After most of his clients have fled, billionaire John Paulson has embarked on a strategy to raise assets and generate big fees at the risk of losing his own capital.
Paulson & Co. signed up last year with the three main providers of so-called first-loss funds to pursue the wagers, according to a March regulatory filing. These deals with Topwater Capital, Prelude Capital Management and Boothbay Fund Management allow Paulson to lever-up his own capital many times over after he squandered much of it on wrong-way bets.
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.”
Paulson, 62, is making the highly levered wagers after suffering years of losses and redemptions, bringing his firm’s assets down to about $9 billion from $38 billion in 2011. He trades at least some of the first-loss assets through his Pure Spread strategy, according to a person familiar with the matter. Merger arbitrage has been a traditional strength for Paulson and he’s using it to refocus his New York-based firm.
Paulson, Topwater and Boothbay declined to comment.
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.
Attracting Veterans
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.