absolutereturn

A HedgeFund Intelligence publication December/January 2007/8 Vol 5 N8 www.absolutereturn.net

Whiteboxs
man of letters

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Whiteboxs man of letters

Andy Redleafs global vision is provocative and profitable
By Carolyn Sargent

man who makes bold predictions may not be seeking the spotlight. But its bound to find him when he manages loads of money and happens to be right more often than wrong. For Andy Redleaf, founder of $3.6 billion Whitebox Advisors, the attention these days is nothing short of glowing. A onetime options trader with a penchant for writing longish, philosophical essays on changes in market dynamics, Redleaf can rightfully claim to have predicted this summers structured finance meltdown, even before he penned his thoughts in a December 2006 letter to investors. And his performance has been enviable. According to investors, three of the firms six funds had netted 25% or more through October this year, in part by implementing Redleafs short credit thesis. (One of those funds, Whitebox Intermarket, won a 2007 Absolute Return Award for top performance in the small-cap equity category on December 4, while two other funds, Whitebox Hedged High Yield and Whitebox Concentrated Convertible Arbitrage, were Absolute Return Award nominees.) Net annualized returns for the four largest Whitebox funds run from the high teens to low twenties. Redleaf, who is 50, has no fear of making grand prognostications. His current view, that both the dollar and the stock

market are in for a long decline, are among the more provocative. Although its too early to know if hell be right on these, a peek at Redleafs writings over the years shows he has been a step ahead of sundry market-moving trends. This past August, for example, Redleaf reiterated his call that the U.S. dollar would weaken, as it did quite dramatically this fall. While lower interest rates may have been the immediate trigger, Redleafs reasoning follows a grander theme: that, absent some unforeseen catastrophe, the liberation of China, Russia and India from socialism will dominate the world economy for a couple of hundred years. Inevitably, the new world will have a new monetary regime . . . and, without question, the international role of the national currency of the U.S. will be diminished, Redleaf wrote. Since then, coincidentally, the dollar has declined about 6.5% against the euro and 7% against the yen. As long as 20 years ago, when Redleaf was trading in the pits of the Chicago Board Options Exchange, he was making public predictions. In the summer of 1987, Redleaf submitted a fourand-a-half page article to the conservative journal National Review, outlining the reasons why the stock market was set for a crash. Redleafs thesis, which was published a month after Black Monday (when the editors had deemed the topic more timely), argued that the stage for decline had been set by a proDECEMBER/JANUARY 2007/8 WWW.ABSOLUTERETURN.NET 2

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liferation of new structured investment products and the elimarea fund of funds. His letters make me think. They are someination of fixed commissions for New York Stock Exchange times contrarian. And they are sometimes completely outside members, both of which encouraged leverage and short-term the box. A prime broker once said that Redleafs letters spread speculation. Redleaf, of course, had been proved right: On like wildfire across Wall Street and can briefly quiet a trading October 19, the Dow Jones Industrial Average plunged 508 floor as traders pause to skim them. points, and Redleaf, by his own account, made money. Lots of In September, when markets were gyrating on uncertainty money. over the meltdown in collateralized debt obligations, or CDOs, If there is a key to Redleafs success, it is his unconventionRedleaf boldly claimed the credit crunch to be over. That was al approach to the markets, to his firm and even to the way he fast, he wrote. The credit crunch, which we first predicted, has gone about staffing it. If you come away from his letters then waffled on, and then predicted again, has already come concluding that he thinks a little bit differently, then that is accuand gone. At the time, Redleaf argued that the credit crisis had rate, says Steve Klammer, who worked with Redleaf for five subsided because the system still had liquidity, as evidenced by years before starting his own statistical arbitrage firm, Highbar Goldman Sachss ability to raise billions of dollars for a disCapital Management. He is not necessarily a contrarian, but tressed fund and Bank of Americas $2 billion investment in he does look for inflection points in areas that other people shy Countrywide Financial, the troubled mortgage originator. If away from. there were a real credit crunch going on, none of this would be The lineup of Whiteboxs single-strategy funds Statistical happening, he wrote. Arbitrage, Hedged High Yield, Intermarket (small-cap market That view is one that Redleaf has since changed he is not neutral), Concentrated Convertible Arbitrage and Diversified afraid to say he is wrong as he is now ascribing a higher probConvertible Arbitrage fails to capture the breadth of Redleafs ability to a sustained credit crisis. wide-ranging investment interests. In the past couple of years, EDLEAF WAS READING Value Line investWhitebox has made an eyebrow-raising purchase of half of a ment research when he was 12 years old small, Twin Cities airline (Sun Country Airlines, an investment and began trading four years later with Whitebox sold in November) as well as a couple of grain elefunds that his father, a doctor of internal vators, which enable the firm to take delivery of commodities. medicine, had initially saved for Redleafs colAnd then theres the firm name, which was chosen thoughtlege tuition. (Redleaf explains that when fully. Whitebox is meant to denote the opposite of black his father got financially comfortable box, where trading decisions are driven solely by secret enough to pay for his four childrens college educations out quantitative models. of current income, he turned these funds over to the intendBased in his home town of Minneapolis, Redleaf formed ed beneficiaries.) Whitebox in 1999 with $10 million in capital. His goal was to After graduating from St. Paul Academy and Summit School create a nimble portfolio whose parts he could change quick(which, in 1911, expelled F. Scott ly. In addition to robust returns, the Fitzgerald for cheating), he enrolled in way to accomplish this, Redleaf I spend a large part of my time Yale Universitys honors program in decided, was to be as candid with mathematics, earning a BA and MA investors as he could. I wanted to reading commentary from other in three years as well as co-winning try to develop relationships with managers, and that is where Andy the universitys undergraduate prize clients and have them know us, distinguishes himself in mathematics. He was accepted Redleaf says. Mark Jernigan into the doctoral programs at Once Whitebox was up and runStanford University, University of ning, Redleaf began to turn more California at Berkeley and Harvard attention to writing letters to University (but, perhaps painfully, not to the program at Yale). investors. Not the kind of cursory market outlooks that many Redleaf, however, wanted to trade a goal that despite his hedge fund managers pen, but lengthy letters (12 pages is not deep interest and strong quantitative credentials, took perseunusual) arguing such theses as the secular decline of the verance to achieve. During the 1976-1977 academic year (his secimportance of labor costs in manufacturing (hastening the end ond at Yale), Redleaf says, he wrote more than 100 letters of international labor arbitrage) and the possibility that, after seeking a summer internship at a securities firm. One rejection years of fairly benign policies, politics in the United States could he remembers vividly: A letter from Robert Rubin, who then once again negatively impact the financial markets. ran the risk arbitrage desk at Goldman Sachs (and who later was Readers have come to expect regular appearances by Mr. U.S. Treasury Secretary), explaining that the firm was not in the Market, one of Benjamin Grahams favorite allegories. Redleaf market for interns. considers Graham one of the Great Ones, along with Warren Redleaf eventually managed to connect with Andy Stillman, Buffett (whose skill at investor relations he admires), George then head of proprietary options trading at Drexel Burnham Soros, Julian Robertson, Michael Steinhardt and Steve Cohen Lambert, where the Redleaf family kept its investment accounts. (with whom he once worked). Redleaf has now written about Stillman didnt have a place for Redleaf but, impressed with the five dozen letters, some republished in books, which investors scholars grasp of option pricing theory, put Redleaf in touch say they turn back to every now and again. with a friend at Gruntal & Co., Ron Aizer, who was running a I spend a large part of my time reading commentary from newly established options arbitrage desk. managers, and that is where Andy distinguishes himself, Aizer wasnt easily persuaded. According to Redleaf, Aizer says Mark Jernigan, who has been an investor in Whitebox hung up the phone four times before Redleaf managed to get a funds since 2003 through Cimarron Partners, his Chicago-

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meeting. During the interview, Redleaf recalls, Aizer expressed explains. If things go well, its because of the portfolio managfrustration that Redleaf didnt know the symbols for a couple er. If things go badly, its because of me. My job is to ensure that of stocks. It was only when Redleaf displayed an understanding it doesnt go badly. of the butterfly spread, and the different ways it could be To launch the first Whitebox fund, a statistical arbitrage stratplayed, that Aizer relented. It was 1978, and Redleaf was Aizers egy that opened to outside investors in January 2000, Redleaf second hire. The first was Steve Cohen, who went on to run his hired Klammer, a former Deephaven analyst. (The stat arb fund, own trading group at Gruntal before founding SAC Capital which manages about $118 million, netted 37.5% its first year Partners. but has struggled of late, gaining about 4% year to date). The Andy was very mathematical and very talented, Aizer second fund to be introduced, Whitebox Concentrated says. But Im not so sure he enjoyed the kind of crazy trading Convertible Arbitrage, is managed by Rob Vogel. Other portthat we did. He was more quiet than that. folio managers include Jason Cross (Statistical Arbitrage and Redleaf left Gruntal in 1980, after about 18 months, to partIntermarket); Gary Kohler (co-manager of Intermarket); Nick ner with his father, who had decided to put his medical career Swenson (Hedged High Yield), and Brian Lutz and Dale on the back burner to trade. Taking a seat on the CBOE, the Willenbring (co-managers of Diversified Convertible Arbitrage). younger Redleaf made a name for himself trading somewhat The investment team claims some eclectic experience, obscure listed equity derivative products, such as preferred equiincluding that of a rocket scientist (Blaise Morton, a PhD in ty redeemable cumulative stock (PERCs) and dividend enhanced mathematics from Berkeley who has worked for the U.S. space convertible stock (DECs). By 1989, Redleaf was partnering on program); a turnaround specialist (Bruce Nordin); a former teletrades with two well-known Chicago options players Irv com banker (Scott Malloy), and a former convertibles trader Kessler and Dan Asher. who, for the past two years, has been the primary person exeKessler and Asher are both serial entrepreneurs. Together, cuting Whiteboxs subprime trade (Paul Twitchell). they had formed a clearing firm (Kessler Asher Group) and KA If a common thread exists among Redleafs hires, it is probTrading, an investment vehicle that focused on convertibles. ably mathematical aptitude. Cross, for example, holds a doctorIn 1992, Kessler, Asher and Redleaf formed the hedge fund firm ate in statistics from Yale and once worked with Myron Scholes now known as Deephaven Capital Management. at Oak Hill Platinum Partners (now Platinum Grove Asset Coincidentally, both Kessler and Redleaf were from Management). Another commonality: Several employees Minneapolis, and they decided to set up shop there. Redleafs including Vogel, Morton, Twitchell, Willenbring and Jonathan role was to trade institutional option products, which he did at Wood, Whiteboxs chief operating officer are migrs from first with proprietary funds and later with outside capital. EBF & Associates, a Minneapolis multistrategy firm that was The Russian debt crisis in the fall of 1998 roiled Deephaven, spun out of Cargill. as it did a number of hedge funds, and, Redleaf says, he disThat breadth of experience, as well as Redleafs well-placed agreed with the other principals trust in his employees, has develbusiness decision to shed risk and oped into a strong asset for liquidate at the bottom of the marWhitebox. Andy may be the prinFact file: Whitebox Advisors ket, in October 1998. cipal visionary, but somehow or Founded: 1999 One of the reasons Redleaf has other, what pops out of this collabFounder and principal owner: Andy Redleaf tried to build strong relationships orative environment is a macro Assets under management: $3.6 billion with investors is to avoid that same view that frequently becomes a Flagship funds: scenario. If we could have raised shared theme in more than one of Whitebox Concentrated Convertible Arbitrage, 23%* $50 million at that time, we would the Whitebox funds, says Jernigan Whitebox Hedged High Yield, 23%* have done really well in the spring of of Cimarron Partners. Whitebox Combined, 18%* 1999. It would have taken a very Rob Vogel joined Whitebox in (*net annualized through October 2007) hard decision off our hands. And I November 1999, initially using a Office: Minneapolis thought, when this happens again, card table as a desk and a computer I want to be in the position to ask that was bought across the street. people for more money. Redleaf paid him by personal check. Redleaf left Deephaven at the end of 1998 in a bitter split that Now manager of the highly successful concentrated convertseems to have been complicated by the other ventures Kessler ible arbitrage fund, Vogel sees Redleaf as a rich resource. I want was involved in, particularly Arbitrade Holdings, an electronto know what Andy thinks, and he doesnt charge me per ic options market maker, which was sold along with Deephaven question. So I ask him questions. He has been exceptional at to Knight Capital Group within a year of Redleafs departure. guiding me through convertibles trading. Redleaf generally spends about half his time in a corner on EDLEAF TRADED SECURITIES both on the Whiteboxs small trading desk and about half the time in his CBOE and for Deephaven. But when it came to office, on the corner of the third floor of a six-story office setting up his own firm (which Asher capitalbuilding overlooking Minneapoliss Lake Calhoun. Redleafs ized with $5 million), he decided to step back first hour or so in the office is often spent reading, an activity from the day-to-day tasks of running a portfolio. that requires a magnifying glass due to his poor eyesight the Redleaf doesnt talk to brokers about prices. And result of macular degeneration. Redleaf reads nonfiction of all he doesnt manage any of the funds in the kinds though not always the morning newspaper from politWhitebox fund family, preferring instead the role of macro ical writings to academic papers to popular financial books and strategist. I am the firms ultimate risk manager, Redleaf the occasional trade publication.
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In eight years, only one Whitebox portfolio manager the chief marketing officer after four years at Bank of America, first, Klammer of Highbar has left. One reason is that Redleaf where he ran Midwest prime brokerage operations. has given each manager an ownership stake in the fund he runs. HE PURCHASE OF HALF of Sun Country All fund managers also share in the profits of the multistrateAirlines in October 2006 has been one of gy portfolio, called Whitebox Combined Fund. Instead of comRedleafs more controversial moves and raispeting for capital, as trading teams do at some multistrategy es a question about the importance of private firms, the portfolio managers are financially motivated to investments in the Whitebox portfolio. At the cooperate, because the better the Combined Fund performs, the time, Redleaf told investors that the cost of the more they all make. Having standalone funds in addition to the transaction plus all anticipated capital expendimultistrategy, Redleaf says, is the difference between selling tures would be less than 1% of Whiteboxs total capital at the time, internally [to the founder] and selling externally [to outside or roughly $16 million. investors]. With the latter, there are a lot fewer hard feelings. As Redleaf explained in a letter to investors, the opportuniRedleaf believes in asking people to do what theyre good at. ty to try a new pricing and service model was too compelling This business is a pyramid. If youre on top of the pyramid, you to turn down. Redleafs thinking, in sum, was that an airline that have to think about how to maintain it and how to keep the peooffers more predictable prices and provides better service ple lower down happy. My philosophy is to have people doing could have a go at developing customer loyalty. what they like to do, and then they are happy. If, for example, Given the difficulty of the passenger airline business, a someone is not good producing analytic, systematic reports, turf number of investors were skeptical. The Sun Country acquiit out to someone who is. sition did sort of make me Portfolio managers dont talk scratch my head, says one. I felt to each other every day, and the I was going to LBO small manufacturing like the explanation was a little fixed-income and equity folks companies, Redleaf says. He went back to contrary to my sense of what dont always know what the they do. There are a lot of smart other is doing. Monthly parttrading, because, he decided, its just way people in this world, and not too ner meetings encourage the too hard to make stuff many have solved the airline ridflow of information. Redleaf, as dle. Whitebox sage, also serves to After having to pour more cross-pollinate ideas among money into Sun Country (the asset classes and strategies. airline reportedly lost $27 million over the past four quarters), The firms core competence is paradigm arbitrage, Redleafs Redleaf apparently agreed with his investors, selling Whiteboxs name for the process of exploiting inefficiencies that arise equity stake in mid-November. from the models that dominate pricing in the financial markets. The Sun Country investment itself was allocated across a Over time, market paradigms change, the hoped-for result number of funds, which are managed to keep illiquids at 10% being that new opportunities continue to present themselves. or less of total capital. The exception is the small-cap One example of this approach is indenture arbitrage a Intermarket Fund, which has two share classes: one with a side trade that has made Whitebox lots of money over the past coupocket of 20%, and one with no side pocket at all. ple of years. Most convertible bond traders rely on sophisticatEven with the side pocket, Redleaf says he doesnt see ed quant models for trading signals. But, as Redleaf sees it, Whitebox morphing into a hybrid hedge fund/private equity individual opportunities often turn on a deep analysis of shop. He has actually already tried private equity once: In qualitative factors, such as call risk, borrow risk, indenture com1984, Redleaf left the CBOE to buy a machine shop. He also plexities, distressed pathways, and special events, none of optioned a plastics blow molder. I was going to LBO small manwhich can be effectively incorporated into the dominant quanufacturing companies, he says. He went back to trading, titative models. because, he decided, its just way too hard to make stuff. A careful analysis of individual bond indentures, or borrowRedleaf does like securities positions that give the firm influing contracts, led Whitebox to buy at a discount some $15 milence and control. In fact, Kohler, who joined Whitebox from lion in convertible bonds issued by Bell Microproducts, a San Okabena Advisors and is now co-portfolio manager of the Jose, Calif., distributor of high-tech products, which came small-cap fund, did so initially to focus on small private equiunder investigation for allegedly backdating stock-option ty transactions. grants. Whiteboxs bet was that the investigation would preRedleaf sees some convergence between hedge funds and vent Bell from filing updated financial reports on time, as private equity but says the division in the industry is elserequired in the borrowing agreements. When Bell indeed where. To be fully institutionalized [as a hybrid firm would failed on this count, Whitebox (and other hedge funds in on the have to be], it means having institutional investors. And in trade) demanded immediate payment of the bonds full princitruth, the biggest institutional investors can really only buy pal, netting a tidy profit. beta. By beta, Redleaf means not beta to the S&P 500, but The distinguishing factor of the firm, and what we do well, what he calls alternative beta, the beta of the alternatives is intelligently blend qualitative and quantitative tools, Redleaf market. When an asset management firm gets to a certain size says. Another distinguishing factor, of course, is Redleafs say tens of billions of dollars the firm is too big to do anyquirky way of looking at the world. Im not sure which is more thing else but deliver a set of returns that represent an asset valuable to me at Whitebox my degree in business from class (alternatives) and not real alpha, or so Redleafs thinking Kellogg or my undergrad studies focusing on philosophy, goes. says Graham Cook, who joined the hedge fund firm in April as

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Instead, Redleaf sees the hedge fund industry bifurcating into family offices for owners and some outside investors and providers of alternative beta, which are fully institutional and scalable. Many highly successful hedge funds eventually turn into family offices, Redleaf explains, because compounding makes the 1.5% and 20% fee structure unsustainable. If you are any good, you have to take in more and more money or else more and more of it is yours. And when a third or a half of the assets are yours, is it even worth bothering with registration, client service and the complexities of running a larger organization? Redleaf would like to make a play on this so-called alternative beta, and in fact he is doing so with Whitebox Diversified Convertible Arbitrage, which is meant to produce alpha while outperforming the convertible arbitrage benchmarks. The fund has accomplished this goal in part because it has a 20% tailwind: It charges a 1.5% management fee but no incentive. The fund is up 7% this year and has a net annualized return of 6.3%. In the end, Redleaf says, Whitebox may not be corporate enough to be a provider of alternative beta. Whiteboxs investors are mostly family offices, funds of funds and wealthy individuals who have a reasonable tolerance for risk and can give Whitebox enough leeway to pursue a broad range of opportunities. In April, for example, some investors backed Whitebox when it launched a special opportunities trading vehicle to short subprime-related securities. That fund, which had a one-time open and close, gained more than 120% through the end of October. There have been missteps along the way. In 2005, Whitebox introduced an energy strategy, Whitebox Hedged Hydrocarbon Fund, that traded energy derivatives. Six months later, the fund was wound down after giving up about 4.5% on a natural gas trade (long summer gas, short winter gas). Closing the fund was a business decision. It is too much of a disadvantage not to be able to take physical possession, Redleaf explains. While that mistake may have cost Whitebox, it didnt cost its investors. The firm made whole all of its clients directly invested in the energy fund, according to two investors. On the drawing board now: a commodities strategy whose form has not yet been set. reader and a Hillary Clinton impersonator, who was asked to talk about Clintons cattle futures trading strategy. Redleaf, who is married with three children, likes to hedge in unusual ways, even at a personal level. When Deephaven was sold to Knight, Redleaf wasnt happy for a lot of reasons. There was a bad feeling about how quickly that deal was done after he left [Deephaven], like maybe there were irons in the fire before he left, Klammer says. After Knight purchased Deephaven, Redleaf bought Knight stock. That way, if the stock went up, Andy would make money. But if it went down, he wouldnt mind so much either, Klammer explains. Redleafs relaxed approach is evident in his dress. He favors golf shirts (he wore one to his birthday party). And shaving is optional. In conversation, his hazel eyes twinkle and his speech is punctuated with laughs when he thinks he has said something that sounds, in his words, absurd. In his letters, his sense of humor shines. In an August 2006 missive, Redleaf, who has a graying mustache and goatee and is neither tall nor svelte, described himself as a figure like unto a hairy man, but yet shorter than a man, and of great stoutness. And his stoutness was even unto many cubits, and his face was covered with hair. Redleaf speaks in paragraphs (like his letters), which means following his arc of thought requires close attention. He is thinking all the time, Vogel says. He wants to make sure his point is fully understood, plus he wants to provide all the attendant reasoning. A question about Sun Country led Redleaf to a lengthy description of how a position in Delta Air Lines enhanced equipment trust certificates almost led Whitebox to take delivery of three 1990 vintage McDonnell Douglas MD-88 airplanes. The planes were orphaned, because no other airline flew them. In the end, Whitebox was able to offload the aircraft thanks to a startup called Allegiant Air, whose business model was predicated on flying low-cost planes. Redleafs point? First, that he had experience investing in airlines. He also seemed to have been commenting on the importance of being ready to take possession of underlying collateral a theme that is echoed in his recent grain elevator purchases. Because of this tendency to lengthy speech, investors say, Redleaf sometimes resonates more in print than he does in conversation. In October, Whitebox funds returned 2% to 6.5%, according to an investor, who attributed the success in part to the second and third leg of trades on the structured credit meltdown. For all but the stat arb and diversified convertibles fund, strong gains continued through mid-November. After Whitebox shorted subprime mortgage securities, the firm bet against mortgage finance companies and, later, against the big, global banks that had exposure to these low-quality loans. Redleafs inclination to make predictions has on occasion led people to ask him for more. My utter lack of faith in my own predictive abilities has never discouraged me from responding to these inquires with an air of serene confidence, Redleaf wrote, tongue in cheek, in October. So here goes: The stock market is set for a long, grinding decline, which many investors will refuse to acknowledge until it is too late. With the S&P 500 down 9.5% since it hit a high of 1565 in October, that thesis may well be unfolding. ar

HEN REDLEAF IS confronted with disappointment, colleagues say, his gentle, low-key demeanor and sense of humor serve him well. In difficult markets, Redleaf becomes more introverted and contemplative rather than angry or rash. You can almost see the gears going as he tries to think things through himself, Klammer says. He is not the impulsive type. In 2005, for example, when convertibles hit a rough patch, Vogel found it hard not to let it get him down. But it didnt get to Andy, he says. Ive seen him nearly every day for eight years. Hes generally happy about life. And not afraid to celebrate it. For his 50th birthday in September, he hosted a party for 175 people at the New York Palace Hotel. Entertainment included a mind

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