Pellegrini 80% Return Proves Paulson Protege No Fluke at Fund

Date: Tuesday, October 6, 2009
Author: Richard Teitelbaum, Bloomberg

Paolo Pellegrini has a nose for trouble. He saw it in rising housing prices in early 2006, when he cranked through decades of home price data and concluded the bubble was poised to burst. Pellegrini then helped engineer a massive bet against subprime mortgages that catapulted Paulson & Co. hedge funds to 2007 gains of as much as 590 percent -- and firmwide profits of more than $3.5 billion.

Pellegrini, 52, pocketed tens of millions of dollars, allowing him to buy a couple of what he laughingly calls “entry- level supercars”: a silver Ferrari F430 with a base price of $168,000 and a black $109,000 Audi R8.

By April 2008, the Rome native smelled danger again. Nearly six months before the collapse of Lehman Brothers Holdings Inc. and the bailout of American International Group Inc., he and his colleagues saw that the unfolding crisis would trigger U.S. government intervention: bank rescues, a stimulus plan and yawning deficits. That move would eventually undercut the dollar and U.S. stocks, unleashing market havoc, Pellegrini reasoned.

“The losses would be massive,” he says. “I knew the policy response would be commensurate.”

So, after wowing the investment world with Paulson & Co.’s subprime bet, Pellegrini is proving he is no one-hit wonder. While still working for Paulson, Pellegrini plowed a chunk of his personal winnings from the subprime bet into PSQR LLC, a private fund he created to protect his newfound riches. He began shorting exchange-traded funds that held financial stocks and, later, those that track the Standard & Poor’s 500 Index.

52% Gain

Then, at the end of 2008, as panicked investors stampeded into Treasuries, sending the yield on the 30-year bond down 184 basis points to 2.52 percent, Pellegrini covered his ETF shorts and began betting against U.S. Treasury futures with underlying maturities of 15 to 30 years. (A basis point is 0.01 percentage point.)

PSQR’s gain from April 15, 2008, through December was 52.4 percent, according to a fund document.

In December 2008, Pellegrini quit Paulson & Co. to start his own firm, PSQR Management LLC, taking his new fund’s white- hot record with him. His firm is staked with $100 million of his personal money. He plans to market it to outsiders in 2010.

“There will be a tremendous amount of interest in his new fund,” says Sol Waksman, founder of BarclayHedge Ltd., a Fairfield, Iowa-based firm that tracks and invests in hedge funds.

Pellegrini, a former member of Italy’s Radical Party with an engineering degree and a Harvard Business School MBA, is pursuing a global macro strategy, wagering on fundamental world economic trends.

Macro Fund

Like such storied macro investors as Julian Robertson and George Soros before him, he’s buying and shorting futures on government bonds, stock indexes and commodities like oil, as well as spot and forward foreign exchange contracts. At Paulson & Co., his brief was narrower; he co-managed two funds that bought credit protection on mortgage-backed bonds.

Since Pellegrini quit Paulson, his career has continued to sizzle. In January, Treasury prices plunged, with 30-year yields rising 92 basis points. PSQR’s short position generated a return of more than 65 percent that month, resulting in a year-to-date gain through July of 80 percent, according to fund documents.

Friends, as well as former colleagues and investors, say Pellegrini has a rare ability to apply rigorous analysis to specific financial markets, as he did with the subprime trade.

“Paolo is a deep thinker,” says William Michaelcheck, founder and chairman of Mariner Investment Group, a New York hedge fund firm where Pellegrini worked as an analyst in 2003 and 2004. “He was able to synthesize the situation into a hedge fund position. It’s the iconoclast’s ability to see things other people can’t see.”

Sober Prognosis

Today, Pellegrini’s economic outlook for the next 5 to 10 years is a sobering one. He says the U.S. economy will groan under the weight of budget deficits, increased regulation and household debt. Europe will perform only slightly better, and Asian economic growth will outstrip that of the developed world. “There are going to be huge shifts in wealth around the globe,” he says. “I want to invest in that.”

Pellegrini says the U.S. stock market is likely to generate negative returns when adjusted for inflation. And the U.S. dollar will flag as an unrestrained Federal Reserve dispenses more money.

“In the U.S., there is limited interest among those in power in the stability of the dollar,” he says.

Buying Oil Futures

Meanwhile, the price of scarce commodities such as oil will surge as global competition for them heats up, Pellegrini says. Accordingly, he expects U.S. Treasuries to fall in price in the long term, and he’s buying oil futures. In September, he owned Norwegian kroner and said he believed the Australian dollar would benefit from that resource-rich country’s geographic proximity to Asia.

When asked why he left Paulson & Co., Pellegrini takes a swig from a bottle of Volvic-brand spring water before answering that Paulson wasn’t interested in having him manage a macro fund. Beyond that, he says, he wanted to run his own show. “I’m an engineer,” he says. “As interested as I am in making investment decisions, I’m equally interested in designing and building an organization.”

Pellegrini, who is 6 feet 2 inches (188 centimeters) tall and weighs 190 pounds (86 kilograms), is a former jazz disc jockey with some unconventional views on how to fix global finance. He says, for instance, that the U.S. government put bank interests ahead of the common good in the bailout. He sees no reason why Americans should deposit their savings in private banks, since the government already guarantees those deposits.

Banks and Risk

The public’s cash, he says, can be held at accounts at the Federal Reserve. Loans can be made by nonbank lending institutions.

At a minimum, he says, there should be limits on bank profits -- perhaps a 10 percent return on equity -- to keep them from taking the kinds of risks that led to the housing bubble.

“You need a system where people won’t be incentivized to take risks,” Pellegrini says. “We don’t need bankers to take risks with our money.”

Pellegrini, who lives on the Upper West Side of Manhattan with his third wife, Henrietta, and her daughter, has a predilection for long, freewheeling conversations in which he tosses out incendiary snippets.

How has the U.S. central bank handled the crisis? “The Fed is printing money, as instructed by the financial services industry, so that they can stick all of us with the bill,” Pellegrini says, slouching in a conference room chair in his offices in the former IBM Building in Manhattan.

‘Zero Confidence’

And Federal Reserve Chairman Ben S. Bernanke? “I have zero confidence in what the Fed is doing.”

Pellegrini has offered some of his solutions to the financial crisis in opinion pieces on financial Web sites and blogs and in correspondence to legislators and senior officials in the Obama administration. Academics have taken note of Pellegrini’s ideas to drastically reduce the footprint of banks, known as “narrow banking” in academic argot. “They are very crisp and different and provocative,” says Kenneth Rogoff, an economics and public policy professor at Harvard University. “As an academic, I find that refreshing.”

The hedge fund manager’s charitable work is informed by his global outlook. Pellegrini is chairman of the U.S. board of the Tony Blair Africa Governance Initiative. The group, founded by the former U.K. prime minister, provides political and business advice to African governments trying to reduce poverty.

Paolo Squared

Pellegrini says his fund’s name, PSQR, is a play on his own: Paolo or Pellegrini Squared. It’s also an anagram of SPQR, the initials of the ancient Roman Republic that stand for Senatus Populusque Romanus, or the Senate and the People of Rome. The four letters are still emblazoned on monuments and signs around the city, where Pellegrini was born and spent his first five years amid the cobblestoned alleys of the Trastevere district.

As PSQR’s assets grow, Pellegrini plans to assemble an investment team of 5 to 10 professionals. In May, he hired Alex Patelis, 38, chief international economist at Merrill Lynch & Co. in London, as PSQR’s chief economist. He joins, among others, two Ph.D.-toting senior analysts, JunTian Xu, 29, and Evan Borenstein, 28.

Pellegrini’s Paulson & Co. pedigree and PSQR track record will generate a lot of interest in his fund, Waksman says. Whether pension funds and other institutional investors will sign on is a question -- though Pellegrini says his firm is self-sufficient and doesn’t need outside investors. Institutions are sometimes restricted in their ability to buy into smaller funds, says Daniel Celeghin, a director at Casey, Quirk & Associates LLC, a consulting firm in Darien, Connecticut.

‘I Love Your Story’

“It may be: ‘I love your story. I love your track record. Call me when you hit $600 million,’” he says.

Plus, Pellegrini earned his Paulson & Co. stripes with credit-default swaps. His tenure in the futures and currencies markets has been brief.

“Can his skills be transferred to new venues?” Waksman says. “It’s a fair question to ask.”

Institutional investors are particularly wary of macro funds. At the end of June, they represented just 18.8 percent of industry assets, according to Chicago-based Hedge Fund Research Inc.

“Macro often comes down to one or two people looking at all this analysis and making a call,” Celeghin says. “That’s a leap of faith for institutional investors.”

Macro in a Rut

In 2008, macro was one of the few categories in which hedge funds made money, with an average return of 4.83 percent, according to HFR. This year, macro managers are in a rut, returning just 2.68 percent through August, versus a 14.1 percent gain for the average fund.

That makes PSQR’s gain of 80 percent through July all the more impressive.

Pellegrini’s quantitative disposition traces back to his early years. The oldest of three children, Paolo Marco Pellegrini was born in 1957 to a household steeped in science. His father, Umberto, was a physics professor, and his mother, Anna, worked as a biology researcher.

The Pellegrinis moved north from Rome in 1962 when Umberto was appointed a professor at the University of Milan. There, Paolo took up classical piano and attended a liceo classico, studying Latin and ancient Greek. In Italy’s left-leaning north, dinner table conversations were often political. While a teenager, Paolo joined the Partito Radicale, a pacifist, anti- establishment party that advocated a ban on nuclear weapons, marijuana legalization and divorce rights.

Electrical Engineer

In 1975, he was admitted to the Politecnico di Milano, where he pursued a degree in electrical engineering. Many nights, he volunteered as a disc jockey at Milan’s Radio Radicale, spinning vinyl by bebop greats Dizzy Gillespie and Charlie Parker.

While a student, Pellegrini remembers circulating Radical Party petitions, including one calling for the strengthening of civil liberties. He stayed clear of demonstrations and student groups advocating violence. The 1970s and early 1980s were Italy’s Years of Lead, during which hundreds were killed or wounded in bombings and assassinations by both left- and right- wing extremists. In 1978, Red Brigade terrorists kidnapped and murdered former Christian Democratic Prime Minister Aldo Moro. Pellegrini focused on school and graduated cum laude in 1980.

Amid the strikes and demonstrations, the Italian economy was a shambles. “There were few opportunities in terms of a real career track,” Pellegrini says. He looked abroad. “Business school seemed like a good investment,” he says.

‘He Was Into Data’

Pellegrini was accepted to Harvard Business School in Boston, where professors stoked his interest in finance, economics and markets. Pellegrini’s field study adviser was Professor Andre Perold. “He was into data and patterns,” Perold says. “He was intrigued by the potential of math-based systems to trade stocks.”

Michaelcheck, a partner in the fixed-income division of Bear Stearns & Co., recalls recruiting the Italian youth as a summer associate in 1984. Pellegrini wrote pitch books on possible mergers and acquisitions for the firm’s clients. He shared an office with an M&A vice president named John Paulson, who was also a Harvard Business School graduate. He and Pellegrini soon became friends. “I found him to be extremely smart and capable,” Paulson, 53, says.

After Harvard, Pellegrini landed an associate’s position in corporate finance at Dillon Read & Co. It was 1985, and swashbuckling raiders had American business on the run. “I must have worked on a dozen deals,” Pellegrini says.

Insurance Expert

Dillon Read itself was bought by Travelers Corp. in 1986, and Pellegrini moved to Lazard Freres & Co. He specialized in insurance, and advised Munich-based Allianz AG on its 1990 acquisition of Fireman’s Fund Insurance Co., a unit of Fund American Cos.

At Lazard, the pace was brutal. Pellegrini often worked 14- hour days, turning off the overhead lights in the office at night and blasting Mozart and Beethoven on his stereo. Yet Pellegrini was not a natural investment banker.

“It involved a lot of salesmanship,” he says. “That’s not my forte.”

In 1994, the fees he was generating dropped as he failed to rope in clients. The next year, Pellegrini says, Lazard fired him.

In 1996, Mariner’s Michaelcheck teamed up with Pellegrini to start a Bermuda-based firm called Select Reinsurance Ltd. After two years, the two, together with the firm’s board, decided an executive with more sales experience should replace Pellegrini.

“I was fired from that too,” he says.

No Traction

In 1999, he started a consulting firm named Global Risk Advisors LLC to counsel companies on reinsurance and other risk- related matters. The venture didn’t gain traction, and Pellegrini closed it in 2002. “Trying to reinvent myself was tricky,” he says.

Pellegrini compares these wilderness years to his treks as a youth in the Italian Alps. “There are times when you are hiking that you are really exhausted; you just put one foot in front of the other,” he says. “When you sit down, that’s when things just fall apart.”

Michaelcheck, back at Mariner, hired Pellegrini as an analyst in early 2003. At the time, a Mariner hedge fund was trading collateralized debt obligations -- bundles of housing loans and other debt -- and Pellegrini developed a fascination with CDOs, credit-default swaps and other derivatives. Michaelcheck assigned him to the fund.

Joining Paulson

Eager for a chance to run his own portfolio, Pellegrini, then 47, approached Paulson in the summer of 2004, asking for a job. “He said, ‘My analysts are more junior than you,’” Pellegrini recalls. “I said I didn’t care.”

Paulson had founded his firm in 1994 and built up two specialties. First was merger arbitrage, a strategy in which traders typically buy the stock of a possible takeover target and short that of the acquirer. The other was event arbitrage -- wagering on corporate developments such as earnings surprises and stock buybacks. Still, he was also looking for a way to make money from what he saw as a growing credit bubble.

Paulson, who makes all investment decisions at the firm, orchestrated the research and assigned Pellegrini to look into housing -- something he was familiar with from his time at Mariner. The surest bet against the housing market would be to buy credit-default swaps on subprime mortgage-backed securities. CDSs are insurance-like contracts used, in this case, to speculate on the default of a bond.

A Nervous Time

Pellegrini says the critical question was whether adjustable-rate mortgages would default as they reset at higher interest rates. Pellegrini believed they would, so in April 2005 Paulson & Co. began buying CDSs in small amounts for its existing funds.

The first year the trade was in effect was a nervous time. “From early 2005 to early 2006, it wasn’t clear the trade was going to work,” Pellegrini says. “People thought we were throwing money down the drain. We asked, Are we missing something?” Pellegrini says he would wake up in the night pondering the trade.

Before he increased his bet, Paulson wanted proof of a housing bubble, and he thought Pellegrini could produce it. “The mortgage market lends itself to deep quantitative analysis and modeling,” Paulson says. “Paolo excelled in this area.”

Finding the Bubble

Pellegrini and his colleagues zeroed in on numbers from the Office of Federal Housing Enterprise Oversight’s home price index from 1975 to 2000. He drew a regression line through the data points that showed prices would have to fall 30 percent to 35 percent just to get back to the historical trend.

“After hearing a lot of arguments for and against the presence of the bubble, we had a simple and clear insight of our own to go by,” Pellegrini says.

He recalls that Paulson broke into a smile when he showed him the proof that houses were overpriced. “John doesn’t smile,” Pellegrini says. “It felt great.”

The next step was to determine the relationship between home prices and defaults. Pellegrini hired a New York firm called 1010Data Inc. to help him integrate two databases: One, compiled by Santa Ana, California-based First American Corp. and called LoanPerformance, tracked 6 million securitized subprime mortgages.

The other was based on an S&P/Case-Shiller home price index, sorted by postal code. The combined database showed that even if home prices merely flattened, defaults would surge. “There was a very strong relationship between mortgage losses and home prices,” Pellegrini says.

A Tough Sell

Paulson & Co. began drumming up money for two new funds -- called Paulson Credit Opportunities and Credit Opportunities II -- that would be dedicated to the subprime bet.

It was a tough sell. With the housing market still galloping upward, investors wanted details of both Paulson & Co.’s research and how the trade would work.

“I remember Paolo stopping by the office at 5 p.m. and staying to 9 p.m. explaining his research,” says Jack O’Connor, chief investment officer of AI International Corp., a family investment office. “We were impressed.” Over nine months, the firm raised $1.1 billion.

As home prices continued to rise, Paulson & Co. took advantage, paying as little as 1 cent for every dollar of credit protection. Former investors still marvel at the payoff. “It was technically a beautiful trade,” one money manager says. “The asymmetry was incredible.”

Market Collapse

The housing market peaked in mid-2006. “Once the year-over- year change in home price appreciation went negative in June 2006, we thought the collapse of the market was almost inevitable,” Paulson says.

For the last half of 2006, Credit Opportunities gained 19.4 percent, according to investors. In 2007, it showed a 590 percent return. In 2008, a year when the average hedge fund lost 19 percent, Credit Opportunities posted an 18.3 percent return. Firm assets rose to $30 billion at the end of 2008 from $7 billion two years earlier.

Pellegrini’s lucrative Paulson & Co. trade -- he won’t discuss the fund returns or how much he made from them -- was based on numbers. It was also based on an assessment of American society. Pellegrini says the credit bubble in the U.S. fed existing income inequalities.

“People were pretending they were earning a living, and they were not,” he says. “Banks lent them the money so they could live beyond their means.”

A Debtor Nation

There is a corollary to that imbalance in the global economy, Pellegrini says. Massive consumption has turned the U.S. into a debtor nation, which will ultimately lead to the devaluation of the dollar, a scenario PSQR is betting on through its long-term short position on Treasury futures and its long position on commodities.

The massive stimulus programs and the resulting deficits will only make matters worse, Pellegrini says.

It’s not a bright outlook for the U.S. Yet Pellegrini’s meteoric rise is proof that bad news can produce a lucrative bounty for those with the foresight to predict it.

To contact the reporter on this story: Richard Teitelbaum in New York at rteitelbaum1@bloomberg.net.