Tepper Turns Panic to Profits With $6.5 Billion Hedge Fund Gain

Date: Tuesday, January 5, 2010
Author: Richard Teitelbaum, Bloomberg

David Tepper often throws a $20 bill on the floor when he’s weighing a big investment with analysts at Appaloosa Management LP.

“Would you pick that up?” Tepper, founder and president of Appaloosa, asks them. His point: The best trades can be like found money.

That was the case in early 2009, he says. Shares of banks such as Citigroup Inc. and Bank of America Corp. were collapsing on rumors they would be nationalized. On Feb. 25, the U.S. Treasury put out a white paper and a term sheet on its Web site for the government’s Capital Assistance Program. They said the preferred stock the government was buying in the banks would be convertible to common shares at prices far above where they were trading -- 37 percent higher in the case of Citigroup and 21 percent for Bank of America, according to Bloomberg calculations.

For Tepper, 52, that meant it was time to buy. “If the federal government was putting out this paper, they weren’t going to nationalize the banks,” he says.

Second, the conversion price of the preferred shares meant the bank stocks were seriously underpriced.

“It was crazy,” says Tepper, a Pittsburgh native. “In February and early March, people were in a panic.”

Appaloosa began scooping up bank-related securities, including common and preferred shares and junior subordinated debt. The Short Hills, New Jersey-based hedge fund firm bought into Bank of America, Citigroup, Fifth Third Bancorp and SunTrust Banks Inc. Tepper also bought the bonds of New York- based American International Group Inc., Frankfurt-based Commerzbank AG and London-based Lloyds Banking Group Plc, paying as little as a nickel on the dollar.

$1 Billion Gain

As the stocks and bonds rose later in the year -- Bank of America and Citigroup shares surged 330 percent and 223 percent from Feb. 28 through September -- Appaloosa made more than $1 billion.

The bank investments helped Tepper’s flagship fund, Appaloosa Investment LP I, achieve a 117.3 percent return for the nine months ended on Sept. 30, making it the best-performing hedge fund with assets over $1 billion, according to data compiled by Bloomberg. Estimated profits for the $3.03 billion fund were headed toward $195 million, after taking into account the fund’s 26.7 percent drop in 2008, Bloomberg Markets magazine reported in its February 2010 issue.

Four Funds

Tepper’s firm has $12 billion under management in four funds and separate client accounts. The funds are: the U.S. flagship Appaloosa Investment; offshore Palomino Fund Ltd., which was up 114.4 percent as of Sept. 30; and the offshore and onshore versions of the Thoroughbred fund, which rose between 83.5 and 95 percent, depending on when investors bought in.

All told, Tepper’s firm gained $6.5 billion through Sept. 30.

Like Tepper, many managers that scored high in Bloomberg’s ranking of top-performing funds sniffed out bargains amidst the detritus of the 2008 crash.

The $3 billion Redwood Capital Master Fund Ltd., run by Tepper’s fellow Goldman Sachs Group Inc. junk-bond-desk alumnus Jonathan Kolatch, is No. 2, with a 69.1 percent return through Oct. 31.

The $1.1 billion Tosca fund, managed by founder Martin Hughes, returned 44.2 percent and ranked No. 12. It benefited from rebounding emerging-market stocks, including China’s Geely Automobile Holdings Ltd., which rose more than fourfold in 2009 through October.

Distressed Loans

The $1.34 billion Tennenbaum Opportunities V LLC fund loans money to distressed companies. It surged 58.5 percent in the first nine months of 2009, winning the No. 5 spot on the best- performing roster.

The most-profitable funds are attached to familiar names. The only fund to break the $1 billion mark for 2009 profits was East Setauket, New York-based Renaissance Technologies LLC’s quantitative Medallion Fund, co-founded and managed by mathematician Jim Simons.

Medallion followed its 80 percent gain in 2008 with a 38 percent rise in the first 10 months of 2009 and earned $1.1 billion, according to Bloomberg estimates. The second-most- profitable fund was London-based Brevan Howard’s Master Fund Ltd., which had estimated profits of $784.3 million.

Also based in London is the third-most-profitable fund, BlueCrest Capital International Ltd., founded and managed by Michael Platt, which rang up earnings of $409.3 million.

High-Water Mark

The ranking of best-performing and most-profitable funds is based on figures taken from a variety of sources, including data compiled by Bloomberg, hedge fund research firms, investors and the fund firms themselves. To derive the profits for funds, a 20 percent performance fee was used if fee information wasn’t available.

Funds that lost money in 2008 had to reach their high-water mark -- make up for losses -- before any profits could be calculated for 2009. Tepper says his flagship fund made up for its losses by June 2009.

Appaloosa’s snapback from its 2008 loss marks a broader trend: the turnaround of the hedge fund industry overall. After losing a record 19 percent on average in 2008, hedge funds racked up gains of 16.7 percent in the first 10 months of 2009, according to Chicago-based Hedge Fund Research Inc. The gain puts the industry on course for its best year since 1999.

Some fund categories beat the average by big margins. Energy funds were up 32.2 percent through October, according to HFR. Russian and Eastern European funds, down 59.4 percent in 2008, were up 47.4 percent. Convertible arbitrage funds, which lost 33.7 percent in 2008, generated 54.4 percent gains.

Waterstone Earns 50%

Convertible arbitrage funds, in their simplest incarnation, buy convertible bonds and sell short, or bet against, the corresponding equity, locking in the bond’s yield.

Convertible arbitrage fund Waterstone Market Neutral Master Fund Ltd. ranked No. 8 on the best-performing list, with a 50.3 percent return. Manager Shawn Bergerson says issuers have been buying back their convertibles at a rapid clip or exchanging them for common stock. And he says big mutual fund managers such as BlackRock Inc., Fidelity Investments and Pacific Investment Management Co. have been buying into the convertible market.

“The new buyers have been pushing up prices,” Bergerson, 44, says. “That’s good for me going forward.”

After the market turmoil of 2008, when the S&P 500 plunged 38 percent, analysts predicted a nuclear winter for hedge funds in 2009. Morgan Stanley’s Huw van Steenis in February forecast that hedge fund assets would likely tumble to $950 million by the end of 2009 from a peak of $1.93 trillion in mid-2008.

Investment Reversal

That didn’t happen. Investors yanked $154.4 billion from hedge funds in 2008 and an additional $146.1 billion in the first half of 2009, according to HFR. By the third quarter, investors had reversed course, adding $1.1 billion.

The 2008 upheaval did cull the herd. HFR estimates 1,471 funds were liquidated in 2008 and 668 more died in the first six months of 2009, leaving a total of 6,723. The research firm calculates that 67.5 percent of funds were below their high-water marks on Sept. 30, 2009.

Now, managers say fresh money is flowing in from underfunded pensions. Seattle-based consulting firm Milliman Inc. estimates that large corporate pension funds as of October were only 75 percent funded, compared with 93.8 percent a year earlier.

“How are they going to make that up?” asks Carrie McCabe, founder of Lasair Capital LLC, which invests in hedge funds. “They can’t do it with fixed income.”

Wild Ride

Pensions that invest with Tepper are in for a wild ride.

“When he sees a fat pitch, he just keeps swinging and swinging,” says Alan Fournier, a former Appaloosa partner and founder of Pennant Capital Management LLC.

That can mean big gains -- and big losses. In three years - - 1998, 2002 and 2008 -- losses exceeded 20 percent.

In his 2009 wager on bank stocks and bonds, Tepper invested a peak of 30 percent of Appaloosa’s assets across the financial companies’ capital structures. In late 2008, Appaloosa bought bonds and preferred shares issued by Washington Mutual Inc. and Wachovia Corp. for about 20 cents on the dollar, Tepper says. After JPMorgan Chase & Co. announced it would acquire the assets of Washington Mutual and Wachovia agreed to be bought by Wells Fargo & Co., the securities soared, with the Wachovia preferreds doubling in price.

Tepper bought AIG’s debt for 10 cents on the dollar in early 2009, when the insurer was still struggling to survive a near-death experience. The U.S. government agreed to acquire about 80 percent of the firm’s stock in September 2008 in exchange for an $85 billion line of credit. By December 2009, Tepper’s bonds were trading for 61 cents.

‘For the Jugular’

“When David sees the right opportunity, he goes for the jugular,” says Kevin Eng, a former Appaloosa partner who is co- founder of Columbus Hill Capital Management LP. “He knows this is a risk-taking business.”

From July 1, 1993, to Sept. 30, Appaloosa Investment recorded an average annual return of some 38 percent, 30.7 percent net of fees.

“I don’t think Warren Buffett holds a candle to him,” Fournier says. Class A shares of Berkshire Hathaway Inc., of which Buffett is chief executive officer, returned 12.3 percent annualized for that period.

Sitting in Appaloosa’s second-floor conference room in Short Hills, Tepper sips from a can of Diet Sunkist orange soda and talks about his recent performance. He is just under 6 feet tall (183 centimeters) and is dressed in a shirt with blue and brown stripes, jeans and white Nike sneakers.

Modest Lifestyle

Tepper has lived with his wife, Marlene, in the same spacious, stone-faced contemporary house in a nearby town since 1991. He owns no vacation homes. His three children either graduated from or still attend local public schools. He coached their softball, baseball and soccer teams.

A sports fan, in September 2009 he bought a 5 percent stake in the Pittsburgh Steelers football team. A Steelers helmet sits on a table in the foyer of his office.

While Tepper is pleased to have done so well in 2009, he remembers the mistakes of 2008 just as vividly.

“We were positioned badly and traded badly,” he says.

Early in the year, Tepper bet heavily on a rally in large- capitalization stocks, buying both individual equities and index futures, he says. The S&P 500 fell 19 percent in the first nine months of the year.

Delphi Lawsuit

The firm also lost money when an Appaloosa-led investment group decided to back out of a plan to provide some $2.6 billion in financing for the bankruptcy reorganization of auto parts maker Delphi Corp.

Tepper said at the time the company wasn’t meeting the terms of the deal. Delphi sued Appaloosa, and the two settled.

David Alan Tepper started modestly. He was born in Pittsburgh in 1957 to Harry Tepper, an accountant, and his wife, Roberta, an elementary school teacher. He grew up in a redbrick house in the neighborhood of Stanton Heights. One of his hobbies was collecting baseball cards -- and impressing his friends by spouting statistics on the local Pirates and other teams.

“My memory is almost photographic, not quite,” Tepper says. “It drives my analysts crazy.”

Nevertheless, he was an indifferent student at Pittsburgh Peabody High School, he says, and something of a class clown. He remembers being kicked out of one class and told by the teacher, “Go roam the halls and act like the animal you are.”

Tepper began buying penny stocks in high school, sometimes conferring with his father on the subject. As a student at the University of Pittsburgh, he got more sophisticated, developing a system for options trading that helped pay his expenses.

Carnegie Mellon Grad

He graduated with a degree in economics in 1978. Later he enrolled in Carnegie Mellon University’s Graduate School of Industrial Administration. At his first presentation, in front of 150 classmates and the dean of the school, Tepper explained how changing one input variable wouldn’t affect the outcome of a particular equation.

“I don’t give a s--t what you put in here,” Tepper told the class, tapping on the blackboard.

After a pause, his fellow students burst out laughing. At the annual student follies, they composed a song to the tune of the Dr. Pepper advertising jingle: “I don’t give a s--t. Be a Tepper. Be like Tepper.”

Tepper was a star of the business school -- renamed the David A. Tepper School of Business since his 2004 donation of $55 million. Dean Kenneth Dunn taught Tepper in an options class -- a rarity at the time -- and recalls the future billionaire hurling tough queries at him.

Tough Questions

“When he asked a question, I’d say, ‘That’s a great one,’” Dunn recalls. “‘I’ll get back to you at the next class.’”

Upon graduation in 1982, Tepper got a job in the finance office of the troubled Republic Steel Corp. in Cleveland -- giving him first-hand experience at a distressed company. Two years later, he landed a credit analyst position at Keystone Funds in Boston.

Then, in 1985, Goldman Sachs called, and Tepper joined its new high-yield bond desk.

“He quickly showed himself to be lead dog,” says Richard Coons, a former Goldman trader who invests with Appaloosa. Tepper moved from research to trading, and by the end of 1986 he was head of the junk-bond desk.

One mentor was Robert Rubin, then Goldman’s fixed-income chief and later co-chairman of the bank. Rubin served as Treasury secretary in the administration of President Bill Clinton.

Junk Bond King

As the 1980s junk-bond rally gathered steam, Tepper’s desk became one of Goldman’s most profitable. One lucrative honor, however, eluded him: partnership. At the time, Goldman partners were named in even-numbered years. Tepper was passed over in 1988 and again in 1990, probably, he says, because the high- yield bond market tanked following the bankruptcy of junk-bond firm Drexel Burnham Lambert Inc.

By 1992, junk bonds were roaring back, and Tepper’s desk earned tens of millions of dollars. A partnership seemed certain. Tepper was disappointed again. “I said there’s nothing I can do to make partner,” he says.

Tepper quit in 1992 to start Appaloosa, together with former Goldman junk-bond salesman Jack Walton. He says he chose the name partly because his first choice, Pegasus -- the winged horse of Greek mythology -- was taken.

Appaloosa was launched with $57 million in assets, most of it from people Tepper met through Goldman, from funds of funds and from insurers. In the last half of 1993, the firm’s fund recorded a 57.6 percent net gain.

Fast Growth

By the end of 1994, Tepper was managing $300 million; the next year, $450 million; and by 1996, some $800 million.   Tepper’s strategy from the beginning was to look for easy money, particularly in distressed companies and countries.

One of his early investments was in Sault Ste. Marie, Ontario-based Algoma Steel Inc. The integrated steel maker emerged from bankruptcy in 1993. Tepper read the prospectus for what were described as preferred shares. He was surprised to find that the shares were actually first mortgage bonds whose collateral was Algoma’s plants and headquarters.

Tepper says he bought the bonds at 20 cents on the dollar and unloaded them within a year for 60 to 80 cents.

“A lot of things are simple in investing, but people don’t do the analysis,” he says.

Appaloosa built its reputation on bankruptcies. Tepper likes to cut through the legal complications typical of reorganizations and snap up cheap assets. He cites Appaloosa’s 2002 investment in the senior debt of Marconi Corp., which traded for less than the cash on the telecom company’s balance sheet.

Cash Cheaper Than Cash

Tepper estimates that the investment contributed more than 5 percentage points to his flagship fund’s 148.8 percent gain in 2003.

“It’s nice when you can buy cash when it’s cheaper than cash,” he says.

Appaloosa’s search for profits has taken Tepper far from his New Jersey base. In 1995, Argentine bonds looked like a bargain because rising bank deposits portended a strengthening economy. Tepper’s purchase of the sovereign debt helped Appaloosa Investment to a 42 percent return in 1995.

In 1997, as the value of the Korean won fell by more than 50 percent, Tepper plunged into Korean currency futures and government bonds -- a move that landed a photograph of a grinning Tepper on the front page of the Korea Times, an English-language daily.

Asian Play

Appaloosa Investment finished 1997, the year the Asian financial crisis began, up 29.5 percent.

Tepper’s timing isn’t always perfect. In 1998, Appaloosa Investment bought Russian debt, wagering the government would not default. It did, helping to trigger a near meltdown of global financial markets and handing the fund a 1998 loss of 29.2 percent.

Tepper snapped back with a 60.9 percent gain in 1999 when he bought Russian bonds post-default. In 2002 and 2003, he profited by snapping up the cratering debt of utilities such as Williams Cos. -- setting up his best-ever return, 148.8 percent in 2003.

Low stock market volatility and a dearth of big bankruptcies worked against Tepper from 2004 to 2007, though he still managed 20-plus percent annual returns from 2004 to 2006.

Tepper runs a surprisingly small operation. Just 11 professionals work at the firm. There are no investment committees.

“The daily meeting is every second of every day of the year,” he says with a laugh. “There’s no place to hide at Appaloosa.”

BlueGold

Not all managers that placed high in the Bloomberg ranking were dumpster-diving value investors like Tepper.

BlueGold Capital Management LLP co-founders Pierre Andurand and Dennis Crema trade oil. Their BlueGold Global Fund LP is ranked No. 7, with a 54.6 return for the first 10 months of 2009, according to Bloomberg data.

Andurand and Crema started BlueGold in February 2008, when rising oil demand in emerging markets and a lack of capacity were sending crude higher. The two, who once worked together in the London office of Geneva-based energy trader Vitol Group, bought crude futures and call options. By the end of June 2008, the fund was up 158 percent as crude prices spiked to more than $140 a barrel.

Then, as the economic slowdown accelerated, oil prices tumbled: BlueGold lost 19 percent in July 2008 alone. The fund went to cash while CEO Crema and Chief Investment Officer Andurand plunged into market analysis.

Volatile Oil

“Oil demand destruction was upon us,” says Crema, 49, who once worked on an oil tanker.

BlueGold shorted both Brent and West Texas Intermediate in September and finished 2008 with a 209.4 percent gain.

By the end of February 2009, Andurand and Crema thought that the worst of the oil sell-off was over. The fund bought futures and options on West Texas crude -- and scored its 54.6 percent return as prices rose and then stabilized above $70.

“The key is about being able to adapt,” says Andurand, 32, who kickboxes before work. “We never get stuck with a position we don’t like.”

Changhong Zhu shares credit with Pimco co-investment chief Bill Gross for his fund’s high 2009 return. Zhu oversaw PARS IV, one of a group of hedge funds run by Newport Beach, California- based Pimco, whose PARS funds use leverage and short selling to hedge unwanted risk and ratchet up performance of the strategies of Pimco’s better-known mutual funds.

Pimco Hedge Fund

PARS IV is No. 4 among the best-performing hedge funds, with a 61 percent 2009 return through October, according to Bloomberg data.

“We’re not supposed to generate returns that are that great, given our diversification,” says Zhu, 40, a native of China’s Anhui province who has a Ph.D. in physics from the University of Chicago.

PARS IV lost 17 percent in 2008 after Zhu made a wrong-way bet that the prices of credit-default swaps and the corporate bonds they protected would converge. Instead, they went in opposite directions.

In 2009, Zhu followed the advice of Gross and other colleagues and bought beaten-down non-agency mortgage bonds. Like Tepper, Zhu also made money buying bank holding company bonds and preferred shares of Bank of America, Citigroup and JPMorgan Chase.

“Crisis in Chinese means both danger and opportunity,” Zhu says. “I never knew what that meant until this happened.”

Crisis and Opportunity

Zhu is scheduled to leave Pimco at the end of February to serve as chief investment officer of a Chinese sovereign wealth fund.

Seizing opportunity out of chaos is the philosophy that has guided David Tepper for years. And his investors know it. Even in the midst of the 2008 meltdown, Appaloosa got relatively few redemption orders, Tepper says. In any case, all investors agree to three-year lockups, and Tepper can limit withdrawals to 25 percent of the requested amount.

Still, Tepper says he doesn’t want to gather assets simply for the sake of reaping more fees -- a surefire prescription for undermining returns. Five times in the fund firm’s history he has returned investors’ capital when Appaloosa had trouble putting it to work.

If there isn’t a $20 bill on the floor to pick up, Appaloosa isn’t interested.

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