Opportunistic and Contrarian

“In a great book, well worth reading, “ Hunters” by Katherine Burton, there is an insightful chapter on Richard Perry.

The OFFICES OF $14 billion Perry Capital nineteen floors above < ?xml:namespace prefix = st1 ns = "urn:schemas-microsoft-com:office:smarttags" />New York‘s Central Park, house aboutfifty pieces of Richard Perry’s art collection, devoted to works of the twentieth century. The reception area combines the playful with the contemporary to create an ambiance that’s hardly the norm at big-deal hedge fund firms. The place is studded with photos, paintings, and installations that would be quite at home at the Museum of Modern Art. On the wall behind a silver metal staircase is an installation of LED light tubes by artist Leo Villareal. Even the candy dishes are artfully arranged, filled with M&Ms that spell out enjoy. Perry’s wife, Lisa, and photographer Martin Sobey designed the wallpaper for the kitchen area: a huge photograph of a grocery aisle: at Kmart, a nod to Perry’s board seat at Sears, which owns the discount retailer. The meeting room, with its view of the park’s Skating rink, is equally striking, with low slung modem couches in beige and gray, accented with bright yellow pillows.

Perry and Lisa-a Fashion Institute of Technology graduate who launched a line of 1960s inspired dresses in early 2007-are mot only avid art collectors in their spare time; they also Support Causes popular among major hedge fund players: political candidates and charities. The couple have been generous backers of Hillary Clinton for her 2008 presidential run-in their home they have a photographic diptych of Hillary taken by artist Chuck Close, as well as an autographed snapshot of them with the candidate.

On the philanthropic front, Perry sits on the board of Harlem Children’s Zone, a charity whose goal is to provide services to children and families living in ninety seven square blocks of central Harlem and to help end the cycle of poverty. The board’s chair is hedge fund legend Stan Druckenmiller, and industry notables Mark Kingdon, of Kingdon Capital Management, and , of the Galleon Group, serve as directors. Perry is also a trustee of Facing History and Ourselves, an organization that works with teachers to educate children about the evils of genocide, racism, prejudice, and anti Semitism.

Since its launch in November 1988, Perry’s flagship fund has returned 15.4 percent a year on average, compared with 11.6 percent for the benchmark stock index, and he’s never had a losing year. He is a creative thinker, and over the years his investments have included real estate loans and private equity deals with partners like billionaire buyout executive Thomas H. Lee.

In choosing investments, Perry has turned to where the action is, in an event driven approach that seeks out companies involved in mergers or acquisitions, emerging from bankruptcy, spinning off units, or going through some sort of restructuring. He has tailored that investment style over the years as more investors have entered the market. To stay ahead of the crowd, Perry has become more proactive, helping to create the events by

www.capitalideasonline.com Page - 1 Opportunistic and Contrarian

working with management to make changes that will increase shareholder value. He will approach only executives he deems open to his counsel.

At fifty-two, Perry is tall and lean and athletic looking-he’s completed five triathlons. His manner is engaging, and he has the diplomat’s skill of seeming to know everyone well, remembering tidbits from conversations he had with people six months earlier. With a directness honed from years of giving chief executives advice that’s sometimes tough to hear, he has no trouble getting people to listen. He tells of calling up a well, known CEO, whom he asked me not to name, and saying: “You’re the best manager in your industry, but you have the worst returns. Your shareholders don’t trust you. Focus on your . You could add a lot of value and get your shareholders’ support.” The CEO eventually agreed and instituted a stock repurchase.

Perry’s roots in the business are the stuff of hedge fund history. The hedge fund industry can, in part, be divided into family trees: Julian Robertson heads one of the largest. His Tiger Management produced scores of Tiger Cubs, who have themselves spawned another generation of managers. Another major branch stems from Robert Rubin’s risk desk at . As a member of the first generation of managers to work under Rubin, Perry helped hire the superstar team that went on to become some of the biggest successes in the industry: Edward Lampert, who now runs ESL; Thomas Steyer, head of Farallon; Daniel Och, who runs Och Ziff; and Eric Mindich, who runs Eton Park. Rubin later left Goldman to serve as Treasury secretary under President Bill Clinton and is now chairman of the executive committee at Citigroup. Perry succeeded Rubin as an adjunct associate professor in the finance department at New York University‘s Leonard N. Stern School of Business.

To hear Perry tell it, it was his tennis game that got him the job at Goldman Sachs.

Even in high school, Perry had 9-n avid interest in business. He had worked for a real estate investment trust as part of a student project and supplemented that by working a few days a week in the business office of his prep school, Milton Academy, in Milton, Massachusetts. Finance fascinated him. “It was practical and logical. There was a balance sheet and line items attached to a budget. You could change the line items and that would change the bottom line. I understood it immediately.” After graduating, Perry headed to the Wharton School at the University of Pennsylvania. It was 1973.

With some help from his father, Perry landed a summer gig at Goldman Sachs, which was highly unusual for an undergraduate who had just finished his sophomore year. Perry’s father, Arnold, who was in the office

www.capitalideasonline.com Page - 2 Opportunistic and Contrarian

machinery business, knew some Goldman Sachs partners from tennis games in New York, where the family had lived since Richard was ten. “They thought I was a good tennis player,” says Perry with a laugh.

That summer and the next, Perry spent much of his time on the trading desk for options, financial instruments that give investors the right but not the obligation to buy or sell a particular amount of a stock, bond, commodity, or currency within a specific time frame. These instruments were just coming into fashion on Wall Street, and the first options exchange in the United States, the Chicago Board Options Exchange, had just opened a year earlier in a smokers’ lounge at the Chicago Board of Trade. Investors were getting a handle on how to value them thanks to the work of academics Fischer Black, Myron Scholes, and Robert Merton, who in 1973 published the Black Scholes model for pricing stock options. Eleven years later, Black went to work for Goldman Sachs and Perry had a chance to interact with him.

Perry joined the options desk full time after he graduated in 1977 and soon made friends with a fellow working on the arbitrage desk. His friend from arbitrage had a gift for the quantitative, and Perry was interested in investing, so the two young men organized a switch, and Perry began working with Rubin, who had taken over the arbitrage desk from L.Jay Tenenbaum, who had been running it since the 1960s. Goldman’s Arbitrage Desk. When Rubin joined the arbitrage desk in 1966, it was already a fabled place. Gus Levy, who later became chairman of Goldman Sachs, had built the original arbitrage group, whose aim was to make money off the differences in the prices of related securities, after World WarII. That desk would buy shares of companies coming out of bankruptcy, going through mergers, or spinning off or selling business units. When Rubin joined, mergers and acquisitions were booming, and the desk would buy the shares of the company that was being acquired and sell the shares of the company doing the buying. The trade was pretty much guaranteed to make money-as long as the merger was completed.

During Rubin’s days on the arbitrage desk, which he describes in his autobiography Inan Uncertain World, the deals were sometimes complicated, and an analyst had to get up to speed on many issues very quickly. Rubin describes the myriad questions that an arbitrageur needed to answer almost immediately: What might due diligence at the target company uncover? What antitrust issue might arise? Were shareholders likely to approve the merger? Would the target company miss earnings or get sued or go through some other event that would threaten the deal? Even though the decisions were based on incomplete information, they weren’t made on instinct. Rubin carefully analyzed the situation to come up with a list of every conceivable event that could scuttle the deal and then calculated the probabilities of these events actually occurring.

www.capitalideasonline.com Page - 3 Opportunistic and Contrarian

Rubin looks at life as a series of probabilities, which gave him the ideal temperament to be an arbitrageur. He hired people with the same outlook. In arbitrage, you need to be right more than 90 percent of the time, and the best people are right 95 percent of the time. Being wrong increased the risk of losing a lot more money than you ever made on any deal.

During Perry’s summers watching traders on the options desk, he had discovered that, like Rubin, he took a more intellectual or analytical approach to investing. “I never relied’ solely on instinct,” says Perry, as did many traders he met. “There are a lot of people who do that and who are successful, but for me it was not a stand alone tool for creating wealth.” Yet options trading provided a good foundation for arbitrage because it too depends on understanding probabilities.

The years with Rubin proved to be a fantastic learning experience for Perry not only because of Rubin’s talents but also because Goldman Sachs emphasized training in a big way. The firm liked to get their employees young, unadulterated by the influences of other organizations. When you joined Goldman Sachs, it was your first job, and higher ups trained and molded you. The firm had little interest in hiring employees who had already proven themselves at other firms. Instead, they spent lots of time developing young talent.

On the arbitrage team, Rubin would add a new person every two years or so, and Perry was involved in hiring all of them. After Perry, the next entrant on the team was Frank Brosens, who joined in 1979. Thomas Steyer and Daniel Och came on board in 1982, Lampert in 1984, and Mindich in 1988. This A Team had many qualities in common. “They were all extraordinary, they all worked very hard, they were high powered, intelligent, and nice people too, with a strong desire to learn and to be cooperative and team oriented,” says Perry. They understood something instinctively about investing, and they had the rare combination of being both intellectual and practical. Team members didn’t always agree on investment ideas, but they responded to the ideas in very similar ways. “Each of us would shake our heads at the same thing,” says Perry. They all understood which issues were key. “When we heard an idea, we all had a sense of whether it was worth spending time on.” If it was, the next step was to calculate the probability of various outcomes. “Investing isn’t black or white. It’s different shades of gray, and what was common to all of us was that we could see the different shades of gray and handicap them. There ‘were very few second chances. The process had to be good.” They called the process “expected value analysis,” and it is still central to’ what Perry does today.

By 1988, Perry’s experience at Goldman Sachs was no longer ideal. A key concern was his compensation. He

www.capitalideasonline.com Page - 4 Opportunistic and Contrarian

didn’t .feel he was being paid appropriately. “I was being compensated well relative to my peers at Goldman Sachs, but relative to hedge funds, it was dramatically lower,” says Perry. “There was no direct tie between my pay and how well our department did.” His understanding was that even if he were made a partner, his paycheck would not rise dramatically. What’s more, his bosses were pushing him to move to London for a job that would take him away from investing and uproot his family, which by then included two year old twins.

Encouraged by his wife and his mother’s brother, Jimmy Cayne, chief executive of the Bear Steams Companies, Perry decided to start his own investment firm. With two months left to go before bonus time, he told his bosses about his plans to leave, volunteering not to poach any Goldman Sachs employees. They paid him fairly, and he was on his way.

Perry set up shop with a part-time secretary, and his fourteen year old cousin filled in by answering the phones. It was a lonely climb. A friend from Boston, Seth Klarman, strongly suggested that Perry team up with Paul Leff, who was then working at Harvard Management Company, which oversees the university’s endowment. Perry balked. While at Goldman Sachs, Perry had had a somewhat rocky acquaintance with Leff. Harvard had been a client of Gold, man Sachs’s during Perry’s days on the arbitrage desk, and Leff was often looking to arbitrage merging companies. Unlike other desks at Goldman, the arbitrage department didn’t have to heed customers’ orders; in fact, it avoided most customer relationships, intending to invest in the stocks themselves. That meant that Leff put in a lot of orders on the desk but never got as much stock as he wanted. At a dinner with Perry, Leff complained about his treatment by Goldman Sachs. Perry unapologetically explained the situation. “The rest of dinner was very pleasant,” says Perry, “but Paul was convinced that he should never do business with us again, which was logical.”

Klarman found Perry’s reservations understandable, but he was insistent, saying Leff’s more macro approach to investing would be a good balance to Perry’s bottom-‘up analysis. As Perry thought more about bringing Leff on as a partner, he realized that Klarman was right. “We thought the same way much of the time,” he says. “He was always trying to do the same things that we were doing.” Perry went to Boston, and they discussed the idea over lunch. Leff quit Harvard a month after Perry left Goldman Sachs, and they remain partners today, almost two decades later.

An early turning point for Perry Capital came in 1989, its second year of operation. About thirty or forty groups were trading merger arbitrage, and Perry’s returns by midyear were smack in the middle. “That was depressing,” says Perry. “Lots of guys who didn’t do as much work were killing us. We weren’t taking enough

www.capitalideasonline.com Page - 5 Opportunistic and Contrarian

risk.”

But with United Airlines, at least, caution paid off. The pilots’ union and management had made a $300- a- share bid for UAL Corporation, the parent of the airline, and although the deal seemed expensive, everyone was convinced it would go through because Citibank, the buyer’s lender, had never reneged on financing be, fore. Many hedge funds loaded the boat with UAL shares. “We thought there was a 75 percent chance it would get done, but for us to invest, we needed it to be 95 percent,” Perry says, given the stock was trading at $290 and the fund would make $10 if the deal went through but lose $200 if the deal broke up. Perry passed on it because he just couldn’t see how the operating income would ever cover the interest on the loans. He was right. “The deal broke, and we went from the middle to the top of the tables.” Within two hours of the release of the news that the deal had collapsed, the Dow Jones Industrial Average plunged 190 points, still one of the biggest daily declines in history. UAL stock plummeted from about $290 to $88 over the next twelve months.

Merger arbitrage, betting on the shares of merging companies, worked well for Perry until about 1992 when he and Leff realized that their strategy was too limiting. They set out to use their research to expand their investment horizons and make more money. Instead of focusing on the difference in prices between the stock of the two merging companies, they decided to focus on everything above and below that spread. Would the merged company, for example, be worth more or less than the price at which the deal was done? “Merger arbitrage was; becoming too competitive,” says Perry. “We were one of the first people to move out and to focus on the pro forma company.”

Two years later, Perry entered what would become a ten year transaction that changed the way he thought about investing and taught him that one of the hallmarks of a great’ money manager is patience. Even after more than a decade, Perry still enjoys telling the story of his takeover and transformation of FTD, the world’s largest floral delivery service.

In 1994, FTD was a cooperative, and the company went looking for a buyer that would convert it into a for profit business. Perry bought the company for about $130 million. He put in $20 million in equity, his partners Bain Capital and Bank of Boston together put up another $10 million, and they borrowed the rest. Nothing about the deal was easy. “We had a very acrimonious relationship with the bank, and the CEO of FTD quit before the bank financing was done,” says Perry. “A lot of florists were hostile and angry because they felt their playground was being taken away. It was a very ugly conversion.”

www.capitalideasonline.com Page - 6 Opportunistic and Contrarian

The nineteen member FTO board approved Perry’s bid by a single vote, but Perry couldn’t complete the transaction unless he convinced more than 50 percent of the member florists to approve the deal. He visited flower shops and did interviews with the press about his plans to spend about $12 million annually on advertising and make other moves to get flower shops into the FTD network. The member florists were also given a chance to buy stock in the new company. “I hadn’t been elected to anything since ninth grade,” says Perry, who eventually won 61 percent of the vote. “I had a belief that I could understand the problems and convince the florists to do things the right way.” He realized he needed to be patient and that the changes wouldn’t happen overnight. They might take three or four years. “We created an enormous amount of value, and it took a lot of work and creativity.”

During those years, FTD changed the ordering system from telephones to computers to connect the 24,000 florists in the network. It protected the trademark domestically and internationally and also started an online unit, FTD.com, transforming the company from a flower vendor to a technology business. Revenues grew dramatically. In 2004, Perry sold FTD for $450 million to Green Equity Investors, about a 28 percent annualized return on his $20 million investment. The florists made good money, too. Those that bought nonpublic shares for around $2 when Perry first restructured the company got $24.85 a share from the new buyers. “It was a process that was financially rewarding in terms of making a lot of money and emotionally rewarding in terms of getting it right for all the people who trusted me,” says Perry.

FTD was Perry’s first experience serving in a position of corporate director, and he liked the view. Discussions inside the boardroom gave him insight into how companies are run and the confidence that he had solid advice to offer management. “I felt I could have a profound impact,” says Perry, “whether it was about operations or financial structure, or how their sales force was operating.” By 2007, he was sitting on four boards.

Before the Perry team invests in a company, they spend a tremendous amount of time talking to management, suppliers, and competitors, producing studies worthy of a consulting firm. Perry tries to understand why the company isn’t making more money, what its main problems are, and whether they can be fixed. “I have close relations with the companies in which we invest. I know what issues they’re confronting, and how they want to address those issues,” says Perry. He tries to avoid hostile situations, believing they take too much time. Perry’s criteria are that the chief executive recognizes there is a problem and has the desire to take action. Perry is willing to wait two to five years for the investment to payoff.

“The longer you’re willing to hold, the less crowded the opportunities are,” he says. When he first started Perry

www.capitalideasonline.com Page - 7 Opportunistic and Contrarian

Capital, he and Leff looked for a definitive catalyst-a specific event that would send a stock rocketing or tumbling. Those opportunities are no longer so interesting for Perry because he can’t get the 25 percent or 30 percent return he wants. “We’ve gravitated toward situations where operational fixes take time, where there is no clarity about what the catalyst is, but where there is a like minded management team.”

Perry focuses on buying assets at a discount but only when management is capable of creating profitability or eliminating liabilities to close that value gap. “You need both great management and a great asset,” Perry says. “Having one or the other is a bad recipe.” Without proper management, the asset’s value will erode over time, making what was once a bargain price look much more expensive. “That’s a value trap, not value investing.”

Part of that job, as he sees it, is to provide CEOs-whom, he finds, often spend most of their time being cheerleaders rather than managers-with vital and sometimes painful information about their business, industry, or competitors. “CEOs get very diluted in, formation. They’re told what people believe they want to hear. We tell them the facts. We call a spade a spade. It’s hard to get the facts because it’s really difficult to know who’s telling you the truth and who’s camouflaging it.” Sometimes Perry must deliver his point of view succinctly and fast. In the 1990s, when privatizations were sweeping Europe, he would meet the heads of the companies about to be sold to the public after years of state ownership. He had less than five minutes to talk to them, and he asked them if they were interested in understanding why chief executives in the United States make so much money and what they needed to do to be equally successful. Some CEOs took the bait, and he advised them to align their own interests with those of shareholders. “Certain management definitely embraced our concept,” he says.

Over the years, Perry has expanded the type of investments he’ll take on and he now characterizes his style as opportunistic and contrarian. “Whereas typical investors are deterred by complex investments, we receive calls from CEOs and CFOs needing a quick resolution to financing problems,” Perry’s marketing brochure explains.

Perry has an edge when it comes to such complexity. And his investors say it’s because he excels at understanding credit and finding transactions that are safer than most investors perceive them to be, because they’re generally overcollateralized. Take his 2005 loan to billionaire Malcolm Glazer for $1.4 billion to help finance the purchase of Manchester United, the British team that has won that country’s top soccer championship sixteen times. In return for the loan-which Perry made with Dan Och’s Och-Ziff Capital Management and Ken Griffin’s Citadel Investment Group-the lenders had the right to seize some of the Glazer family’s stake in the soccer team if the company failed to repay the debt by 2010. By August 2006 Glazer had paid back the debt. His cost of financing was roughly 20percent.

www.capitalideasonline.com Page - 8 Opportunistic and Contrarian

Perry’s raison d’etre is to generate creative business ideas. One of the days I interviewed Perry, he had just come back from a meeting with Harvey Weinstein, whom he backed when he and his brother Bob left Miramax Film Corporation in 2005, and Bill Ruprecht, the head of the auction house Sotheby’s. The subject was a programming idea for Ovation, a cable network of which Perry Capital and Weinstein are backers. Perry had come up with the idea of an Antiques Roadshow meets Project Runway in which the television audience gets the behind the scenes dope on the artwork to be auctioned, watches the sale, and can even participate in the bidding over the phone. In exchange for providing access to a wider audience of art buyers, Ovation would receive a cut of Sotheby’s auction take. Although he’s not sure the show will ever become a reality, it’s an example of the kind of brainstorming he does continually. One of his other ideas for Ovation was to have various ballet companies across the country do a bake-off of performances of theThe Nutcracker, which will probably air in December 2007. “The goal is to constantly show executives ideas,” says Perry. “I don’t want to have any meeting, with anyone, ever, that is not a give and take. I want it to be as mutually beneficial as possible.”

Perry promotes the give and take mantra within his own organization as well. Just as training was a huge part of the Goldman experience, so it is at Perry Capital. The hedge fund is perhaps unique in that it offers a two-year training program for analysts, after which it expects that virtually all of the trainees will leave.

Making promises he can’t keep is not Perry’s style, and a relatively small organization, where there are only about twenty portfolio managers-many of whom are partners in the firm-leaves little room for promotion. His solution is to manage the analysts’ expectations up front by capping their stays at two years, after which they go off to business school or take jobs at investment banks or other hedge funds. Of the forty-five analysts Perry employed in 2007, only a handful are senior analysts who have stayed beyond the two-year program.

Perry trains by example. The investment staff doesn’t have private offices, and the analysts listen in on phone calls and sit in on meetings to learn firsthand how the investment process works. The portfolio managers each have responsibility for their own pool of capital and manage the money following various guidelines that stipulate the amount of long versus short positions and the size of trades. When they have ideas they believe are worthy of a bigger investment, they make a pitch to Perry or Leff, who manage the core sixty to seventy positions-which Perry calls the master portfolio.

By and large, decisions result from consensus. “It’s a very collective process. I almost never make a unilateral

www.capitalideasonline.com Page - 9 Opportunistic and Contrarian

decision,” says Perry. He meets with the portfolio managers to discuss the current positions, new ideas, and risk management. “We meet formally once a month, but we talk continually,” he says. The bulk of his time is spent talking to his colleagues about the core positions. The portfolio managers generally do their own calls and meetings, although for the most challenging investments, they bring Perry in to talk to the chief executives.

Although Perry enjoys his conversations with corporate titans, he doesn’t like to talk shop with other hedge fund managers, and he demurred when asked to name younger managers whom he respects. He claims it’s tough to know who will make it over the long haul. “Most successful people are unbelievably challenging and complex. It’s unclear whether or not they will be as consistently successful in the future as they’ve been in the past.”

Aside from his own partners, the only managers he says he knows well are the Rubin-led team he worked with at Goldman Sachs. He remains especially close to Lampert, who asked Perry to sit on the board of Sears in 2005. “Eddie is the most successful guy of our generation,” says Perry. “He has intelligence and commitment to work hard. He has a unique thought process coupled with an enormous drive. He is a phenomenal manager.”

As for the rest, “I really try to avoid other managers as much as I can,” says Perry. Their strong opinions invariably generate what he calls distracting “noise.” “I don’t want to hear it.”

www.capitalideasonline.com Page - 10