lose money, Paulson could see what's left of his capital vanish in an instant in what would amount to a devastating margin call, according to Bloomberg.
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."
As Bloomberg explains, these types of funds were pioneered by Norwalk, Conn.-based Topwater. The funds really took off in the aftermath of the financial crisis, as the rise of passive investing and widespread underperformance started inspiring clients to jump ship. Fund managers were then forced to consider increasingly desperate options, like first-loss funds.
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.
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.
First-loss funds, meanwhile, have attracted a flood of investor capital because, although the funds are relatively high, first-loss funds almost never accrue 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.
One of Bloomberg's sources said Paulson is making the wagers through his Pure Spread strategy, which is essentially a less volatile iteration of Paulson's trademark merger-arbitrage strategy. Pure Spread mitigates risk by only betting on announced deals. The strategy, as we previously noted, was up 12% last year. It was one of the few Paulson funds that didn't return capital to investors earlier this year, like his gold and special situations funds did. Paulson also shuttered a long-short healthcare fund last year amid staggering losses as several of its biggest holdings tanked.
Paulson had roughly $80 million in his pure-spread strategy at the end of last year. His first-loss fund positions are worth several hundred million dollars.
Representatives from the long-short funds said they "look forward" to a "long-term partnership" with Paulson, which is a bit of gallows humor that many readers might overlook.
That's because, if Paulson suffers even a brief run of bad look, it could be enough to shut the lights off for good.