market folly

John Paulson catapulted to hedge fund fame during the financial crisis for his profitable bets against subprime. His exploits were even catalogued in the excellent book, The Greatest Trade Ever. Yet before all that, he paved his way on Wall Street in mergers & acquisitions.

In 1994, he started Paulson Partners and focused on arbitrage strategies. Today, Paulson & Co is the third largest hedge fund. This article traces Paulson's roots in order to learn about risk arbitrage from the manager himself.

It's little known that Paulson actually authored a chapter on the subject in the book, Managing Hedge Fund Risk compiled by Virginia Reynolds Parker. She is a graduate of Harvard Business School and founder of a firm that specializes in the design and management of fund of hedge funds.


The "Risk" in Risk Arbitrage

In the book, John Paulson writes that simply, "The 'risk' in risk arbitrage is therefore anything that affects the deal's completion, the timing of completion, or the amount of consideration received at completion."

His chapter on the subject begins by sharing advice from a risk arbitrage veteran with over 40 years of experience. This practitioner told him that, "risk arbitrage is not about making money, it's about not losing money." Given such prescient advice, it should come as no surprise that the "risk" in risk arbitrage is the key focus.

Paulson divides risk into two categories:

1. Macro Risks: Such as interest rates, exchange rates, commodity prices, and market volatility.

2. Micro Risks: Details pertinent to the specific transaction such as regulatory issues, financing, and earnings.

When looking at arbitrage opportunities, he lays out screening criteria in which he says to avoid the following: agreements in principle, deals subject to financing, targets with poor earnings, and deals in cyclical or highly regulated industries.

On the other side, he prefers to focus on: definitive agreements, large acquirers, deals with no financing conditions, reasonable valuations, and limited regulatory risk.

He concludes that, "Unfortunately, every deal has risk, so one cannot avoid risk entirely. Instead, one must prudently manage risk to produce a desired return with minimal drawdowns and low market correlation."

For an in-depth look at the strategy, embedded below is John Paulson's chapter from the book Managing Hedge Fund Risk:



You can download a .pdf copy here.

While Paulson got his start in merger arbitrage (and still today runs a fund pursuing that strategy), he has also ventured into new territory. His bets against subprime have been well documented. He's also bet on a US recovery via his aptly named Recovery Fund. His next big wager is a bet against the US dollar via his gold fund. And, in his year-end letter, he said he is recently also focusing on restructured equities.

Paulson & Co has evolved into an asset-gathering behemoth pursuing multiple strategies. But Paulson's roots stem from risk arbitrage and hopefully the above has been a useful look at this popular hedge fund strategy from a prominent manager himself.

For further insight from on hedge fund strategies from John Paulson and other managers, check out the book Managing Hedge Fund Risk. And for analysis of Paulson's latest investments, head to Hedge Fund Wisdom, our quarterly newsletter.