Steyer had created what would later be known as an “event-driven” hedge fund. He specialized in events that caused existing prices to be wrong—moments when a disruption suddenly rendered the market’s settled view inoperative. The moment before a takeover bid, a company’s share price embodies the verdict of investors who have projected future earnings: The price is efficient in the sense that it has been analyzed to death already. The moment after the takeover bid, the old calculations are scrambled: Now the analysts have to look at the size of the takeover premium, the time until it is likely to be realized, the rate at which it should be discounted, and so on. In similar fashion, an event such as a bankruptcy scrambles yesterday’s consensus on the value of a company’s bonds. Again, the challenge is to look afresh at the cash flows that each busted bond seems likely to generate.
Even before the Drexel coup, the news of Steyer’s performance had reached the ears of David Swensen. Steyer was making excellent money irrespective of whether the stock market was up or down—he offered diversification. Steyer was generating profits by focusing on occasions in which settled prices were scrambled; to a financial economist attuned to the limits of the efficient-market hypothesis, the success did not look merely lucky.11 These two factors were enough to make Swensen reconsider his initial refusal to invest in Farallon. But before he went further, Swensen had to take the measure of Steyer the man. He wanted partners with integrity, and he wanted something more as well. Beating the market was only possible for people with a sort of obsessive passion. “Great investors tend to have a ‘screw loose,’ pursuing the game not for profit, but for sport,” Swensen wrote later.12
As Yale did its due diligence, it found that Steyer had all the qualities that the endowment could hope for. This guy was not running a hedge fund because he craved luxury: You just had to look at his office to see that. This guy shared Swensen’s passion for pure compensation incentives: He insisted that Farallon employees keep their liquid savings in the fund so that they would feel the pain if they lost money.13 Steyer also embraced the convention of a “high-water mark,” meaning that if his fund was down he would take no further fees until he earned the money back for his investors.14
In the fall of 1989, Swensen flew to San Francisco. He visited Farallon’s scruffy office and approved of what he saw; but over a cheap lunch with Steyer and another Farallon partner, Fleur Fairman, Swensen repeated his earlier verdict that Yale would not invest with them. Hedge funds, he said bluntly, would stiff their clients if their strategies went wrong. Rather than working without compensation to earn the capital back, as the “high-water mark” promise suggested, hedge funds would simply close up shop, reopening under a new name with a fresh set of investors.
“Look, the reason we don’t want to do this honestly is in this format, if you lose money, you won’t want to earn it back. You’ll close down and start a new fund. That’s the problem with the whole format.”
Steyer might have argued back, but Fairman beat him to it. “That’s a bunch of bullshit!” she exclaimed, and Swensen could see that she was furious. “If you think that’s who we are then we don’t want your money anyway!” Fairman carried on. “You have no idea who we are! It’s just ridiculous that you’d say that!”15
This was a better response than Swensen could possibly have wished for. He had found the integrity he sought: Fairman took her decency so seriously that she flew off the handle when you questioned it.
In January 1990, Yale invested with Farallon. The university injected $300 million into Steyer’s fund, boosting his capital to a total of $900 million and kick-starting a gradual change in the social impact of hedge funds.
SWENSEN’S PARTNERSHIP WITH STEYER BEGAN THE REPOSITIONING of Yale, ultimately affecting the investment style of nearly all endowments. Until the Farallon deal, Yale had a smattering of holdings in private equity and “real assets” such as real estate, but nothing in hedge funds. Half a decade later, in 1995, the allocation to hedge funds had jumped to 21 percent, with another 31 percent in private equity and real assets.16 Other universities followed, with a lag: For a typical university endowment, the allocation to hedge funds rose from nothing in 1990 to 7 percent in 2000.17 In the years after the dot-com crash, endowments that experimented with hedge funds were rewarded particularly well: From July 2000 through June 2003, the S&P 500 lost 33 percent of its value while the HFR index of hedge funds gained 10 percent. Yale itself was up 20 percent over this period, and a couple of years later, when the university celebrated the twentieth anniversary of Swensen’s arrival, his investment decisions were celebrated for generating $7.8 billion of the $14 billion in the Yale endowment—that was the amount by which he had outperformed the average university fund during his tenure. Fully $7.8 billion: It was a staggering number! With Swensen eclipsing storied education philanthropists such as Harkness and Mellon, hedge funds became more than just vehicles for the rich to get richer. By 2009 roughly half the capital in hedge funds came not from individuals but from institutions.
The rush of endowment money into hedge funds ensured that there was no need at all to write an epitaph for the industry. At the start of 2000, when Soros proclaimed that the hedge-fund era was over, hedge-fund assets had stood at $490 billion. By the end of 2005, they stood at $1.1 trillion. Soros’s epitaph was at least partially apt for his own type of trader: The first years of the new century were a relatively lean time for macro hedge funds. But event-driven funds such as Farallon made up for that.18 Farallon’s assets ballooned from $8 billion in 2002 to $16 billion in 2006, and imitators crowded in. Och-Ziff, created by another veteran of the Robert Rubin arbitrage group at Goldman Sachs, grew from $6 billion to $14 billion over the same period. Perry Capital, another Rubin offshoot, grew from $4 billion to $11 billion. This “Rubin three” soon exceeded the Commodities Corporation three in terms of asset size. By 2006, Caxton, Tudor, and Moore marshaled a combined total of $35 billion, $6 billion less than the total for Farallon, Perry, and Och-Ziff; and a host of other products of the Rubin arbitrage group, including Frank Brosens of Taconic Capital, Eric Mindich of Eton Park, and Edward Lampert of ESL Investments, were flourishing. In the hedge-fund family tree, perhaps only Julian Robertson had more offspring.
It was not just that returns earned by event-driven funds were impressive. From the point of view of endowment managers, who reported to oversight committees that asked skeptical questions, the returns were pleasingly explicable. Macro traders like Paul Tudor Jones might talk about Kondratiev waves and breakout points: To the average investment committee, this was hocus-pocus. But event-driven funds like Farallon involved no mystery at all. These guys studied legal labyrinths. They understood the odds that a given merger would go through. They could judge how a particular slice of subordinated debt was likely to be treated by a particular bankruptcy judge in a particular court. With this sort of edge, of course they would make money! Besides, the endowment oversight committees could grasp that event-driven funds succeeded because others were hobbled. Institutional investors had rules that forced them to sell the bonds of companies in default, so they were required to cede profits to Steyer and his imitators. The more endowments displaced rich individuals as the chief investors in hedge funds, the more it mattered that hedge-fund strategies could be understood. A rich investor can bet his personal fortune on a mysterious genius if he so chooses. Endowment committees must protect their backs with PowerPoint presentations.
Along with profits and transparency, the event-driven merchants promised consistency. They used very little leverage, which in the wake of Long-Term’s blowup was a selling point in itself; partly as a result, their returns were almost miraculously steady.19 Farallon’s consistency was legendary: Between 1990 and 1997, there was not a single month in which the fund lost money. As a result, Farallon’s Sharpe ratio, a measure of returns adjusted for risk, was roughly three times higher than that of the broad stock market, making it an overwhelmingly attractive place for endowments to park savings.20 Even
during the height of the dot-com madness, Steyer sailed along serenely. He did not ride the bubble like Stan Druckenmiller. He did not get run over by it like Julian Robertson. Instead, he applied his methods to analyzing the epic takeover battles of the era, hedging out the market risk as he did so. Naturally, this strategy looked good when the market collapse sank both Druckenmiller and Robertson.
In sum, the event-driven hedge funds were producing understandable, unvolatile returns—returns, moreover, that reflected pure investment skill and were uncorrelated with the market index. This was the holy grail, the elixir that endowment consultants called alpha, and institutional capital flooded into their coffers. And yet the triumph of the event-driven hedge funds was not bereft of risk. Even the stars like Farallon had vulnerabilities that few suspected.
BY THE LATE 1990S, FARALLON WAS OPERATING OUT OF a fashionable skyscraper in yuppie downtown San Francisco. The commander’s work space was modest as always, but there was a Henry Moore sculpture outside and a lawn where beautiful people ate organic sandwiches. From this bastion of serenity, Steyer’s small operation was venturing to ever farther-flung frontiers. In 1998 it launched a merger-arb operation in London, arriving within a few months of its rivals, Och-Ziff and Perry Capital. It bought a stake in Alpargatas, a bankrupt Argentine textile and shoe maker. It installed new managers at Alpargatas and restructured the firm’s debt; soon some two thousand idled workers found themselves employed again, and Farallon had proved that it could do well by doing good in a frontier economy.21 But nothing could match what was about to follow. In November 2001, Farallon set out to buy the biggest bank in Indonesia.
Farallon’s target, Bank Central Asia, had been founded by Liem Sioe Liong, who had been Indonesia’s richest man and a firm friend of the country’s modernizing dictator, Suharto. Liem’s empire was said to account for 5 percent of Indonesia’s output, and the secret of his success was best illustrated by the flour business. Playing on his connections to Suharto, Liem arranged for Indonesia’s government to sell him imported wheat at a subsidized price and then to buy it back from his flour mills at a markup—nice work if you can get it.22 Untroubled by competitive pressure, Liem’s flour mill in Jakarta grew to be the largest in the world; the second-largest, in Surabaya, belonged to Liem also. And although the mills were supposed to sell their flour back to the government, an impressive quantity found its way to another Liem enterprise, Indofood, which consequently controlled 90 percent of Indonesia’s instant-noodles market. In similar fashion, Liem prospered mightily in coffee, sugar, rubber, cement, rice, and cloves. Naturally, a man of his standing needed his own bank. Naturally, the bank was the nation’s largest.
By the time Farallon came on the scene, Liem’s empire had imploded. The patriarch had hedged his political risk by awarding Suharto relatives large stakes in his firms.23 But the currency crisis that cost Soros and Druckenmiller a fortune triggered a slow-motion revolution in Indonesia, culminating in the fall of the Suharto government. From that moment on, Liem’s political insurance policy became a target painted on his chest—friends of the fallen president were now enemies of the people. Rioters broke into Liem’s compound, set his cars ablaze, and smashed his Chinese vases. Shorn of their political protection, Liem’s businesses went bust, and since many of their loans had come from Bank Central Asia, they threatened to bring the bank down with them. To stem depositors’ understandable panic, the government rescued it.
Farallon was used to event-driven investing, but the collapse of the Suharto regime was a more extreme event than the average takeover announcement. Millions of people were driven into poverty; thousands of demonstrators died in clashes with the police; hundreds of businesses were looted. Many Indonesians blamed the calamity on Western hedge funds, and American financiers in the country had been known to receive death threats. But the more Farallon studied Indonesia, the more the opportunities in the country seemed too good to pass up. Indonesia’s government was the classic noneconomic seller. The International Monetary Fund was goading it to off-load the chunks of the private sector that it had been forced to rescue, and to do so at almost any price; precisely because most financial players would not set foot in the country, Farallon could expect limited competition in bidding for distressed assets. During the crises of 1997, hedge funds had profited by betting against governments that set illogically high prices for their currencies. In the hangover from those crises, hedge funds would profit by betting against governments that set illogically low prices for the broken jewels of their economies.
By the fall of 2001, Farallon had amassed $1 billion worth of holdings in Indonesia.24 It had bought stakes in PT Semen Cibinong, Indonesia’s third-largest cement company, and PT Astra International, the largest automaker; it bought the Jakarta Container Port Terminal and sold it on to Hong Kong–based Hutchison. Then one day Ray Zage, Farallon’s point man in Indonesia, got an unusual message from a government contact. Bank Central Asia would be reprivatized soon. Perhaps Farallon would like to bid for it?
It was an astonishing proposal: A small San Francisco fund would take over the commanding heights of the world’s largest Muslim country. Farallon boasted no more than a few dozen employees; Bank Central Asia had eight million accounts and eight hundred branches. Farallon was the product of the Goldman arb culture plus a dollop of California cool; Bank Central Asia had been the embodiment of Indonesia’s crony capitalism. Andrew Spokes, a dapper English banker whom Steyer had recruited from the Goldman Sachs office in Hong Kong, later conceded that the deal was a stretch. “We were a little off piste,” he conceded, coolly inspecting his cuffs.25 He sounded like a vintage James Bond who skis an avalanche in a tuxedo.26
By the time the Bank Central Asia opportunity arose, the September 11 terrorist attacks had made Indonesia dicier than ever. A country torn by economic disaster and political revolution seemed vulnerable to Islamist extremism. The huge California state retirement fund, CalPERS, was getting ready to announce that it would not invest in Indonesia, period; even the intrepid Goldman Sachs tightened the limits on the Indonesian exposure that it would tolerate.27 The Farallon team began to behave differently on its periodic visits to the country, especially when it found itself in concentrated clumps of foreigners. Ray Zage viewed the area between the customs checkpoint and the taxi rank at the airport as a natural kill zone. “I remember Ray observing it would be great not to be mowed down there,” Spokes recalled matter-of-factly.28
Farallon proceeded to weigh up the case for buying Bank Central Asia. The discipline of event-driven investors is to zone out the chatter and the panic and focus on value—when market prices cease to be a guide, you decide what to pay for an asset based on the cash flows it will generate. Spokes pushed past Bank Central Asia’s reputation as the center of Liem’s crony-capitalist empire and focused on three facts. Since nationalization, the bank’s rotten loans to Liem’s enterprises had been replaced with special recapitalization bonds, so that instead of depending on repayments from busted crony companies, BCA depended on repayments from the Indonesian state: BCA was really less a bank than a government bond fund. Moreover, BCA enjoyed access to cheap capital from retail depositors: Unlike most other bond funds, BCA came bundled with bargain-basement leverage.29 Finally, if the local economy picked up, the bank could start making profitable loans to businesses: BCA was a bond fund, plus bargain-basement leverage, plus a free option on Indonesia’s recovery. As to the political risk, Spokes had an answer to that too. Precisely because the world viewed Indonesia as scary, the post-Suharto leadership could not afford to treat Farallon capriciously. If they cheated a foreign investor in a high-profile deal, their reputation would be mud indefinitely.
After some spirited debate, the Spokes argument for off-piste investing convinced Steyer and the other partners. Only a year or so earlier, Farallon had had no track record in Indonesia; now it would be bidding for Bank Central Asia—and going up against a consortium led by Standard Chartered, a venerable lender with deep roots in
the region. In late 2001, Farallon duly submitted an offer of $531 million, and in March 2002 the government announced that it had won: A hedge fund from latte land had bought control of the top bank in the nation. The outcome was so improbable that conspiracy theories blossomed. Was Farallon a front for the U.S. government? Was it a Trojan horse for Liem, who dreamed of reviving his old empire?
Despite the fervid whispers, Farallon’s investment was a blessing for Indonesia. Farallon installed a new chairman, brought in some consultants, and patiently coaxed the bank out of the Suharto era. By 2006, when Farallon sold most of its stake to an Indonesian partner, BCA’s share price had risen 550 percent since the purchase; just as with the Argentine shoe company, Farallon had shown it could do well by doing good in a tough country. But Farallon’s investment had another effect too. The spectacle of a swashbuckling hedge fund dashing into Indonesia turned heads in New York and London, and institutional investors began to give the country a sympathetic second look. In the year leading up to the BCA purchase, a mere $286 million of net portfolio investment had trickled into Indonesia; but the following year almost $1 billion of foreign capital came in, and the year after that brought more than $4 billion.30 Farallon had scrambled the market’s settled view on all Indonesian assets, setting the stage for a rebound. An event-driven fund had created an event, helping to turn the economic tide for a nation of 240 million people.31
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