|Farallon Capital’s Andrew Spokes
ON AN EARLY MORNING IN OCTOBER, just as San Francisco was starting to emerge from the fog, Thomas Steyer, founder of Farallon Capital Management, strode across the ballroom stage at the historic Fairmont hotel. Wearing one of his signature plaid ties — a fiery red sartorial flourish — Steyer radiated casual power and confidence. His investors have come to expect no less. Since launching hedge fund firm Farallon more than a quarter century ago, Steyer has gained a reputation for aggressively pursuing investment opportunities across a wide sweep of markets around the world and tenaciously holding on to some positions for years. His ability to deliver steady returns has attracted a roster of blue-chip investors, and on that day about 200 of them were eagerly awaiting the chance to hear him speak.
But that morning was different from previous investor meetings, because Steyer, 55, had just announced his plans to retire.
A few days earlier he had written to his clients to tell them he intended to step away from the business at the end of 2012, and he named his co–managing partner, Andrew Spokes, as his successor. Although the timing was a surprise, the decision was not. For the past five years, Spokes, 47, has been working alongside Steyer at the firm’s San Francisco headquarters, gradually assuming greater control of Farallon’s $18.6 billion portfolio. In recent years most clients have called Spokes when they needed to know what was happening with a particular investment. But few people outside the firm are familiar with the genteel, boyish-looking Brit. Over the past few years, as Steyer has increasingly stepped into the media spotlight as the public face of Farallon, Spokes has remained the inside man.
Now the former Goldman, Sachs & Co. investment banker has taken on a more visible role as the leader of one of the world’s largest hedge fund firms — and the pressure is rising. In Steyer’s absence Spokes will have to deliver profits in line with Farallon’s historical performance, satisfy clients’ expectations and keep the investment team focused. Everyone will be watching the numbers. Although the firm suffered a disastrous year in 2008, when its flagship fund, Farallon Capital Partners, lost 36 percent net of fees during the financial crisis — humbling Steyer and his team — its returns over time have been solid if somewhat unspectacular. Since its 1986 inception Farallon Capital Partners has delivered a net annualized return of 13.41 percent, besting the S&P 500 index, which has returned an annualized 9.55 percent during the same period.
Steyer emphasizes capital preservation, and that is no accident. Early in his career he observed that there are primarily two reasons financial businesses blow up: using too much leverage and being dishonest. The native New Yorker vowed to avoid both sins. As his fund grew he spent tremendous energy seeking to insulate his portfolio from downside risk — a characteristic that set his business apart from its high-flying, more volatile peers. For 22 consecutive years, until the financial crisis, Farallon made money. That remarkable consistency helped attract investments from prestigious institutions including Yale University, where Steyer earned his BA in economics and political science in 1979, and Stanford University, where he got his MBA in 1983. Steyer has also won mandates from major pension funds and foundations, including the Canada Pension Plan Investment Board and the William and Flora Hewlett Foundation.
Given the change in leadership at the top of the firm, however, Spokes can no longer take those high-profile allocations for granted. If he wants to keep them, he’ll have to engage more closely with clients even as he assumes ultimate responsibility for Farallon’s investment portfolio. Steyer will be watching to see how he does. Although the hedge fund impresario doesn’t intend to have any further involvement in the firm, he does plan to remain its largest investor. “From here on out,” Steyer told the assembled crowd at the Fairmont, “I’ll be sitting with you in those seats, looking back up at the podium.”
The key to Farallon’s future lies in the firm’s understanding of ever-more-important cross-market interplays, whether they occur in the U.S., Asia or Europe. Onstage at the Fairmont, Steyer seized the opportunity to highlight Spokes’ international experience, underscoring his co–managing partner’s knowledge of various geographies and strategies. Since joining Farallon in 1997, Spokes has worked as an investor or team manager across most of the firm’s five portfolio strategies: credit, arbitrage, value investing, real estate and special situations. In late 1998 he was responsible for opening Farallon’s London office, which he ran for nearly a decade before moving back to San Francisco. He has also lived and worked in Hong Kong and New York. From Steyer’s perspective, Spokes’ ability to move fluidly across business cultures gives him a competitive edge. “You need someone at the head of the organization who understands — and is comfortable in — different geographies,” he says. “Globalization has occurred.”
Although the financial crisis has clearly had a sobering effect on Farallon, prompting a massive rethink of the firm’s approach to liquidity risk, the core tenets upon which Steyer built the firm still hold. Integrity counts. Absolute returns have to be earned, not leveraged. Risks must be understood.
Spokes, who has adopted his mentor’s style of investing as his own, strongly believes in the value of providing risk capital in a liquidity-constrained market. Like Steyer, he seeks to gain an edge by performing rigorous analysis of companies’ cash flows, probable returns and potential downside hazards. But merely emulating Steyer’s approach may not be enough to secure the future of the business; Spokes will need to carve out his own strategic approach and raise his profile.
The urgency of that challenge has prompted Spokes to open up, and, in the months leading up to Farallon’s leadership transfer, he and Steyer spoke extensively — and exclusively — to Institutional Investor about their 15-year partnership and the firm’s transformation in the wake of the financial crisis. In a series of conversations that took place in Farallon’s offices in San Francisco and London, the two reflected on the changing nature of the hedge fund industry and their desire to build a lasting enterprise.
|Exiting founder Thomas Steyer
The very nature of the hedge fund business complicates such transfers of power, because these firms, given their entrepreneurial origins, are often hard to maintain without their founders’ direct involvement. In the past hedge fund managers tended to shutter their firms upon retirement or turn them into family offices; more recently, however, as the industry has become institutional, managers have been increasingly motivated to resolve the succession question and keep their funds open to new investors.
Steyer and Spokes spent considerable time — literally years — preparing Farallon’s clients for the transition. Ana Wiechers-Marshall, co-CIO at the Menlo Park, California–based Hewlett Foundation, which manages $7.5 billion in assets and has invested with Farallon since 2001, considers those preparations time well spent. “For any investor who has really had an ongoing dialogue with the firm, the news came as no surprise,” she says.
Jeffery Mora, a partner at Makena Capital Management in Menlo Park, agrees. “I think it’s been a pretty seamless transition,” says Mora, who oversees absolute-return and tactical hedged equity investments for Makena and has known Steyer for more than a decade. “Even though Tom is riding off into the sunset, he is still in touch with what’s going on at Farallon because he has a significant personal investment with the firm.”
For Spokes there may be no sharper goad than knowing that his former boss is betting on him to preserve his wealth. Spokes may not be as outspoken and flamboyant as Steyer — who once bought dozens of red plaid ties after his own fraying favorite was swiped by his mischievous staff — but he has a marksman’s eye for detail. His thoughtful, incisive approach to investing has already won admirers.
“Andrew has got a rigorously analytical mind,” says Reuben Jeffery III, chief executive of New York–based investment management firm Rockefeller & Co., who worked with Spokes at Goldman Sachs in London in the early 1990s. “He is smart, precise and incredibly disciplined in his thought processes. He is also, in his own quiet way, fiercely competitive.”
As experienced as Spokes is, current market conditions are bound to test his mettle. The affable Brit will have to navigate a difficult macroeconomic environment and recruit bright new talent as Farallon expands into distant international markets. The firm’s ambitions are wide-ranging, but the team has a knack for finding unusual, uncorrelated investments. Over the past two years, for example, Farallon’s credit portfolio has profited handsomely from the firm’s growing involvement in the recovery of client assets from Bernard Madoff’s Ponzi scheme — an investment that took legal savvy and a lot of research. Looking ahead, Spokes is keen to further diversify his firm’s portfolio and expand its geographic reach. In 2011, Farallon helped found a dedicated subadvisory firm in Brazil that is now securing private investment natural-resource deals. In 2012, Farallon received permission to launch a commercial lending operation in mainland China, and the project is under development. “It’s really quite exciting,” Spokes says. “We’ve been approved to do onshore lending, so it’s not a banking license — we can’t take deposits — but it will allow us to be providers of capital for small- to medium-size businesses.”
FARALLON WAS NAMED FOR AN ARCHIPELAGO OF WINDSWEPT islands about 27 miles west of San Francisco that form part of the Golden Gate Biosphere Reserve. Home to thousands of seabirds, the Farallons are desolate, self-contained and remote, but so rich in marine life that they’ve been dubbed the Galápagos of California.
For Steyer, who grew up on New York City’s Upper East Side, California represented a new frontier, and starting a hedge fund allowed him to chart his own destiny. Although he was a rising star in Goldman’s risk arbitrage department in New York — and a protégé of future Treasury secretary Robert Rubin’s — he quit his job and moved west when his then-girlfriend (and future wife) Kathryn (Kat) Taylor made it clear she didn’t want to raise a family in New York. Matthew Barger, who was friends with Steyer as an undergraduate at Yale and later attended Stanford Graduate School of Business with him, also likes to take credit for luring Steyer west, but he was perhaps more instrumental in getting his former classmate launched. Barger, now a senior adviser at San Francisco–based private equity firm Hellman & Friedman, introduced Steyer to his boss, Warren Hellman, one of the founding partners of the firm, in 1985. Hellman (who died in 2011, aged 77) took a chance on Steyer based on little more than gut instinct. When Farallon, then known as HFS Partners, opened for business in March 1986, Steyer had just $15 million in assets under management: $4 million from Hellman and the rest from family, friends and some of Hellman & Friedman’s clients.
|Farallon team members (clockwise from top left): Gregory Swart, Thomas Roberts, Daniel Goldberg, Rajiv Patel, Lars Bane, Mark Wehrly, John Warren and Richard Fried
Setting up a business in San Francisco allowed Steyer to develop his own investing style. Unlike many of his swashbuckling New York contemporaries, he eschewed the use of leverage, deploying it sparingly, if at all, to keep tight control of his portfolio. He developed an affinity for fundamental research and still considers himself more of a value investor than a trader. His proximity to Hellman & Friedman helped shape his approach, giving him the confidence to make longer-term, more illiquid investments based on the strength of his team’s research.
Just as Steyer was finding his feet as a hedge fund entrepreneur in San Francisco, Spokes was interviewing at investment banks in London, hoping to land a job in finance. Eight years younger than Steyer, Spokes grew up in Winchester, Hampshire, the youngest child of two; his father was a lawyer and his mother a doctor. He graduated from the University of Oxford with a degree in chemistry in 1987 but quickly decided to abandon science altogether in favor of banking. “Finance appealed to me as a career because I admired the people I met, it was international, and it seemed to offer the prospect of a more rapid ascent to a senior position than scientific research,” he says.
Spokes joined Goldman Sachs’ investment banking division in 1987, just months before the October market crash wiped $500 billion from the value of U.S. companies. In the aftermath corporate takeovers soared. Some companies sought to merge to survive; others, which had seen their stock prices destroyed, were swiftly privatized. Spokes tended to work on technically difficult transactions. “From an early stage in his career, Andrew could readily take on responsibilities that traditionally a more senior person would have had to handle,” says Rockefeller’s Jeffery. “He seemed to thrive on complexity.”
Over the next decade Spokes moved among cities, spending several years working for Goldman Sachs in New York and Hong Kong as well as in London. Wherever he went, he kept in touch with David Cohen, a Goldman colleague who had been one year ahead of him in the analyst training program in London. Although Cohen had started at Goldman in corporate finance, he’d moved in 1989 to the risk arbitrage department — Steyer’s old training ground — and tried unsuccessfully to persuade Spokes to join him. By 1992, Cohen had gained responsibility for overseeing the bank’s entire international risk arbitrage portfolio; Steyer hired him away that year.
The early 1990s were heady days for Farallon, which was expanding beyond its original focus on merger arbitrage and event-driven opportunities as Steyer sought to gain better access to new strategies and geographies. By 1990, Steyer had added distressed-debt and liquidations; by 1993 he was investing in real estate too. He also started expanding into Asia and Europe; Farallon’s international investment assets quadrupled, to $2.9 billion, between 1994 and 1997. Steyer began looking for someone to help lead the overseas effort, and Cohen introduced him to Spokes.
Steyer hired Spokes in 1997. Even then, Spokes says, his partners at Goldman thought that Steyer had already been so successful that he wouldn’t remain at Farallon for long. “That was one of the top five Letterman-style reasons I was given not to leave Goldman Sachs,” Spokes says wryly. The former investment banker began working out of Hellman & Friedman’s offices in Hong Kong, researching merger arbitrage opportunities in Asia. But the Thai baht crisis exploded in July 1997, and the merger market evaporated. At Steyer’s suggestion, Spokes relocated to San Francisco to begin exploring European merger arbitrage opportunities. The logistics of covering Europe from California proved difficult, however, and in 1998 Spokes moved back to London to open Farallon’s first European office. That year he recruited another Goldman colleague, Nicolas Giauque, who joined him in London in 1999.
As the business evolved, Spokes began overseeing most of Farallon’s overseas expansion efforts. He also helped recruit and train some of the hedge fund firm’s most talented partners, including G. Raymond Zage III, a veteran of Goldman Sachs’ investment banking division in Singapore, with whom Spokes had worked previously in Asia. Zage joined Farallon in 2000 and worked in San Francisco for a year before joining Spokes’ team in London in 2001, then returned to Singapore to set up a new office in 2002. Since then Farallon has established offices in Hong Kong (2006), Tokyo (2010) and São Paulo (2011).
In 2003, as Farallon was becoming larger and more complex, Cohen and Spokes proposed banding together to create an organization that could centralize management of Farallon’s teams based outside San Francisco. Steyer, keen to keep them in-house, assented to the creation of Noonday Asset Management, an independent private investment firm that acted as an exclusive subadviser to Farallon. Under the leadership of Cohen and Spokes, Noonday — which was named for one of the Farallon islands — had the freedom to hire its own research staff and invest its own portfolios, but the two partners agreed not to raise any capital beyond what Farallon allocated to the business. The organization launched in January 2005. “I just thought, ‘If this is what it takes to keep Andrew and David happy, then I’ll do it,’ ” Steyer recalls.
Steyer believed that if he allowed Farallon’s investment teams greater freedom, they would be able to deliver higher, more robust profits. A certain degree of decentralization didn’t bother him. “Tom didn’t want the teams to have boundaries put on them in terms of where they looked for opportunities,” says Gregory Swart, Farallon’s chief financial officer. “He just wanted them to find the most interesting companies and situations around the world and figure out where the best risk-adjusted returns were.”
At the same time Steyer was granting greater autonomy to Spokes and Cohen, he was becoming more involved in politics. A Democrat, Steyer openly supported Hillary Clinton’s presidential campaign in 2007 and helped raise funds in the Bay Area for the Democratic Party. A persistent rumor started circulating that Steyer would likely be one of the names on Clinton’s short list to replace Henry (Hank) Paulson Jr. as secretary of the Treasury should she win the presidency. As Clinton’s star rose, Steyer’s did too, and his investors started to ponder what would happen to Farallon if its founder took a post in Washington.
Steyer never openly admitted his interest in a political appointment, but he started his succession planning in earnest. He’d already begun talking to Spokes in the summer of 2006 about moving back to San Francisco to help run the business as his co–chief investment officer, and those negotiations accelerated. Spokes returned to the Bay Area in August 2007. “The job I was doing was simply too big for one person to handle — or too big for this person,” Steyer says. “I felt as though managing the firm properly would take more than 24 hours a day, 365 days a year, which I just didn’t have, and since Andrew and I had both worked at Goldman Sachs, the idea of having two co–managing partners didn’t seem at all strange to me.”
THROUGHOUT THE GLOBAL FINANCIAL CRISIS, Steyer and Spokes worked side by side at adjacent desks, fighting to stay on top of emerging risks as liquidity dried up across successive markets and asset values plummeted. Part of the challenge, Steyer says, was that Farallon had been riding high on its previous successes and didn’t respond to the changing macroeconomic conditions with enough alacrity. By the end of 2007, the firm had started to dial back its exposure to emerging and frontier markets, which had done particularly well over the preceding year, but it had moved too slowly. When the global equity markets reversal began in 2008, Farallon lost money; by the end of the first quarter, the flagship fund, Farallon Capital Partners, was down 7.4 percent gross.
“We made a mistake, doggone it,” Steyer says. “We should have trimmed those positions much harder, much sooner.”
As the crisis accelerated, Farallon’s own fund structure complicated its ability to respond to its clients’ needs. Since 1993 the firm had had the freedom to put varying amounts of client capital — as much as 35 cents of every client dollar, depending on the fund — into illiquid private investments. Those so-called side pockets had been designed to take advantage of the team’s best ideas in private equity, real estate and credit. But as the crisis deepened, Farallon’s clients began to have divergent liquidity requirements and needed more flexibility.
Steyer and Spokes sought to respond to them, but the challenge cut to the core of Farallon’s multistrategy approach. Coming into 2008, Farallon had $37.4 billion in assets, including 82 percent in liquid funds. The remaining 18 percent was held in less-liquid assets, particularly real estate, which constituted 11 percent of the firm’s total investment capital. The value of those holdings plunged during the crisis, but exits were inadvisable, if not impossible. “Real estate financing had dried up at all levels,” Steyer says, “and at that point, if you wanted to sell, it was the definition of a fire sale.”
Steyer and Spokes had good reason to worry about their real estate exposure during the crisis: Two of the largest deals in the firm’s history had been struck at the peak of the market. In February 2007, Farallon formed a joint venture with Indianapolis-based real estate investment trust Simon Property Group to bid for Mills Corp., which owned 20 regional malls and 17 indoor retail outlet centers. Farallon, whose funds already held nearly 11 percent of Mills’s shares, saw an opportunity to overhaul and upgrade the mall owner’s 45 million square feet of retail space. Farallon put up half of the $1.3 billion in equity paid for the deal, which was valued at $7 billion and completed in March 2007.
Farallon and Simon Property immediately replaced most of the company’s management team and sought to raise occupancy, says Farallon’s Richard (Rocky) Fried, who oversees real estate investments. But no one realized that mall occupancy nationwide was about to take a massive hit. “We bought a good asset that was being badly run,” Fried says, “but we still lost a lot of tenants during the downturn as companies like Circuit City filed for bankruptcy.”
Shortly after that deal closed, Farallon made another large real estate play, partnering with Chicago-based Helix Funds, a private real estate investment firm, in April 2007 to make a joint bid for the manufactured-home unit of troubled trailer park company Affordable Residential Communities. In July the joint venture partners bought ARC for $1.8 billion, including cash and assumed debt. As with Mills, Farallon was already one of ARC’s largest shareholders, with a 10 percent stake in the publicly traded REIT, which owned and operated 275 trailer parks in some 23 states.
Farallon promptly installed Helix Funds’ founder David Helfand as ARC’s new chairman and set to work on cleaning up its operations and systems in an effort to restructure the business. When mortgage availability dried up during the crisis, Farallon could do little but hold on and wait for the U.S. real estate market to recover.
For Farallon, 2008 proved to be a watershed year. The firm’s flagship fund fell by 36 percent net; Farallon’s firmwide losses were not much better, averaging 33.5 percent across all funds. (The firm has four main funds, including its flagship.) Several blue-chip clients, including the California Public Employees’ Retirement System, redeemed their investments. Farallon set up a liquidating trust in December 2008 to meet demand and gradually sold approximately $6 billion in illiquid private investment assets to satisfy investors’ requests for cash.
In 2008, Steyer and Spokes set about transforming Farallon: realigning its decision-making processes, transforming compensation practices and repairing relationships with the firm’s remaining clients. The gradual recentralization of investment oversight allowed them to streamline operations and consolidate their teams, some of which had begun to overlap and compete. Between Farallon and Noonday, for example, the firm found itself supporting four U.S. credit teams: one in Charlotte, North Carolina, where Cohen had set up a U.S. office for Noonday, and three at Farallon’s headquarters in San Francisco. Steyer and Spokes reduced the four U.S. credit teams to one. Today the consolidated U.S. team is run by veteran Farallon partner Rajiv Patel, who joined the firm in 1997, the same year as Spokes, and partner Michael Linn, who joined in 2002.
The restructuring process had its unanticipated consequences. In 2010, William Duhamel, the star equity trader who had led the value investing team for eight years, departed with three of his colleagues to set up Route One Investment Co. Their exit gutted Farallon’s long-short value investing team, which has had to be rebuilt and is now overseen by a four-member investment committee chaired by John Warren, who previously worked for Hellman & Friedman.
In the past few years, Steyer and Spokes have redesigned the reporting structure at the firm. Although Farallon still has a partly decentralized approach, all investment professionals now report to a senior partner, and all the senior partners now report to Spokes. “Entrepreneurialism still exists, and talented people are still motivated to stay here,” says Thomas Roberts, who used to work in merger arbitrage for Noonday in Charlotte and now runs the merger arbitrage team for Farallon in San Francisco. “But we now have a clearer effector mechanism from the center of the firm, which is really helpful in times of market stress,” adds Roberts, a former oncologist, referring to the means by which the body responds to stimuli after detecting them.
Steyer and Spokes have also tackled the firm’s compensation structure, which used to mirror the traditional Wall Street model of rewarding individual teams on their performance — the so-called eat-what-you-kill approach. But that model eventually created internal tension because the teams competed for capital, irrespective of broad market conditions. Incentives were not properly aligned. In the wake of the crisis, Steyer and Spokes restructured compensation to link pay in large part to the firm’s overall performance, reasoning that this would encourage the partners to think more holistically about overall capital allocations.
Farallon has sought to strengthen its relationships with its investors, becoming more transparent and responsive in the aftermath of the crisis. In 2010, Farallon hired Goldman Sachs’ head of West Coast prime brokerage, Robert Ceremsak Jr., as its first official head of investor relations. Since January of that year, instead of using its investors’ assets to fund illiquid side pockets without their explicit permission, Farallon gives its clients the power to opt in or out of its private investment pools on an annual basis. At the end of every year, Farallon asks clients how much capital they want to invest in the coming year’s side-pocket or private vintage deals, which are run separately alongside their hedge fund assets.
“Investors are still somewhat reluctant to make illiquid investments,” says CFO Swart, “but our recent vintages have performed really well.”
IN THE COMING WEEKS TOM STEYER will set up an office near, but not too close to, Farallon. He has already received several offers of space, he says, and he anticipates that he may even remain in the same building as his former colleagues. But he won’t lurk.
“I’ll be only an elevator ride or a walk away,” Steyer explains, “but I’m not going to be like an annoying uncle who calls all the time or stops by for lunch unannounced.”
He does remind Spokes, sitting beside him during one of their II interviews, that as the firm’s largest investor he expects to be treated with a degree of abject servility. “Whatever is considered appropriate,” Steyer adds with a twinkling, mock-serious air.
Spokes just laughs.
The easy rapport between the two men is obvious. Equally obvious is that Steyer has enormous confidence in Spokes and the crew they’ve gathered around them at Farallon. In the five years that Spokes has been comanaging the firm, he has worked closely with each of its investment teams, across multiple time zones, helping them assess potential investments and possible risks in the aftermath of the financial crisis. The paradox of the current investing climate is that the broadest risks are driven as much by political uncertainty as by economic weakness — which makes them harder to evaluate and quantify — but Spokes and his team are remarkably upbeat about the opportunities to get paid, as they put it, “to be providers of capital where it’s in short supply.”
Spokes will now have to extend Farallon’s tradition of selective capital provision without losing sight of the risks. Farallon is not a macro fund, but the financial crisis has taught Spokes to be more aware of external dangers. The goal, he says, is to become highly macro-aware even as the firm’s partners continue to hone their particular style of gritty fundamental analysis. The advantage of such analysis, of course, is that it tends to reward effort, particularly when an investment is unusual or complex. But Spokes and his team can’t afford to get caught out. Like his predecessor, he is cognizant that he’ll be known as much for the missteps he avoids as for the profits he makes.
Clients who know him well, like Carrie McCabe, founder and CEO of Lasair Advisors, consider Spokes to be one of the few people who could succeed Steyer. “Andrew is a Renaissance man in the hedge fund industry,” says McCabe, who works with institutions on their hedge fund allocations and has invested with Farallon for 20 years. “Of all the managers I’ve worked with, he is one of the most well read and well traveled; he really thinks about investing from a wider perspective.”
At the investor day in October, Spokes gave clients an overview of three simple tests Farallon uses to begin to assess risk: current levels of fundamental valuation, as reflected by expected returns; trailing returns in light of the market’s propensity for mean reversion; and market exuberance, or signs of speculative excess. Looking across Farallon’s potential sources of market return — equity risk premiums, credit spreads, arbitrage spreads, real estate and risk-free rates — Spokes said virtually all of the categories are displaying normal or better-than-normal conditions. The two exceptions are credit spreads, particularly in the U.S., and risk-free rates.
“If you think of the capital markets as a building in which risk and return increase as you ascend to higher floors, the part of the building that shows above ground looks pretty normal,” Spokes told investors. “But the part of the building that lies underground, resting on the foundation of the risk-free rate, does not appear normal at all.”
The global search for safe yield has created various market distortions, including minibubbles inside different asset classes and strategies. Spokes says the risk premium for equities is fairly attractive except for those stocks that have really safe, solid dividend yields. Similarly, the least attractive corporate bonds are those paying easy, predictable yields, he says. The search for safety has even affected arbitrage, where safe-looking spreads are significantly less appealing on a risk-reward basis than deals with “a little bit of complexity, or hair, to them,” Spokes says.
Farallon has responded by aiming to achieve something akin to opportunistic moderation: investing in securities and deals that appear to offer the best individual risk-reward profile, while paying close attention to sizing and the firm’s overall risk profile. One of Farallon’s key tools in mitigating downside hazards is balancing the firm’s capital allocation by strategy. As of December 31, Farallon had 29.4 percent of its assets allocated to credit opportunities; 28.5 percent to value investments (both long and short positions); 11.6 percent in real estate; 10.3 percent in direct investments; 9.4 percent in arbitrage; 7.5 percent in other, hard-to-classify investments; and 3.3 percent in cash.
In 2012, Farallon Capital Partners was up 11.42 percent net but still lagged the S&P 500, which posted a total return of 16 percent. Although the firm doesn’t like to disclose many specifics about its current investment positions, one of the major contributors to its overall performance came from its U.S. credit portfolio, where its single largest position involves the recovery of assets from the Madoff Ponzi scheme. In 2010, Linn, who oversees the U.S. credit portfolio with Patel, began researching victims’ claims against Madoff’s estate. He believed the claims would be decided on net equity value — the total invested with Madoff minus the amounts withdrawn — as opposed to clients’ final statement values, which reflected purely imaginary gains.
Linn based his assessment in part on Madoff’s lack of trading. The former Nasdaq Stock Market chairman never made any investments, according to court documents; he simply shuffled money among client accounts or skimmed it for his own use. Linn also spent considerable time researching the legal aftermath of the Bayou Group, a hedge fund Ponzi scheme that unraveled in 2005, for clues as to how the Madoff litigation would progress. Farallon retained several law firms to help research claims and assess the legal implications of the asset recovery process; Farallon’s in-house legal team, led by general counsel Mark Wehrly, helped structure those deals.
Linn and Patel made the decision to start buying up the claims of Madoff victims in 2010. At the time, the cash pool was estimated to be about $1.5 billion. Some of Madoff’s clients were eager to get what they could and accepted offers of 15 to 20 cents on the dollar to settle; since then the recoverable assets have grown, and the latest estimate stands at $11.5 billion. With the increase in recoverable assets, claim values have soared and are now trading at between 30 and 40 cents on the dollar, depending on the claim size. “The market for these claims has increased, but we’re still buyers,” says Linn.
Other strategies have not played out quite as favorably, although Farallon’s beleaguered real estate portfolio has recovered well as markets have improved. Over the past few years, Farallon has sought to return cash from its real estate holdings to its investors; last year the total number of positions dropped from 58 to 55. In March 2012, Farallon — having upgraded tenants and raised occupancy in most of its Mills properties — sold its interest in 27 of the 37 malls in the Mills portfolio to Simon Property for $1.5 billion, which included Farallon’s share of its corporate debt. In August 2012, Farallon sold 64 of the ARC communities for $343 million; the firm sold an additional 36 in December for $305 million, and most of the remaining portfolio of 145 communities is under contract to be sold later this year.
Looking ahead at other strategies, Spokes and his team are still positive about their value investing prospects, not least because the velocity of new ideas, both long and short, continued to flow swiftly throughout 2012. Because the U.S. value portfolio targets 25 long positions (which are hedged by independent short positions and some index hedges), new ideas essentially have to compete for space. As of December 31, the largest position in the U.S. value portfolio was News Corp., with $193 million, followed by Dollar General Corp., with $191 million; Google, with $156 million; Rockwell Collins, with $134 million; and Priceline.com, with $134 million. The top five long positions accounted for 27 percent of assets in the U.S. value portfolio.
Credit, which has been one of Farallon’s largest capital commitments over the past year, still appeals to the investment team. Although Spokes is not enamored with U.S. corporate credit, he is optimistic about opportunities in Europe, where the risk-reward imbalance favors the brave. Giauque and Lars Bane, who run the London office under the Noonday name, are keenly watching for opportunities in European corporate credit, but no one is expecting a fire sale of assets by European banks any time soon. Still, Giauque and Bane are optimistic about the refinancing of existing senior loans on stressed credit, where the underlying business operations are solid but the companies are simply overleveraged.
Farallon’s efforts to be an innovative provider of capital extend far beyond Europe. The firm’s Asia expert, Zage, and his team have taken on the ambitious task of setting up a commercial lending business on China’s mainland. The new enterprise, which received key approval in September 2012, only allows the group to make loans — it cannot take deposits — but Spokes is excited about the prospect of providing capital to privately owned, small- to medium-size companies that cannot access financing as easily as China’s large state-owned companies and municipalities.
“If you want to borrow $20 million to $50 million to do something sensible for your business, it is extremely hard to get it from the banking system,” Spokes says. “We see that as an opportunity because there is a real shortage of available capital for these companies.”
In August 2011, Farallon helped launch an exclusive subadvisory firm in Brazil, FKG Capital, run by Daniel Goldberg, a former president of Morgan Stanley in that country. The hedge fund has committed approximately $161 million to private investments in Brazil and Peru, largely in natural resources and media, and has also started a long-short equity portfolio.
Spokes’ affinity for less-obvious opportunities in international markets may serve the firm well given that so many of its competitors — particularly the proprietary trading desks of the big banks, but even some hedge funds — have stepped away from complex risk. The challenge now, as Farallon expands its reach, will be to maintain quality control and avoid costly mistakes. Many of Farallon’s clients, including Makena’s Mora, believe that Farallon’s deep bench — currently, the firm has 21 partner-level employees with an average tenure of 12 years — may be its best protection. As Farallon has expanded into new territory, the firm has focused on putting senior, home-trained talent on the ground with the charge of developing strong professional relationships and sourcing proprietary investment ideas. Spokes, Mora says, has a real knack for working “with and through” his colleagues to implement those ideas across the portfolio.
“It seems to be a very healthy dynamic,” Mora says, “because Andrew is an excellent manager and so many of these guys have known him for decades.”
Steyer placed tremendous importance on hiring well and hanging on to staff, creating an open, collaborative partnership culture that harks back to his training at Goldman Sachs. If the leadership transition is to function smoothly, Spokes will need to protect that legacy at the same time that he vigilantly manages investment risk.
Steyer remains convinced that Spokes has what it takes to keep his cool — not least because of his expertise as a former captain of the rifle team at Oxford. To shoot straight, Steyer says, Spokes not only had to learn to pull the trigger between breaths; he had to learn to shoot in the downtime between heartbeats. Self-control was paramount. Steyer says drolly, “Rifle-shooting shares an unglamorous feature with investing in that your results — your returns — are basically defined by the mistakes that you manage to avoid.”