Nice read he realy stole more banks than we knew
February 01, 2010
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[David Tepper][Appaloosa ]
Never afraid to be first, David Tepper's Appaloosa grossed $7.5 billion last year by betting on financials early on.
By Stephen Taub
When Lehman Brothers filed for bankruptcy in September 2008, most hedge funds and other investors saw trouble. David Tepper sensed opportunity.
Tepper—who headed junk bond trading for Goldman Sachs until he left to start Chatham, N.J., Appaloosa Management in 1993, recalled the last banking crisis, in 1990, when he made big bucks scooping up the paper of the holding companies of troubled financial institutions such as Republic Bank and MCorp. He remembered that while failing banks were seized by the government and reopened under new owners, the bank holding companies were in great shape, with billions of dollars in cash and other nonbranch assets. And he knew the government couldn't break into the holding companies to take those assets. "Banks go down, but the government is not allowed to take the holding company," Tepper explains. "You can have value in the holding company. We knew the structure, how holding companies were set up. We were smart to analyze the cash."
Tepper himself was sitting on a lot of cash in the fall of 2008, having sold out of most of his positions in the spring. Nor did he have any debt, allowing him to take advantage of the tremendous opportunity his analysis turned up: Tepper's firm, Appaloosa Management, grossed $7.5 billion in 2009, more than any other hedge fund firm last year.
Most of Appaloosa's peers had spent the final quarter of 2008 desperately trying to mitigate their losses while fending off a flood of redemption requests as most stocks, especially those of banks and financial institutions, plummeted in the markets' free fall. But Tepper and his partners were busily buying battered bank debt of holding companies such as Washington Mutual, and common and preferred stock of Wachovia and others.
"When the banks went down in September, we had already set up our analysis," says Tepper. "Ah, analysis. What a funny thing."
Tepper also bought on the cheap commercial mortgage-backed securities, credit card debt and government-guaranteed student loans—the seemingly toxic stuff no one else wanted at the time.
"You had to have balls to buy all of the securities of the financial institutions," says Alan Fournier, principal at Pennant Capital Management, a $2.8 billion long/short equity manager. Fournier worked at Appaloosa from 1996 through 2001.
Sure enough, the financial paper rallied at the end of the fourth quarter of 2008, offsetting shortfalls from Tepper's longer-term holdings and enabling him to be flat for the final three months of the year, when most hedge funds suffered their biggest losses. Nonetheless, 2008 was one of his worst—Tepper's flagship fund, Appaloosa Investment I, was down 26.7% for the year due to his holdings in losers like Delphi. Thoroughbred, the fixed-income fund he started in June 2008, finished up 12.5% for the year because it wasn't saddled with troubled legacy investments.
"Investors overreacted," says the 52-year-old Tepper. "Fortunately, Bolin and I were alive in 1990. It's a bitch to be old, but sometimes it is not so bad. How many people are around who went through that in the 1990s?" (James Bolin, a former Goldman senior debt analyst and one of Appaloosa's senior partners, works with the analysts, especially on financial investments.)
Tepper and his team weren't finished. They thought the government's stimulus plan and Federal Reserve's easing would provide a tailwind for banks and other financial institutions. They also doubted that the biggest banks would be nationalized or be allowed to fail. So they continued to buy the securities of beaten down financials.
Then, sometime in February, Tepper saw what he reckoned was a sure bet. The government announced its sweeping Financial Stability Plan, which included the Capital Assistance Program, designed to shore up the capital of banks. Under the plan the U.S. Treasury committed to provide banks preferred securities that they could convert into common equity if needed to preserve lending in a worse-than-expected economic environment. This security included a conversion price "set at a modest discount" from the prevailing level of the institution's stock price as of February 9, 2009, according to the plan, which was spelled out and posted on the Treasury's Web site for all to see.
A lot of people missed it, apparently. Some fearmongers continued to worry, for example, that Bank of America might go down the tubes after buying Merrill Lynch. But Tepper turned bullish on the big bank because the government said, in effect, that it would buy its shares if they dropped to the $6s. The stock subsequently dropped to the $3s. "The government told me in writing what it would do and at what prices," he chuckles. "If they didn't, we thought it probably would have been a violation of securities laws."
Bank of America common stock would end up being the biggest hedge fund trade of the year, with more funds holding it than any other publicly traded security. But Tepper got in long before his peers, most of whom didn't brave the waters until at least the end of the first quarter.
Armed with a 30% cash position (50% in Thoroughbred) even after voluntarily returning 20% of his investors' capital at year-end, Tepper and his team went on a shopping spree. They purchased Bank of America common in the low-to-mid $3 range and junior debt and preferred stock for as low as $0.15 on the dollar. They also bought the bonds and preferred of Citigroup, eventually becoming the largest holder of preferred in Bank of America and Citigroup, except for several sovereign investors. After accounting for preferred converted to common, Tepper's average cost of Bank of America common was $3.24, while for Citi it was just $0.70. At presstime, Bank of America's common traded at $15.25; Citi's traded at $3.37.
"Do I have to be a genius here?" Tepper asks flippantly. "Normally, one or two others are buying along with us. But this time there was no one—not even the guy in Omaha. We were all alone, not a bad place to be."
Tepper also bought the common and preferred of Fifth Third Bank and SunTrust Bank and American International Group's senior and junior subordinated bonds, which were trading for as little as $0.09 on the dollar even though the government owned 80% of the company. By the end of March, Tepper spent his cash down to around 5% from 30% three months earlier, while Thoroughbred went from 50% in cash to about 13% at the end of the first quarter.
By June of 2009, his main funds were up 69% as the global stock markets, led by financials, had begun to rally in mid-March. Tepper's daring, early bet on financials set the stage for his second-best year ever, rising by 117.5% by the end of September and finishing the year with a gain of 133% net of fees. Thoroughbred, which he launched in June 2008, was up about 120% for the year.
Early on, however, investors were a bit nervous. When one asked him what his hedge was for the trade, Tepper quipped: "A shotgun. That's what we'll all need to protect our homes if I'm wrong."
The comment, and the trade, are classic Tepper, who is affectionately called the Godfather by those who know him well. Like the firefighter who runs into a burning building, he relishes when he's buying and everyone else is bailing out in a stampede. "David knows when things are out of whack," says Fournier. "He's not afraid to buy early."
Third Point founder Dan Loeb, who has known Tepper since the early 1990s, elaborates: "When other people are panicking, he has an uncanny ability to take the other side of the trade."
Appaloosa's investors largely trust Tepper, which partly explains why he did not get many phone calls questioning his performance at the end of 2008 or threats to pull out their money, as was the case at many other losing hedge funds—including a number of moneymakers. Tepper's funds—which frequently hold illiquid securities—are permitted to lock up 75% of the assets for three years, although he has never put this policy into effect. The two previous times Tepper lost money, the following year he racked up his then-best performances—up 149% in 2003 and 61% in 1999. While Tepper and his partners own a significant chunk of the firm's assets, some 60% is owned by outside investors, including institutions, foreigners, and wealthy individuals.
"We don't get much pressure from investors," said Tepper on a recent sun-drenched afternoon, as he basked in his triple-digit 2009 returns. "Investors don't leave Appaloosa. We have a lot of original investors. This is a good place to be during a panic. If you came to our office when we were down 20%, you wouldn't see a difference—it's another day at Appaloosa. The best time to invest with me is when I am down." Including 2008, he has had three down years. Appaloosa lost 29% in 1998 and 25% in 2002.
"His investors look forward to it," says Fournier. "They know what comes next."
When Tepper's funds make money, they make a bundle. He has had only one annual single-digit gain since his 1993 inception. In fact, if you had given Tepper money after 2003, you would have more than tripled your money in the ensuing six years, while the S&P 500 was flat.
Tepper has one of the highest annualized returns since inception for anyone who's been in business that long. Altogether, the flagship has compounded at 30.7% since he launched Appaloosa I in 1993, while Palomino, his offshore fund, has compounded at 28.9%. Today, Tepper manages $12 billion, including $7.3 billion in Appaloosa I and his offshore fund Palomino combined. They can invest in anything and charge a 2% management fee and a 20% performance fee. There is also $4.7 billion in Thoroughbred, which must invest at least 70% of its assets in fixed income. It charges a 0.75% management fee and a 30% performance fee above a 3% hurdle. "I think this structure is better for investors," he asserts. "You can make a return in cash when there aren't good investments."
Tepper is not shy about his abilities to outshine (and outlast) a number of hedge fund luminaries. "We can last because our returns are the highest except for those in quant, black box and high-frequency trading strategies," he asserts.
The man says his tolerance for volatility and large losses stems in part from his upbringing in the working-class neighborhood of Stanton Heights in the East End of Pittsburgh. His father was an accountant—not a CPA—and his mother a teacher. When his father won the lottery in 1986, the winnings provided an extra $30,000 per year. Although Tepper likes to say those winnings merely served as his father's pension, it seems apt that a lottery winner's son became known for his willingness to take big bets. After earning a degree in economics from the University of Pittsburgh in 1978 and trying his hand as a credit and securities analyst in the trust department of Equibank in Pittsburgh, he returned to school and earned his MBA from the Carnegie Mellon Graduate School of Industrial Administration—which was renamed the David A. Tepper School of Business at Carnegie Mellon when he donated $55 million in 2004.
Upon graduating in 1982, Tepper got his introduction to the junk bond market at the embattled Republic Steel, which did a flurry of financings of below-investment-grade debt during Tepper's two years in its treasury department. The job whetted his appetite for the junk bond market.
In 1984 he was recruited to be an analyst for junk bond funds at Keystone Mutual Funds—now part of Evergreen Investments, which is owned by Wells Fargo. The following year, Tepper was lured away by Goldman Sachs as a credit analyst in its newly formed high-yield group. Within six months, he moved into trading and six months after that became the head trader on the high-yield desk, focusing on bankruptcies and special situations. He left Goldman in 1992 when he failed to be named partner for the third time—which many attribute to his inability to fit the button-down mold of Goldman.
Tepper also found himself in the midst of the firm's politics, according to an individual close to the situation. He ruffled feathers when, after forming the junk bond group, he took bankruptcy investments away from the risk arb desk. In addition, he got caught in the middle of a turf war. Initially, Tepper reported to Robert Rubin, the legendary head of the risk arb desk who was co-chairman of Goldman before becoming Treasury Secretary under President Bill Clinton. When Jon Corzine took over as Goldman's co-head of fixed income, Tepper continued to seek advice from Rubin, which Corzine did not like. Tepper started Appaloosa the following year with Jack Walton, a former senior portfolio manager for Goldman Sachs Asset Management, who has been out of the picture for many years.
The onetime junk bond trader's investment style is tough to define. Tepper is known for his expertise in distressed securities, which he calls his bread and butter. Yet equities generally make up about 30% to 40% of his overall portfolio, and over the years, he has cashed in on the stocks of major domestic and international industrial companies as well as in emerging markets. In fact, in 2009 his equity portfolio was up roughly 220%, while his fixed income portfolio rose "just" 150% or so.
"If we were that kind of fund, people would be saying what a great equity fund this is," he says. Tepper's funds often take concentrated positions and on occasion, he will also take an activist position, as he did with health care services provider Beverly Enterprises several years ago. Or he'll play banker to bankrupt companies, as he proposed with auto supply giant Delphi before backing out of the deal in 2008, when the economy and the auto industry's prospects soured. Tepper lost about $200 million on Delphi, hurting performance in 2008. Had it not been for the settlement costs of Delphi, plus a small loss on the position, returns in 2009 would have been even better.
Since Tepper frequently takes a macro view, he admits that his biggest mistake in 2008, including Delphi, was that he invested poorly and traded poorly because he was too long, thinking the economy was stronger than it was. But in early 2009 he correctly wagered that the environment had improved for financial securities because the U.S. Federal Reserve and its counterparts in other parts of the world were committed to cutting rates to try to jumpstart the economy.
After assessing the big picture, Tepper looks for the best value within the capital structure—whether it is bonds, preferred stock, bank debt or equity—sometimes engaging in capital structure arbitrage. He also is not afraid to be the first in, either. In late 2006 he cashed in by making a prescient bet on 70 large cap stocks, while in 2004 he took a large position in a number of commodities stocks before anyone else. "We have an internal saying: The worse it gets, the better it gets."
Tepper generally prefers investing in areas that are way out of favor. "When bad becomes good after an inflection, people are still in a bad mood," Tepper explains. "We are good at the inflection point." He cites as examples Russian paper at the end of 1998 and commercial mortgages at the end of 2008, when investors wanted to get these investments off their books.
"David is the smartest, shrewdest, quickest analyzer of information I have ever seen," says Jeffrey Altman, founder of the hedge fund Owl Creek Asset Management, who has known Tepper for about 20 years. "He combines speed of analysis and a strong conviction, and then puts his weight behind it."
Jerry Boesel, an early investor in Appaloosa while managing director in charge of hedge fund investing at Weyerhaeuser, says of Tepper, "He has been a trader all his life so he has a trader's mentality." Boesel retired in 2007 as chief investment officer, and head of liquid markets strategies at the alternative investments products division at Morgan Stanley. "Unlike other traders, who see price movements, David incorporates fundamental ideas from his analysts. I think he is amazing in his ability to develop a conviction, make a large bet on that conviction, and then change his conviction on a dime if he gets information in contrast with that belief."
And Tepper is not afraid to lose money, which he views as critical to his success. He says that while many managers have a lot of trouble being down and coming back from it, "it's almost cultural at Appaloosa. We are consistently inconsistent."
At the same time, he insists that he doesn't take unnecessary risks. In 2008, for example, he scaled back leverage to less than one-for-one and went largely into cash. At the same time, he is willing to absorb a large decline if necessary while buying at that perceived inflection point and waiting for his bets to pay off. "You don't make money if you don't take risks," Tepper says, "but you must take the right risks and have the right risk management."
At Appaloosa, there is no rigid process for identifying investment opportunities. Tepper scoffs at the idea of running screens, asserting, "You just have to open your eyes." Back in the mid-1990s, shortly after he launched Appaloosa, Tepper made a lot of money in Argentinian bonds during the Mexican peso crisis after tracking bank deposits in Argentina.
Tepper was early into Korea after the 1997 Asian currency crisis when he saw reserves start to pick up. He says that in 1998 he found bargains in the sovereign debt of many emerging markets, especially Russia following the Russian ruble crisis, and that most investors didn't want this paper on their books after it collapsed. "People get too negative and take things down to crazy levels," Tepper says. "The bad was turning good. But people get too negative to realize things are turning good."
That said, Tepper laments that in 2007 he was up only 9% because he missed a once-in-a-lifetime play in the subprime meltdown, which put Paulson & Co.'s John Paulson on the map when he personally made $3.7 billion in one year shorting subprime mortgage securities.
Tepper entered 2008 with a big exposure to large-cap stocks. But when Société Générale revealed in January of that year that a rogue trader cost it $7 billion, Tepper overreacted by dumping his long positions, fearing there would be a huge global sell-off. And the market did fall, but then it turned up. "We got whipsawed by that," he concedes. Eventually, the global markets plummeted, especially in the second half, but Tepper laments that he could have better managed that large-cap position.
Tepper hasn't always been right, of course. His most high-profile setback was his ill-fated investment in the auto parts industry. In 2005, Tepper bought the stock and bonds of Delphi. More than a year later, his firm teamed up with Cerberus Capital Management and other investors that pledged to pump as much as $3.4 billion into the autoparts maker, which was already in bankruptcy at the time. The offer was terminated six months after a judge approved Delphi's bankruptcy plan.
Appaloosa wouldn't give up. In 2007, Appaloosa led another investor group that promised to invest $2.55 billion in the company in exchange for stock. The group tried to amend the deal but eventually withdrew altogether in April 2008 as the overall economy continued to sour. Delphi sued. And in October 2009 Delphi announced it had reached a settlement with Appaloosa. The terms of the arrangement were not announced, and neither party would comment.
Tepper is most guarded when talking about his Delphi experience. He says Delphi's bonds were cheap when he first invested in them. But then, he says, the world fell apart. "Like a lot of people, we did not see how awful the economy would get," Tepper says. And even though some of his peers did see it coming, none of them can match his long-term record. "The world got worse."
Tepper says he wanted Delphi to cut debt, figuring it would have been too leveraged after it emerged from bankruptcy and therefore would have likely returned to bankruptcy after a reorganization. So Tepper made sure his financing deal with Delphi contained a number of covenants that were triggered by market-based interest rates and other factors that, he says, enabled him to back out of the deal. "We had tests to protect ourselves," he says. "They questioned our protections."
Tepper says he learned a powerful lesson for any future bankruptcy deals he may do. "I will be more circumspect and careful about how the whole bankruptcy process works," he promises.
As Tepper winds down his second-best year ever, he is holding on to some of the positions that generated his outsize returns. He continues to have paper gains in many of the bank securities he bought early in 2009, although he says he has trimmed many of those holdings. And most of the easy gains have already been made, he warns.
Yet he thinks shares of Bank of America, even now his largest equity holding, could double in price. For example, he has a roughly $3 per share earnings estimate for the bank, and it is trading for only around $15. Whenever financials sell off, he adds to his bank holdings with other names he won't disclose which aren't in his portfolio.
Before the new year, Tepper argued that the most attractive opportunity was in the preferred stock and hybrid securities—a combination of preferred stock and junior subordinated debt—of a number of banks and insurance companies. They each offered their own individual risks. But many of them were yielding between 10% and 11%. For example, he owns the subordinated bonds of Lloyds Bank, which have a 10.5% yield to maturity. "It is a very good bank," he insists.
Tepper also owns the convertibles of Wells Fargo, paper issued by Wachovia before it was bought by Wells Fargo in 2009. The converts are currently trading to yield about 8%, but Tepper thinks that could drop to around 7% if the spread to Treasuries narrows—it's a play on the world economy not slipping back into recession. If he's right, he figures to make 12 to 13 points on price appreciation plus the coupon.
Although many of the commercial mortgage-backed securities Appaloosa bought at the end of 2008 have climbed from their depressed prices of about $0.19 or $0.20 on the dollar to about $0.40 to $0.50, Tepper says the market continues to be interesting. "They rallied, but still people don't want to show commercial mortgages on their books," he notes. "People also don't understand the structure of CMBS."
It's mostly the first mortgage paper Appaloosa buys, as Tepper thinks that if there are some problems in the market, maturities will mostly be extended. Holders of the equity may get wiped out, and mezzanine debt holders will likely be hurt, but the first mortgage holders won't. Tepper typically buys several tranches of first mortgage paper, and he figures the returns range from 7% to 8% for the least risky to as much as 20% for the riskiest.
"Big opportunities remain," Tepper says. But he warns not to expect his performance in 2010 to come close to that of 2009. In fact, he says most of the markets he is invested in look "boring," requiring him to grind out returns. He says investors should look for returns of 20% or so on the bank preferreds and hybrids from the end of last year.
Tepper is not anticipating either strong economic growth or a recession. Rather, he expects something in the middle, but it will be choppy—what he calls a Texas two-step—with a good statistic followed by a bad one. For instance, he doesn't think the Fed will raise rates until stronger growth in the economy is evident or unemployment starts to come down.
In the junk bond market, spreads are relatively wider than they should be in such an environment, according to Tepper, who prefers to play BB paper. In general, junk spreads have narrowed sharply from 2000 basis points to between 550 to 600 nowadays. Historically BB paper has been closer to 250 to 300 basis points above comparable Treasuries, but Tepper says the slow-growth economy should lead them to bottom out a little over 400 bps. "I think 400 will be the new 300," he says. This means he can still enjoy a 50- to 100-bps move. "To get to the new normal will be a grind," he warns. "This is really boring compared with what we just had."
Tepper thinks that that the overall size of the junk bond market will shrink and that there will be no new net supply because most of the new issues are just refinancings. Moreover, there are very few new leveraged buyouts and no big capital projects to finance and other companies are paying down debt with cash. "So, you got to grind, grind, grind," he says. "But boring doesn't mean you can't make money."
On the equity side, Tepper is not overly bullish. He does not think the stock market overshot its targets in 2009, given that he expects slow economic growth for 2010. He points out that the average earnings estimate for the S&P 500 is around $73 to $75. With the S&P at about 1090, the price-to-earnings ratio would be about 14.5. "This is nothing to get excited about," he stresses. However, if the economy grows 2% to 3% or so for the next few quarters, he thinks P/E multiples could expand to 16 or as much as 18 times earnings. "To go to 16 times, $75 is not so bad," he adds. "If you believe there will be 4% growth, you better be buying the market."
However, he is a bit nervous about what he fears will be policy mistakes as a result of the new populism on both sides of the political aisle and expresses concern that both Fed Chairman Ben Bernanke and Treasury Secretary Tim Geithner will be dumped.
Over the years, Tepper has tried to pass himself off as just your ordinary billionaire next door. While his children were growing up, he says he tried to keep them as grounded as possible. He coached their soccer, softball and baseball teams, and he points out that he lives in the same house he bought about 20 years ago and does not own a second home or even a boat. "We have a lot of middle class-type values," says Tepper, casually dressed in an argyle sweater, which makes him look more like the firm's IT guy than its billionaire owner. Only in recent years did his children learn the extent of their father's wealth, mostly from press reports chronicling his annual earnings and wealth.
Of course, they couldn't help but be impressed with their dad's pledge to Carnegie Mellon University and the subsequent renaming of its business school after him. And several years ago Tepper hired Ashlee Simpson to sing at his youngest daughter's bat mitzvah.
As his youngest child prepares to head off to college next fall, Tepper makes it clear he is itching to reap more of the benefits of his success as well as raise his profile. "I tell my kids, now I am ready to be rich," Tepper quips. "I'm serious." He no longer needs to be around all the time or raise them in one home. So, he is thinking about buying an additional place, perhaps either in the Hamptons or Florida. And earlier this year, he became a minority investor in his hometown Pittsburgh Steelers football team.
These days he is spending less time at the office. Instead of working from 7:30 a.m. to 6 p.m., he is coming in closer to 8:30 and leaving by 5:30. Eventually he would like to cut back a day or so. For more than a year now, he hasn't been doing the trading on a day-to-day basis (having delegated the responsibility to three additional employees), although he was heavily involved in the pivotal bank trades last February and March. "They will survive without me being here all the time," says Tepper. "You can't work the same way at 52 as you did at 35."
Tepper wants to devote more time to charities. He wants to help boost education in New Jersey and has given money to non-profit TurnAround, which works with school districts to improve them. As the economy sank deeper last winter, Tepper also gave money to soup kitchens, pantries and food banks in New Jersey and Pittsburgh. He is giving again this year.
Scaling back should not be too hard for Tepper. He has never been concerned about going public or creating a firm that would outlive him. However, as he spends less time at Appaloosa, he doesn't think anything will change much because he has a solid team. He says that Bolin is "the best pure analyst on Wall Street" and partner Michael Lucas is "a great analyst."
Tepper recently expanded the firm to 23 people when he picked up three individuals from Columbus Hill Capital Management, which was founded by former Appaloosa employee Kevin Eng. Tepper had planned to merge with Columbus, but the deal fell apart.
However, Tepper once again plans to shrink the firm's assets. He never aspired to top the list of the largest hedge fund firms, having returned a total of $6.3 billion to investors over the years, including redemptions. This includes 2008, when he gave back 20% of his assets on two different occasions. The second time, however, was tricky. Mired in litigation with Delphi, Tepper had to reserve about $3 billion of the assets, but he did not want investors to feel obligated to remain in the fund and pay a management fee just because some of their money was being set aside. So he offered them a choice: If they wanted out of the fund altogether, he would take their share of the reserve and place it in a separate account, invest it in T-bills and not charge a management fee. Or they could put the money in Appaloosa. Tepper estimates his redemptions amounted to only 5% or so, although he concedes this is partly because investors assumed that if they had to leave some money behind for the Delphi reserve, they might as well leave it in the fund.
In any case, as 2009 wound down, Tepper acknowledged he was uncomfortable sitting on such a big pile of assets and says he will most likely return money to Appaloosa investors (but not those in Thoroughbred) sometime in 2010. He won't say how much. "Appaloosa is more art," he says. "It is hard to create art. It can't be that big and create art."
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