By Irwin Speizer
Dan Arbess was an ambitious young lawyer with a newly minted Harvard degree and an abiding interest in Cold War politics in early 1990, when he slipped through one of the first tears in the Iron Curtain to set up shop in Prague. As a legal adviser working for a U.S. law firm, Arbess was instrumental in guiding the privatization of state-owned industrial companies, including the sale of Czech automaker Skoda to Volkswagen. Two decades later, Arbess found himself in another pivotal car deal—the U.S. government rescue of Chrysler.
An idealistic view of free markets developed by reading Ayn Rand as a child fit Arbess’ role in returning state property to private hands in the former Czechoslovakia. But in the U.S., Arbess found himself philosophically at odds with the Obama administration when the sale went the other direction. The U.S. government invested in ailing Chrysler and pushed through a bankruptcy rescue plan and sale to Fiat that punished secured lenders, including Arbess’ hedge fund, Perella Weinberg Partners Xerion Fund, which initially opposed the government’s plan. Obama lashed out at investors like Xerion in a speech that stunned most hedge fund managers who, like Arbess, had backed Obama. In the end, Xerion opted for the deal—and profited nonetheless.
Ideology aside, the lessons Arbess learned in Eastern Europe have made him a thoughtful distressed hedge fund manager whose investment theories and methods are informed by his worldly experience, particularly the sudden collapse of the once-powerful Soviet Bloc and the industrial rise of China and India. The path between the two car company deals is the story of how Arbess reinvented himself as a hedge fund manager, founding Xerion in 2003 to specialize in distressed investing.
“I learned the value of hard assets, and the process of multi-stakeholder negotiation,” says Arbess. “If you think about it, the whole region was distressed. Nothing worked the way it was supposed to in a market economy.”
The perils of investing in former communist countries also taught Arbess that a dark cloud lurks beneath every silver lining. Such caution led him to be one of the first to predict the credit crisis that swept the world financial markets. He was early in betting against home builders and mortgage-backed securities. His main vehicle, Xerion Fund II, netted 38.83% in 2007, its second-best year. Arbess eschewed leverage and kept his bets against mortgages and home builders at a fraction of his portfolio.
“Our highest priority is to protect the downside,” says Arbess. “We size our positions based on what can happen if things go wrong, not on how much we stand to make if they work out as planned. If creating safer returns means we will earn our fees over a longer period, I’m fine with that. This business is a marathon, not a trade.”
Arbess stands out as a fretful and cautious manager. It’s an approach viewed as a balm by some investors and a bane by others. Arbess himself tells of one institutional investor who bolted in 2005 after a particularly bad year for Xerion (the fund ended the year down less than 1%). After his assets under management slipped as a result of redemptions in 2005, Arbess bounced back, landing enough new investors to bring his assets to $1 billion by early August.
One of those recent investors is Pacific Alternative Asset Management Company (PAAMCO), an Irvine, Calif., fund of funds that put money into Xerion about a year ago. Jim Berens, a managing director at PAAMCO, describes Arbess as a highly intelligent investment manager with a distinct world view and sharp, analytical mind. Berens ranks the investment letters that Arbess pens as among the “top 10 in the industry” for their reasoned insights into macro global trends and their orderly progression to specific investment opportunities. One of Arbess’ enduring attractions is that he can be counted on to invest money as if it were his own, Berens says."His pain threshold for losing money is pretty low.”
When he was doing personal background checks on Arbess as part of PAAMCO’s due diligence review, Berens kept hearing comments about Arbess’ high level of integrity. “You don’t get that from a lot of hedge fund managers,” he says.
Still, the hedge fund game is ultimately about making money, and Arbess has demonstrated an ability to do that over the years. His Xerion Fund II (which started out as Xerion Fund I) has recorded net annualized returns of 18.09% since inception in January 2003. This year, the fund has gained 13.43% year to date through July. By comparison, the preliminary estimate for the Absolute Return Composite Index was up 8.08% through July, while distressed funds rose 12.4%. In the bruising 2008, when hedge funds lost money on average, Arbess finished just about even, up 0.31%. In 2008, the Composite Index fell 12%, while distressed strategies lost 22.77%.
Xerion’s specialty, distressed investing, is not a field for the fainthearted. Arbess trolls for troubled companies by buying their debt at a deep discount, a style often referred to as vulture investing. Arbess is unfazed by the criticism. “It doesn’t concern me at all,” he says. “I regard what we do as identifying value where or when others don’t necessarily see it.”
Donald Sussman, founder of Paloma Partners in Greenwich, Conn., hired Arbess to run a distressed credit account for the firm and seeded Arbess when he formed Xerion. He says Arbess possesses a unique set of talents that make him well suited to the distressed arena. “Dan is an extraordinarily smart lawyer, but he is also extraordinarily astute as a business manager,” Sussman says. “He understands capital structure better than most analysts. He knows how to use sharp elbows when sharp elbows are necessary, how to use pressure when appropriate. It is an unusual set of skills.”
Arbess prefers to focus on midsize companies, although he sometimes invests in large-cap companies—such as Chrysler. Arbess bought senior-secured Chrysler debt on the cheap, hoping to cash in if the company filed for bankruptcy. When the government stepped in, however, it put other interests ahead, giving the auto workers union pension fund priority with an equity stake in the soon-to-be restructured company, even though the union’s claims were unsecured. An assessment of the deal by two law school professors put the value of the pension fund deal at 50 cents on the dollar, while secured creditors like Arbess got 29 cents.
Arbess initially fought the deal with other creditors but backed down after President Obama stepped in. Arbess was shrewd enough to make money on the outcome. He had continued buying debt as Chrysler’s situation worsened, picking up enough near the bottom—for as little as 14 cents on the dollar—to get out with a profit.
To his chagrin, the brouhaha created a minor media stir for Arbess and the firm that owns Xerion—Perella Weinberg Partners, a financial advisory and asset management firm. Though Arbess would not discuss his Chrysler investment (or any other specific investment), he did offer some observations in a May commentary letter to investors.
“Given the visibility of our Chrysler investment, we feel it appropriate to comment—an unusual departure from our reluctance to discuss investments at the level of individual securities,” he wrote. Arbess said that although he felt he might have gotten a better deal by continuing the fight, the president’s speech had given him pause. “In considering the President’s words and exercising our best investment judgment, we concluded that the unpredictable risk of capital loss that could arise from fighting this in bankruptcy court far outweighed any realistic potential upside.”
Arbess operates from a modest office on the 16th floor of New York City’s GM Building on Fifth Avenue. No bigger than a typical branch bank vice president’s, it houses a computer terminal on a glass and steel desk, two desk chairs and a few family photos on some low shelves that also contain exactly four books of political and social philosophy: “False Necessity” by Roberto Unger; “Anarchy, State and Utopia” by Robert Nozick; “Theory of Justice” by John Rawls, and “The Machiavellian Moment” by J. G. A. Pocock. Arbess spends little time in his private office, preferring a desk he maintains on the long line of open cubicles populated by the Xerion staff out on the trading floor alongside other funds and operations that are part of Perella.
Perella bought Xerion in 2007 in a marriage that frees Arbess to concentrate on his portfolio while Perella manages the back office and business side of the operation. Arbess became a Perella partner as part of the deal. His staff consists of seven analysts and a trader, and he makes use of Perella’s technology and support team.
William Kourakos, another Perella partner, said the firm looked at nearly 150 different investment managers, most of them hedge funds, before selecting Xerion. One of Xerion’s key attractions to Perella was how dedicated Arbess was to shielding assets from potential losses and his willingness to quickly cash out of any investment that didn’t seem to be working as expected.
“We thought Dan was a conservative portfolio manager with an eye on downside protection,” Kourakos says. “We liked that.”
Kourakos says Perella was also impressed and intrigued by Arbess’ career path, and how he had transformed himself from a lawyer into a hedge fund manager. “Dan has a very eclectic background,” Kourakos says. “You don’t find many people who completely change their professions and are highly successful in two different fields.”
For Arbess, the route from attorney to money manager is simply an expression of broader intellectual interests that he traces back to his childhood in Canada and a particularly influential grandfather.
“I became an investor in an evolutionary way,” Arbess says. “I didn’t wake up one morning in high school and say I want to be a hedge fund manager. My evolution from restructuring professional to distressed investor and eventually to long/short multi-event hedge fund manager followed the progression of what I thought was interesting and important in the world.”
Arbess, 48, grew up in a solidly middle-class family in Montreal. His grandfather, an accountant whose clients were mostly companies in the area, had an abiding interest in politics and world affairs. Arbess recalls hours spent listening to his grandfather hold forth on the issues of the day. “The topic was always policy and politics and human progress. He had a great social conscience.”
Those talks sparked a keen interest in social and political issues. Arbess says he tracked regional, national and international policy debates as a teenager. When the Province of Quebec launched the massive and hotly contested James Bay hydroelectric project in 1971, a precocious 10-year-old Arbess attended government meetings and various rallies to watch and listen as the government and business interests fought environmentalists and native Cree Indian. During this period he read Ayn Rand’s “Atlas Shrugged,” a book that continues to influence his worldview.
Arbess did his undergraduate work at the University of Western Ontario and then received his law degree from Osgoode Hall Law School in Toronto in 1984. He had an abiding interest in international affairs, particularly for the Cold War issues of the day. “U.S.-Soviet political and economic relations became my fascination,” he says. After graduation, he joined the World Policy Institute in New York City, a non-partisan research organization that analyzes global issues and proposes solutions.
Two years later, Arbess decided it was time to start practicing law. To advance his career, he applied to and was accepted by Harvard Law School. By the time he received his degree, Arbess had already spent a decade thinking and writing about U.S.-Soviet relations and the Cold War.
When Mikhail Gorbachev unveiled his startling new policies of openness and economic restructuring in 1987, Arbess immediately saw the potential for a powerful wave of change that could undermine the entire Eastern Bloc and its system of government-managed industries.
“I had this deep-seated conviction that there was going to be a shift in the legal and economic foundations of the former Socialist world,” Arbess says. “There would be opportunities to advise sovereign governments on the transformation of their economies. So I sought a job in a law firm that I knew was very internationally oriented.”
In the fall of 1987, Arbess took a job with White & Case, the global law firm based in New York City, and began molding himself into a specialist on the Soviet Union and the Eastern Bloc. When the Berlin Wall fell in 1989, Arbess talked the firm into sending him to Prague, where the Velvet Revolution was creating a breakaway republic. Arbess met Vaclav Havel, the new president, and promptly became a key adviser on privatizing the Czech economy.
“I became the first American lawyer on the ground and found myself right in the middle of one of the most interesting and important developments in the world,” Arbess says. “The Czechs were at the vanguard of privatization. I had the privilege to be involved in some of the most exciting deals of the period.”
Arbess worked on efforts to unload the old communist-owned Praha Hotel in Prague, to mediate a beer brand licensing dispute between the Czech company Budvar and U.S. brewer Budweiser, and to resolve a long-running feud over ownership rights to the Bata shoe empire. The biggest deal of that period was the $6.4 billion sale of Skoda, the Czech auto company, to Volkswagen, a seminal negotiation that paved the way for other western investments in Eastern Europe. Arbess followed the privatization wave east, helping set up White & Case’s offices in Moscow, and then in the former Soviet Republics of Kazakhstan and Uzbekistan. In 1992, Arbess became, at 31, the youngest partner at White & Case.
Arbess developed a grand thesis that industrial change in the emerging markets of the world—not just those of the former Soviet Bloc but in such places as China and India—would provide the engine for global economic growth over decades. U.S. companies would be pinched by the emerging economies, resulting in opportunities for distressed investors.
Eastern Europe proved to be a great place to hone distressed investing skills. “What I learned is, if we can buy an appropriately located industrial site like a chemical factory at five cents on the dollar of what it would cost to build and we can fix the working capital function and the marketing function, we can begin to generate significant earnings, and the return on a small amount of capital will be huge,” he says.
Arbess determined to be a player rather than a middleman. In June 1996, he formed a new private equity company, Taiga Capital, in Prague, with Morton Meyerson, who had been Ross Perot’s chief executive at EDS. Arbess set off for Russia, where he bought and turned around a struggling specialty steelmaker that he later sold at a profit to a Swiss company. He spent the next few years focused on distressed deals in Russia. With his wife expecting their second child, Arbess relocated to New York City in 1996. For two years, he commuted every two weeks to Russia (often all the way to Siberia) negotiating deals.
In 1998, Russia defaulted on its debt, the boom was over, and Arbess considered his next act. He joined a startup distressed credit asset management firm in New York City, then formed his own distressed credit firm in 2002. His big break came in early 2003, when Paloma Partners’ Sussman was looking to start a distressed credit fund and picked Arbess for the job. “He stood out head and shoulders above the rest,” Sussman says. “Usually you find people who are smart analysts or smart lawyers. This guy happened to be both.”
Arbess began trading a managed account for Paloma in 2003 that reached about $250 million within a year. Impressed with Arbess’ performance, Sussman agreed to sponsor Arbess as a stand-alone hedge fund. By 2004, Arbess was managing $500 million in assets. He called his new fund company Xerion, which describes a mythical process of alchemy to turn base metal into gold.
He began writing fund performance updates and market reviews that would become a trademark of his style, combining dense and detailed financial analysis with broad pronouncements on global trends. One report includes a travelogue to China, another cites the George Eliot novel “Silas Marner” to make a point.
Xerion did well immediately upon its launch in January 2003 as a pure distressed debt fund, posting a 43.24% net return for the year. In 2004, Xerion returned 18.81%, but then slipped in 2005, down 0.88% as Arbess guessed incorrectly that the credit cycle would peak, liquidity would dry up, and that there would be serious and unpredictable dislocations in the economy. Arbess took a defensive posture, lowering exposure, and waited for defaults to rise and present him with investment opportunities in distressed credit. It didn’t happen.
As he wrote in a January 2007 outlook report, “We positioned in 2005 as though the credit cycle was in its 9th inning. Clearly it was not, as the tide of global liquidity has since extended the game well into extra innings. In 2006, we stopped waiting on the sidelines and identified other opportunities less dependent on the credit cycle.”
Since 2006, Arbess has broadened the investment scope of the fund to other event-driven strategies in both debt and equity. Although Arbess declined to discuss any of those new investments, a private communication sent to an investor contains some specific recent examples.
In an event-driven play, Xerion bought bonds in a communications company earlier this year, based in part on a possible joint venture. The bonds rose 15% in 60 days. In a more classic distressed credit move, Xerion bought the senior secured bank loans of a highly leveraged truck carrier in the third quarter of 2008, figuring the company would either violate loan covenants that would allow restructuring favorable to Xerion or else its operations would improve, and the loans would increase in value. The company beat expectations, and the bonds returned 65% in one year. In typical Xerion fashion, each of those investments remained a small part of the overall portfolio.
Arbess has mixed feelings about where company earnings and market trends are headed, writing in his July letter to investors that Xerion will probably find its investment opportunities for the short term in event-driven investments. He is also looking forward to a boon in distressed credit as some 40% of all U.S. corporate debt comes up for refinancing in 2013 and 2014.
Still, Arbess hedges his bets. “I have seen a lot of unpredictable things take place,” he says. “What invariably sinks an investment is not the risk identified on page five of the investment memo, it’s the bolt from the blue. You must be prepared for the unpredictable.”
As Arbess knows, that’s the case whether you’re working for the government or you’re negotiating on the opposite side of the table.
