I recently had the opportunity to sit down with David Cohen, who is both the president of Karlin Asset Management, which he founded in 2005, and the co-founder of Karlin Real Estate. Cohen has over 20 years of experience in principal investing, real estate, private equity, mergers and acquisitions and capital markets. Karlin Asset Management, which manages more than $1 billion for one primary client, exemplifies the type of expertise that's in high demand by large single-family offices. In the following interview, Cohen describes the firm's investment philosophy and how it was able to succeed during one of the most volatile financial periods in the nation's history.
Prince: Can you tell us about Karlin Asset Management?

Cohen: We're a Los Angeles-based $1 billion-plus family investing office. Our principal's original wealth was generated from the sale of a medical device intellectual property portfolio.

We like to say, "We buy value and control risk." More specifically, our mission is to opportunistically pursue superior long-term, risk-adjusted returns. This often leads us to execute contrarian and value-oriented views and investment themes. These themes are based on a strategic asset allocation, coupled with tactical overlays, where investment ideas and themes are expressed through a combination of direct investing in securities and assets, and employing outside managers.

People describe us as operating more like an institution than a family office. And I think that's right. We operate as an opportunistic investment management business. We have clearly defined functional investment areas such as securities analysis and selection, risk management and tactical hedging, asset allocation, outside manager selection and monitoring as well as direct investments in distressed real estate, lending and timber. What separates us from many other investors is the patient, stable, long-term nature of our capital. This allows us to take a highly flexible approach; we can play in many different securities, markets and asset classes.

And while I and most members of our team were trained on Wall Street, and bring that financial sophistication and rigor to Karlin, we also benefit from being based on the West Coast. First, some distance from Wall Street liberates us from the pack and allows us to think and act pretty independently. Second, we really believe that the same type of influences that make California such an entrepreneurial hotbed also drive the creative imagination that underlies our investment activities. 

Prince: How do you approach family office money management?

Cohen: It's interesting. The world labels us as a "family office" because we are in terms of managing the wealth of one private investor, but we don't think of ourselves as one, at least in terms of how most people perceive family offices.  We are really a money management shop with one stable client.  We are an active investment fund, don't manage the family office services of the principal, have institutional coverage from the Street, have short positions and hedges, and are global in our thinking and investing.

First and foremost, we are value-oriented, which just fits with my lifelong investment constitution. We have analysts with broad generalist, as well as sector-specific, experience, which is a good fit for our value focus. Then we leverage our experience, an awful lot of hard work and study, and a broad network of relationships to identify investment themes and new ideas. We pursue asymmetrical risk/reward scenarios, and we use every ounce of our creativity to discover ways to create value. We are always on the lookout for market displacements and contrarian opportunities. And as I mentioned, I have found that being 2,500 miles away from Wall Street-where most of us first earned our investing stripes-is helpful; we feel we can pursue more creative constructs and be more independent in our thinking.

For execution and management of our investments, we rely primarily on our own internal capabilities, strategically complemented with world-class outside managers.  And we maintain a fundamental, rigorous focus on risk controls across our portfolio. We monitor correlations, concentrations, and transparency risks, among others, and we'll hedge where appropriate. We really focus hard on counterparty risk, custody providers and arrangements, and our prime broker relationships. There are many institutional investors that wish they had done the same in the 2008-2009 collapse. We also are constantly seeking to optimize our tax position, but not allow it to drive our investment process. The "quants" refer to it as being "tax aware."

I should also mention that, from the beginning, we always tried to "wrestle above our weight class." We sought out and insisted on working with premier, "top-drawer" banks, prime brokers, global custodians, attorneys, accountants and consultants before we really had the girth, track record and reputation to deserve some of those relationships. They have been critical to our success. Finally, as I mentioned, we are fortunate to be working with patient capital and fully supported in our long-term focus.    

Prince: What did you do before running Karlin?

Cohen: I have spent my entire 20-plus-year career in investing and finance, first as a Wall Street investment banker and derivatives specialist at Lazard Frères, and then in a role similar to my current one for another Forbes 400 member for almost a decade. Prior to that, I received my undergraduate degree in engineering and master's degree in finance, so I always like to understand quantitative inputs and problem solving.

Prince: Where do you see the family office model evolving to?

Cohen: I have been doing this-managing the portfolios of ultra-wealthy individuals-in one form or another for most of my career.  I've seen a dramatic change in the last few years as more and more successful families have become disenchanted with both the traditional outsourced private banking model and the performance of their portfolios. 

There is a growing movement to bring in Wall Street-trained talent to properly handle money management and risk controls, and to take a much more active investment role. In other words, large family offices are beginning to be run like institutional-quality businesses under the management of experienced financial professionals. Frankly, my response is, "What took so long?" The era of passive management or, in many cases, poor-quality active management-often by the principal, or the principal's lawyer, accounting firm and other wealth advisors with all of their inherent conflicts of interest-while not over, is slowly fading away. 

If I were a Forbes 400 member and not an experienced investment professional, the first thing I'd do is hire a team like we have built here. I would look in the mirror and say, "The skills and talents that enabled me to build my wealth in the first place are not those that will allow me to maintain and grow that wealth. I need to bring in state-of-the-art capabilities to manage my wealth." And we know, for better or worse, that Wall Street has attracted the best and brightest from our universities in the past 20 years. That means I'd have to bring that talent in-house or I'd pretty much be walking into a gunfight with only a knife.  And if I brought those capabilities in-house, I'd feel pretty confident that my risk-adjusted net returns would exceed what I could earn by just investing myself, relying exclusively on often conflict-ridden private wealth advisors, or by spreading my wealth among a cast of outside managers. 

Prince: How has performance been at Karlin?

Cohen: We don't disclose specific returns and timing, but, in broad strokes, we have been very fortunate over the last six years to produce superior risk-adjusted returns. We are blessed with a flexible mandate and, as a result, have been able to significantly outperform the vast majority of institutional investment benchmarks, broad or narrow, with much less volatility. Recently, a consultant looked over our risk-adjusted return results and said that we were in the very top of the top deciles in the institutional investment universe. For example, our returns have been multiples above the equity market, hedge fund indexes, and traditional private bank benchmark, after fees and expenses. And all this during the most chaotic investment environment in over 80 years, marked by the Lehman bankruptcy, the Bear Stearns collapse, the Bernie Madoff and Stanford Companies frauds, the stock price collapse, and over 60% declines in the stock prices of major financial institutions like Citigroup, Wachovia, Bank of America and Merrill Lynch.

How have we done this? Complementing the approach I just described, we try to stay within ourselves, within our "wheelhouse." We know what we know and we know what we don't. We don't try to run all asset classes in house. We go outside when it can be done better. We have been very fortunate in attracting excellent team members to our platform, which not only has powered our investment performance, but also makes it a nice place to work.  We pride ourselves on the collegial environment and we are all pursuing excellence together. 

Don't get me wrong-we have made plenty of mistakes, too. But we notch more wins than losses, and we feel very fortunate.  

Prince: Can you give us a few examples of investment areas that you have been focused on?

Cohen: Our two overriding themes are value orientation coupled with tail-risk hedging. We have always been focused on tail risk, even before people referred to it as that. Tail-risk hedging, of course, means creating positions within our portfolio for the purpose of protecting against those outlier events in a statistically normal distribution curve. Maybe it's the engineer in me, but I believe in quantifying and measuring everything that can be measured, and I think it's important to understand and make rational decisions about what positions you own and how they might all move in a market displacement. For example, in 2007 we had no view on the level of the market but noticed that volatility was at a 25-year low.  We put on a large, in notional terms, position of equity index put options that cost us very little given this lower volatility. Our view was that if the market maintained its level but volatility spiked due to some global event, this cheap insurance would pay for itself. As luck would have it, these global options appreciated during the 2008 crash when the market took a fast and violent 50% fall. So we benefitted from volatility spiking and, at the same time, from a market correction. The large profits from this trade helped to insulate the portfolio from a massive down stroke in 2008, and provide liquidity, which set us up for a big recovery in 2009. Once volatility spiked, we switched our tail risk hedging strategies to incorporate put spreads, given how expensive puts became, and also incorporate hedges on interest rates, credit spreads, currencies and commodities.

We also look for massive cyclical displacements. I have some experience from the RTC days in the early 1990s when I worked for another Forbes 400 member, an experience that gave me a feel for real estate cycles. I promised myself all those years ago that if anything like RTC 2 came along, I would have the capital, knowledge, experience and contrarian confidence to recognize it and take advantage of it. In late 2006, I got a beautiful gift in my e-mail inbox. It was the investment prospectus for what was at the time the largest real estate investment offering ever-over $5 billion: an opportunity to invest in a massive multifamily transaction alongside some of the marquee institutional real estate investors. The bankers were telling us it was heavily oversubscribed. The property itself needed a lot of freshening up, but carried a pro forma cap rate of 4% with a business plan to upgrade, increase rents and manage it better. I think they even had some "new" cash flow and income measures that I hadn't even heard of, which is always a bad sign. Warren Buffett would have called it "priced to perfection." The lights and siren went off in my mind, and it's all I could think about. We were fast approaching the frenzied top of the real estate cycle and a large correction seemed imminent! This party just smelled like it would end badly and I wanted to set up a distressed real estate team to be in front of the curve. 

I immediately contacted several headhunters and started networking in the real estate community nationally. In general, I found a lot of "group think" and scores of senior real estate executives that couldn't step outside their bull market perspectives. I had a lot of real estate experience from the 1990s, but felt we needed additional bankruptcy and distressed experience. Anyway, we paced ourselves. We took over a year to hire the head of the group and then, together with him, watched for another year as the real estate market kept searching for a bottom. By the time we believed the bottom was near, we had built a highly skilled, highly professional distressed real estate team that was poised to invest. These folks are experts not just in real estate, but in bankruptcy and foreclosures, and have a great feel for the arcane science of unraveling difficult and complex capital stacks and making opportunistic buys of real estate and property loans and notes. We did eight direct deals last year. We also work with a top five bank, which has been financing us as well. We are growing that business exponentially at extremely attractive rates of returns with very low risk. We have been referred to as a "by the pound" buyer, which means we are willing to assume and box traditional risks all at a price. This theme is consistent with our overall philosophy, which is to understand and insulate from worst-case scenarios and position us well if things work.

We also have a meaningful timber investment in Central American hardwoods. This includes building one of the world's largest teak plantations, which will be an excellent investment from a rate of return perspective and is tax efficient. As important is the fact that we are doing our part to reverse climate change with the replanting of 40 square miles of grazing land that was formerly rainforest with six million new trees.

Another area we have done well in is master limited partnerships. MLPs are generally oil- and gas-oriented. We were in the sector going back to 2006 and liked the risk/reward dynamic, yield and tax efficiency. After our entry into the market, we began to see what became a flood of new investment funds specializing in this area. But when the market began to turn south on them in 2008, some of the funds experienced a "run on the bank"; investor redemptions forced them to sell. Other funds were highly leveraged and debt covenants forced them to sell, almost wildly, to stay in loan compliance. In this frenzied selling, we saw a huge opportunity unfold. We were initially a holder of LP interests, which typically trade at higher current yields, but offer lower long-term cash flow growth, than GP interests. We saw an inversion start to emerge. GP interests began to get cheaper, driving their yields up, while still offering superior upside in the long-term. At that inflection point, we began trading-selling LP interests and stocking up on GP interests. MLPs became our largest position at over 15%.  This really powered our returns in the 2009 and 2010 recovery. We did really well.  The benchmark Alerian MLP index, for example, was up over 70% in 2009 and 30% in 2010.

So, that's a sample of what we do. Stable capital is so important to us. For example, during early 2009, I was running around the office telling everyone that the hardest thing to do was buy and the second hardest thing to do is not sell. It was hard, but with our tail risk positions insulating us from some of the direct brunt of the economic storm, we were able to actually do both of those things. It was painful to put on more risk at that time, but the crowd did exit, some voluntarily and some less so as a result of fund redemptions, and our contrarian nature led us in the right direction.

Prince: Do you have any other thoughts you can share when it comes to investing more than a billion dollars?

Cohen: I think we are equally as proud of what we didn't do as what we have done.  For example, during the 2005-2007 period, we watched the birth of many enhanced credit strategies. During that period, we didn't feel risk credit spreads accurately reflected the underlying financial and operational risks. Visitors pitching these wares wore out the carpet in our lobby, but we just stuck to our beliefs and wouldn't bite. And, of course, we are very fortunate we didn't.
We also have never been overallocated to traditional private equity, for a couple reasons. First, over the past six years, we just didn't see a significant arbitrage opportunity between the prices of private and public equities. Second, without that arbitrage opportunity, the 10-year locks didn't make much sense to us. We place more value on liquidity. Cycles are faster now, so we feel we need this liquidity. 

And expanding for a moment on liquidity, it's critical to the way we work. We always feel we have to dig our wells before we get thirsty. So when the capital markets downturn began, when long-term lack of liquidity became a meaningful risk to most investors, we had a lot of cash on hand, undrawn credit lines we could tap if necessary, and prime broker and derivative relationships in place that would have been hard to establish in the midst of a downturn.  And we have always been highly strategic in our use of hedges, which not only protect our portfolio, but also operate to provide liquidity when we most need it. 

Prince: When it comes to investing, do you have any regrets?

Cohen: For us, the proverbial one that got away was the subprime trade-the short side of it, of course. We did a lot of work on the trade in the late part of the cycle. We were establishing bilateral derivative agreements, collecting data and talking with several professionals about joining us to execute when the collapse started. Frankly, I think we were three months too late, especially because we like to be early. We firmly believed the housing market was increasingly inflated.  We didn't necessarily know where the top was, but, in our constant search for cheap options, thought this trade should be part of our tail risk strategy. Oh well!

Prince: Would you consider taking outside money?

Cohen: Well, we are really focused on our own knitting for the moment, but we have gotten more than a few offers from the family office community to co-invest with us, which is flattering. Scale cuts both ways. Girth can give us access to certain opportunities, but it can also get in the way and prevent us from earning really high returns in niche categories. I would describe our position as "interested as a future possibility."

Prince: What is your philosophy on recruiting your team?

Cohen: Most of our investment professionals come from the institutional world-investment banking, hedge funds and private equity. Philosophically, we are committed to conducting our business with the highest levels of integrity. Thus, we hire with that foremost in our mind. We hire for, and encourage, creativity, contrarian ideas, entrepreneurialism and open debate. I am proud of the skill sets and professionalism of our team members, but even more so for them as people. I'm also lucky to have learned long ago the key to success is hire people smarter than you!

Prince: Thanks for your time.