Andy Redleaf’s Many Happy Returns
A Bloomberg reporter observed last summer that Andy Redleaf looks more like Jerry Garcia when he was lead guitarist of the Grateful Dead than he does a Gordon Gekko–style financier. He is short, the New York Times has noted, and has “a belly big enough to balance a pen [on], which he does sometimes.”
It all rings true when Redleaf, 53, shuffles into a conference room at his firm’s offices near Lake Calhoun—big salt-and-pepper hair, engaging smile, a guy you instantly want to like. He’s dressed as if he were joining a backyard barbecue, in a blue golf shirt and jeans, and carries only a list of today’s interview questions and a magnifying glass. Redleaf uses the magnifier frequently when he reads, compensating for macular degeneration that was first diagnosed in 1995. He speaks haltingly, with an occasional stutter.
If the phrase “hedge fund” calls up images of steely market movers, polished to the tips of their Pradas or John Lobbs, Redleaf defies them. He is CEO and founder of one of the world’s most successful hedge fund families: Minneapolis-based Whitebox Advisors.
Whitebox’s multi-strategy fund ranked 58th on Barron’s annual list of the world’s 100 best-performing hedge funds in 2009. HFM Week, a trade publication, honored Whitebox for the performance of that fund and two others that year. The multi-strategy fund, the firm’s principal investment pool, generated returns of 80.6 percent in 2009 and 17.6 percent in 2010, easily outperforming industry-wide indexes for similar strategies.
Last year, Redleaf served up a slashing, witty critique of big banks, regulators, and academe in his book Panic: The Betrayal of Capitalism by Wall Street and Washington, which was coauthored and published by Richard Vigilante, Whitebox’s communications director. The book fingers culprits in the financial meltdown in 2008, and rips popular academic theories of how the securities markets work. Panic has won influential fans, including Yale University economist Robert Shiller and New York Times columnist Joe Nocera.
Redleaf gets kudos for being among the first to predict the seize-ups that shook credit markets starting in 2007. But he failed to foresee the impact of the financial meltdown on Whitebox, which took its worst-ever drubbing in 2008. Now he and his hedge funds are back on top, after what Barron’s, at the end of 2010, called a “ho-hum” year for the industry overall. This year looks to be anything but that.
“Sludge” Paces a Rebound
Redleaf owns 85 percent of Whitebox, which manages $2.8 billion and employs more than 70 people, about half of them portfolio managers, traders, and other investment professionals, the remainder in back-office functions. Most work at the headquarters in a building on Excelsior Boulevard in Minneapolis.
Whitebox has one other office, in Austin, Texas. The firm’s clients are predominantly U.S. based: family offices, funds of funds, wealthy individuals, and increasingly, pension funds.
Redleaf’s unpartitioned office is a few steps from the firm’s trading area, but he seldom trades. He describes himself as a big-picture strategist who talks out ideas with the traders. Redleaf says a broad grasp of markets is what makes his firm special.
“As an example, in March of 2009, we kind of pounded the table for what I’d call ‘sludge,’” he says. “Sludge” meant corporate bonds whose prices had sunk to 30 percent or less of their face value. “I said the best group of securities was performing bonds trading below 30. Of all the predictions and calls that I’ve made in my life, I think this one was the best,” Redleaf says. The prices of those bonds surged in 2009. It was a key to Whitebox’s sharp rebound.
Investment strategies flow from Redleaf’s refusal to rely on the complex financial models that competing traders use. In his view, the models often fail to reflect reality and instead produce the pricing inefficiencies that his traders take advantage of.
Whitebox focuses on “relative value arbitrage.” Its traders pounce on mispriced securities that have a relationship with one another—the stocks and bonds of a single, often distressed company, for example—to ring up profits. Frequently, a company’s bond prices send up red flags about trouble ahead long before its stock does.
“Convertible arbitrage,” a subset of this strategy, is a Whitebox speciality. Employing it, a trader purchases a company’s bonds, which are convertible into common stock. Simultaneously, he shorts the stock—borrowing the shares, selling them at the current price, buying them back at a lower price, and pocketing the difference. Or he shorts the bonds and buys the stock. Sometimes, Whitebox gains from both sides of the trade.
Last spring, Whitebox launched a new “event-driven” strategy to exploit price dislocations in commercial and residential mortgages, mortgage-related securities, and securities sensitive to interest rates. The firm is exploring new product offerings to attract investors, but “we like being the smallest of the competition in our field,” while still being large enough to “see a really good cross-section of the market,” Redleaf says.
A Whitebox Among the Black Ones
Believe what you will: The hedge fund industry is either booming again, about to whither, or more likely has entered an era of slower growth than in most of the past two decades.
In March reports, hedge fund assets were back up to pre-financial-crisis levels. Hedge Fund Research, Inc., based in Chicago, estimated assets at $1.92 trillion, nearly matching the $1.93 trillion peak reached in the second quarter of 2008.
Deutsche Bank, a major lender to hedge funds, predicted a banner year for them this year. Based on annual survey responses from 528 investment groups overseeing more than $1.3 trillion in hedge fund assets, Deutsche Bank projected an inflow of more than $210 billion to the funds in 2011, almost four times the amount raised in 2010. At average returns of 7.6 percent projected by the bank, fund assets would reach a record-breaking $2.25 trillion by year’s end.
However, that’s “provided the industry is not affected by events that generate negative publicity,” Deutsche Bank said in its March 8 statement—which came out the same day a major insider-trading trial got underway with the Galleon Group hedge firm at its center. That case is part of a larger investigation of hedge funds by federal prosecutors in New York.
The Securities and Exchange Commission (SEC) is also scrutinizing hedge funds to see whether consistently market-beating returns are on the up and up. Hedge funds—largely unregulated and often opaque about their holdings, leverage, and strategies—have been viewed warily by regulators and investors. Starting this July, any fund with more than $150 million in assets will have to register with the SEC and become more transparent.
Whitebox has been filing reports with the SEC since at least 2003. Professional investors have wanted more transparency for some time, Redleaf says.
According to Jeff Ross, a Minneapolis attorney who does legal work for Whitebox and other hedge fund firms, Redleaf generally gives investors more of a window on his firm’s returns, portfolio positioning, and forecasting than his peers do. That happens primarily through cerebral client newsletters. But Redleaf says he’ll work with investors to provide the kind of analysis they want to see, including helping them get maximum benefit from whatever risk-analysis software they use to weigh investment options.
“I’m somewhat of an agnostic,” Redleaf says about his industry’s future. “It’s very much an open question.” It takes about twice the capital to start a fund now that it did 10 years ago, he says, in part because it takes more back-office support and compliance capability. For new firms, “it will be harder to go from an independent start-up to critical mass as a business.”
Redleaf is a poker player. He plays weekly and won modest amounts in tournaments at Canterbury Park in 2009 and 2010. He also plays “lightning chess” each week, 15 or 20 games that take about five minutes per game. His chess partner is Ross, whom he has known since first grade.
Redleaf’s nightstand reading goes beyond finance. In March, he was working through Ron Chernow’s 928-page biography of George Washington.
He’s made gifts to the arts and other causes over time, but his philanthropy has not been as thoughtfully placed as it could be, Redleaf says. In a possible preview of more-targeted donations, he gave a $75,000 challenge grant last year to Chesterton Academy, a new Catholic high school in St. Louis Park, citing its rigorous, affordable, and classical education. He also is a major financial backer of Shiller’s behavioral finance research at Yale.
Ross remembers when Redleaf, now a libertarian conservative, handed out leaflets for Democrat George McGovern during the 1972 presidential campaign. Redleaf’s politics have changed, but his entrepreneurial itch is long standing.
The son of a physician, Redleaf grew up in St. Paul’s Highland Park neighborhood. When he was 11, he was reading finance magazines that his father brought home. Redleaf upgraded the standard newspaper carrier route by arranging with the region’s then-only distributor of the Sunday New York Times to deliver that publication.
At St. Paul Academy, he was enrolled in a widely regarded math program developed by the University of Illinois. Later, at Yale, it took Redleaf just three years to earn both his undergraduate and graduate degrees in math. He shared the university’s highest math prize when he graduated.
He worked at an arbitrage desk in New York City for a short time, then got a seat on the Chicago Board Options Exchange and for much of the 1980s, was an options trader there. Twice he lost big money then recovered it while at the CBOE. In 1984, he quit the exchange briefly to buy a machine shop. By 1994, he cofounded the Deephaven Capital Management hedge fund firm in the Twin Cities with two trading partners. They split after a dispute in 1998, and Redleaf founded Whitebox.
He has a heady side that can make his appearances at investment events memorable. Jim Steiner, managing principal at locally based wealth management firm Lowry Hill, remembers when he and Redleaf were panelists together at Yale’s 2006 fall investment forum in Minneapolis.
“He predicted the mortgage crisis and was the first one who was able to explain the danger with clarity,” Steiner says. Redleaf downplays that call. Last June, he told Research magazine that “of the 50 hedge funds that matter . . . 10 to 20 got it right.”
But author Michael Lewis, who wrote about who got it right in his best-selling book The Big Short, describes Whitebox’s call as a “straightforward bet against the entire multi-trillion dollar subprime mortgage market, and by extension, the global financial system. In and of itself, it was a remarkable fact,” Lewis sums up. “The catastrophe was foreseeable, yet only a handful noticed.”
Redleaf spoke at the Star Tribune’s investor-outlook roundtable in December 2007, and Steve Leuthold, another forecaster at the session, says most other participants had a hard time grasping what Redleaf was talking about. “He’s almost in a different world,” says Leuthold, chief investment officer at the Leuthold Group in Minneapolis. “It’s difficult to follow him because he is so cerebral.”
Joe Hurley, president and chief investment officer of Chi-Rho Financial, an Atlanta-based fund of funds that invests with Whitebox, says Redleaf’s sophisticated explanations of markets can sometimes be so multilayered that Hurley and others refer to them as “Speaking Redleaf”—almost like another language. “He’ll go off where no other ship has been to explain a trade,” Hurley says. Redleaf is “investor friendly.”
Navigating the Meltdown
“We missed it at first . . . we really did not foresee the September crash coming,” Redleaf admits in his book, writing about the fall of 2008. Whitebox expected Treasury bonds to suffer as U.S. policymakers rushed to stimulate the economy, so the firm began betting against them. Instead, the financial environment grew so terrifying that Treasuries were seen as “rock solid,” while private credit almost disappeared.
Talking about that experience now, Redleaf recalls that he “told clients that we try to manage the fund so that the worst scenario we can imagine is down single digits, approaching 10 percent. We were down a multiple of that, so I was wrong in my imagination” of the decline’s depth at Whitebox.
“In the middle of September, I remember looking forward to what was coming,” he adds. “By October, I had definitely changed my mind.”
Testifying before the Financial Crisis Inquiry Commission last August, Jon Wood, COO and CFO for Whitebox, said that the market for convertibles, where the firm does much of its trading, “essentially evaporated in November and December of 2008.”
Wood shuttled to New York every other weekend, trying to figure out how much additional collateral Whitebox’s lenders, also sorely pressed, would want. He is one reason Whitebox climbed out of trouble, says Chi-Rho’s Hurley, who suggests that Whitebox’s culture of keeping debt down also helped to save the firm: “They use leverage, but judiciously.”
Whitebox successfully restructured its funds. “We didn’t sell out at the bottom,” Redleaf says. “The steps we took allowed us to stay in business and keep our portfolios intact.”
But up to half of the firm’s investors were lining up to get their money back, he acknowledges: “There was a very high probability that if we had met those redemptions, we would have lost access to any credit. Vendors would have decided we were going out of business and they would have cut us off.”
Instead, Whitebox was among the first hedge funds to limit redemptions. If it hadn’t, investors who remained would have held largely illiquid securities. Whitebox returns ended the year down more than 30 percent. Assets under management, which had peaked that summer at $4.8 billion, had fallen by a third at year’s end.
Looking Ahead to “the Old Normal”
Even before the market meltdown, some of Whitebox’s plans didn’t click.
In October 2006, Whitebox and Petters Group Worldwide each acquired a 50 percent stake in Twin Cities–based Sun Country Airlines. Redleaf says Whitebox thought Sun Country’s stress on bargain fares and service would enable it to become a standout carrier: “We called it Costco Air.”
Two years later, Tom Petters was charged and ultimately convicted for engineering a massive Ponzi scheme. Neither Whitebox nor Redleaf was ever accused of wrongdoing. Sun Country declared bankruptcy, from which it emerged early this year. Finally, in mid-March, a sale of what became Whitebox’s 44 percent stake in Sun Country appeared imminent.
“Obviously, if we had known Petters was running a Ponzi scheme, we wouldn’t have gotten involved,” Redleaf says.
A big stock-option-backdating play ran into a different obstacle: the courts.
In one of the biggest business scandals of the past decade, a Wall Street Journal investigation led to evidence of stock-option backdating at more than 140 companies, including UnitedHealth Group in Minnetonka. A massive earnings restatement at UnitedHealth resulted—$1.5 billion over 12 years.
Whitebox researchers did their own investigation, studying 60,000 option grants at 6,000 public companies. They identified several hundred companies with suspect grants, UnitedHealth among them, then attempted to profit by trading in both the stocks and bonds of these businesses.
Once the companies disclosed that they were being investigated for backdating, their stocks fell, which led to immediate profits for anyone who had shorted them. The companies would also have to delay reporting their financial results in order to restate their earnings. That meant their bonds would technically be in default. Bondholders traditionally overlook such technicalities, but Whitebox and several other hedge funds did not. They figured to profit by redeeming the bonds early or by negotiating a fee from the companies to settle the dispute.
Those plans were foiled when a U.S. district court and a federal appeals court both ruled that hedge funds could not exploit the technicality.
“At the end of the day, we lost money” on the backdating play, Redleaf says, though both the Sun Country and backdating setbacks accounted for tiny fractions of Whitebox’s overall portfolio. The court decisions “convinced me that a hedge fund cannot get a fair trial anywhere in America.”
Meanwhile, the housing bubble was expanding and the crash looming. Some market observers see new bubbles forming—in consumer credit, in commodities, or as Yale’s Shiller has posited, in farmland.
Redleaf writes in Panic that the way to temper future investment bubbles is less regulation and more disclosure. In the recent crisis, he argues, supposedly capitalistic bankers substituted efficient-market theory and elegant financial models for entrepreneurial thinking, hard-boiled credit analysis, and human judgment. What the federal government should require is that financial institutions, including hedge funds, disclose their financial assets—“every stock, bond, and derivative, every mortgage or commercial loan . . . millions of lines of data for the big banks, every Monday morning before the markets open.”
But how likely is that, given the powerful lobbies of financial institutions? “I understand it to be dead on arrival,” Redleaf says of his recommendation. “There’s absolutely no constituency for it”—even from his peers. “I could easily be a minority of one in the hedge fund industry,” he laughs.
Then are we doomed to live in bubbleland, and about to get hit with another boom-bust cycle? That’s not in Redleaf’s crystal ball, at least not for the next couple of years. He sees no great drama. Instead, he envisions a reasonably good investment environment for stocks and bonds.
The near term looks good to a man who challenges the conventional wisdom that great reward comes from great risk.
“I think we’re in a period of what I actually call ‘the old normal,’” Redleaf says. “I think the world is okay.”
Hedge Funds Grow—and Get Clipped?
The phenomenal growth of hedge funds in the past two decades slowed in the recession and looks like it’s over. There is new scrutiny from regulators, and the Securities and Exchange Commission will enact rules this July that restrict personal trading by fund principals, and require funds to operate with greater transparency.
What’s more, the pressure on profits is growing, as suggested by surveys that show a small decline in the fees paid to fund operators. And while the industry’s performance has clearly bounced back from an ugly 2008, it has been lagging behind other investment benchmarks. Last year, when the Standard & Poor’s 500 rose 12.8 percent, the Hedge Fund Research Composite Index went up 10.5 percent. In 2009, the S&P climbed 23.5 percent, while the HFR Composite was up 20.1 percent.
As reporters for the New York Times’ DealBook blog put it in March, some of the “luster and mystique” of hedge funds has faded. With Carl Icahn and several other big fund managers leaving the industry recently, “the ‘smart money,’ it would seem, is having second thoughts.”