By Katrina Dean Allen
Photographs by Chris Clinton
In the fall of 2008, Edward Perlman’s hedge fund firm, Scottwood Capital Management, seemed to be in free fall. After enduring a six-month losing streak when the fund posted a 14.76% loss from March to August, investors handed in redemption notices, and Perlman watched as some 40% of his painstakingly built $985 million in assets disappeared in an instant. Less than three weeks later, Lehman Brothers blew up, adding to the already charged atmosphere of investor panic and leading to an industry-wide rush for the exits.
But instead of imposing gates or side pockets on his remaining investors—or simply shutting the firm down altogether—the 52-year-old Perlman regrouped and entered October fully invested, with short positions in consumer and financial names. The firm’s Scottwood Partners fund realized gains of 7.30% in that first week, and rather than continue to try and make sense of a chaotic market, Perlman opted to book his gains and move the portfolio to cash.
In early October, seeking to calm investors, Perlman sent them an e-mail to share his decision. But neither Perlman nor his staff could have imagined that e-mail would cost the firm another $100 million.
“Almost the second I hit “send,” I got an e-mail from someone telling me I was nuts and investors were going to stampede for the door,” recalls Perlman. “But I wanted people to know their money was safe.” Although Perlman could have imposed gates according to the fund’s terms, he chose not to. Scottwood narrowed its losses by year-end—finishing 2008 down 7.60%, compared with a loss of 23.35% in the AR Event Driven Index—but ended the year with only $310 million in assets, almost two-thirds smaller than the fund’s peak size.
“They say no good deed goes unpunished,” says Gideon King, a friend of Perlman’s and the chief investment officer and owner of multistrategy hedge fund firm Loeb Capital Management, which also did not impose gates and subsequently lost half its assets in 2008. “But it struck me how focused Eddie was on getting people their money back. It was in direct contradistinction to those funds that were focused on triage, using gates, excuses and other constructs in order to mask the fact that they were not adhering to their mandates.”
Perlman addressed his employees at the firm’s annual holiday dinner that year, reiterating that he had no plans to quit the business and that in fact the fund was well positioned to take advantage of the credit opportunities created by the crisis.
“Eddie reassured everyone that they had a job,” recalls Marc Gelbtuch, a senior investment analyst at Scottwood. “It means a lot when you hear your boss saying that.”
True to his word, Perlman did not downsize or cut back on expenses, and the firm went on to have its best year in its eight years of existence. The fund returned 44.05% that year, with a Sharpe ratio of 3.15 and without the excessive use of leverage, which the firm uses sparingly. That performance earned Perlman and his team a nomination for best-performing event-driven fund at the 2009 Absolute Return Awards gala. An even bigger reward: The final investor to redeem from Scottwood at the end of 2008 was one of the first to reinvest in early 2009, Perlman says. The firm’s assets have also recovered: It now manages $750 million, up more than 100% from the end of 2008.
Last year, the strongest contributors to Scottwood’s performance came from distressed debt and event-driven special situation trades in credit. In early 2009 the fund made profits mostly on the short side, in both equities and cash bonds, on names like Harley-Davidson. Later in the year, gains came primarily from the long side in both credit and equities. A big winner for 2009 was the firm’s long position in the senior unsecured bonds of American International Group, which Scottwood entered into in the second quarter, after the U.S. government subordinated most of its investment in the company and removed the most toxic assets—the derivative liabilities in AIG’s Financial Products Division—from AIG’s balance sheet. Other notable winners came from trading the debt of automobile names such as General Motors and Ford Motor and real estate investment trust General Growth Properties.
Scottwood is named after the street Perlman grew up on in a small suburb of Cincinnati. He hails from a tight-knit, middle-class family and attributes his cautious investment style to his stable upbringing. And he wasn’t following the markets.
“You hear these stories about other managers who started investing when they were ten years old,” Perlman says. “When I was ten, I was in Hebrew day school. I didn’t even know what a stock was.”
Perlman continued to ignore Wall Street well into his 20s. He aspired to be a lawyer and earned a degree in economics from the University of Cincinnati and a law degree from the University of California at Los Angeles. He then went to work for a securities law firm that worked with the savings and loan industry—and promptly realized that he did not like being a lawyer.
When a senior member of his law firm left to join an investment bank in New York, Perlman began to rethink his career choice. Burdened with law school loans, he knew he couldn’t move to New York without a job, so he began looking for positions in the financial sector in Manhattan.
“I didn’t know anyone and had no connections,” Perlman remembers. “I sent out dozens of résumés and got nothing back.”
Finally, he got a break. In 1983 Citicorp, which was looking to expand its investment banking side, called Perlman in to its Los Angeles office for a preliminary interview. Despite his economics degree, Perlman had no accounting or business experience, so he found himself in the library at UCLA checking out books on investment banks before the interview. The cramming paid off: The firm offered him a job at $40,000 a year, with the stipulation that he live in New York for a minimum of six months in order to participate in a training program. “Back then that was a lot of money,” recalls Perlman. “I thought if in my lifetime I could make $50,000, that would be pretty good.”
Perlman spent three years at Citicorp, where he eventually traded U.S. corporate loans and Latin American sovereign and corporate loans. In 1986, he moved over to Dean Witter for a year, where he was part of a team charged with creating a loan-trading business. Then he heard about a small start-up distressed-securities group at Oppenheimer headed up by Jon Bauer, who later became one of the co-founders of the multibillion dollar distressed hedge fund Contrarian Capital Management. Milton Lewin, now the chief operating officer at Scottwood, worked in the group and called his former Citi colleague to tell him about it. The intense, research-driven atmosphere that Lewin described appealed to Perlman. He made the switch, and Bauer became his mentor.
“When I first met Jon, he told me there were two things I needed to know about Wall Street,” Perlman recalls. “One was, if I wanted to have a long-term career, I needed to be honest; and the second thing was that I needed to learn to add value. He said, ‘Eddie, you cannot do what everybody else is doing because then you are just a commodity. If you can manage those two things you will always have a job on Wall Street.’” At Oppenheimer, Perlman honed his skills researching, selling and trading high-yield and distressed securities. The fledgling group at the firm would later spawn a few other hedge fund managers. Besides Bauer and Perlman, who started their own funds, Jamie Zimmerman went on to launch her own event-driven fund in 2000. Zimmerman now manages $770 million, and her Litespeed Partners fund has an annualized net return of 11.49%.
“We are all contrarians, and I believe we learned a lot from Jon and each other,” says Zimmerman of that time.
Despite the think tank-like atmosphere, Perlman began to get restless after a few years. He was offered an opportunity to work in a similar group at Jefferies & Co. and decided to take it. Perlman didn’t feel like he fit in at Jefferies and regretted the move almost instantly.
But it wasn’t until a year later that he would pick up the phone to speak with Bauer about returning to Oppenheimer.
“I made a mistake. I was lured by the money,” Perlman says. Bauer did end up rehiring Perlman, who worked at Oppenheimer for another four years.
“Jon tells people that he was a day-one investor with me and that, in all the years he worked on Wall Street, I was the only person he ever rehired,” says Perlman.
After leaving Oppenheimer in 1997, Perlman went to work for the high-yield and distressed securities department at Bear Stearns. By the spring of 2001, he was feeling ready to go out on his own, but he didn’t yet have the money or the investor following. He approached his bosses and told them he was interested in leaving, and in an unusual move, the firm set up a small managed account with a few million dollars in offshore money for Perlman to invest. That account returned 35% between April and November of 2001 and gave Perlman the track record and confidence he needed to strike out on his own.
The terrorist attacks of September 11, 2001, along with the market meltdown and prevalence of fraud, helped Perlman decide the time was right to make a move. He left Bear on Friday, November 30, and, with the help of friend and co-founder Adam Weiss, opened Scottwood’s doors on Monday—just as Enron filed for bankruptcy. Perlman began with $28 million from friends, family and some offshore investors and returned 1.85% his first month.
The contrarian viewpoint Perlman cultivated earlier in his career, and the training he got in terms of looking at out-of-favor situations, continues to drive him. Perlman follows an investment philosophy he has dubbed “the five C’s"—buying things that are cheap, looking for a catalyst, having clarity on a potential investment before diving in, investing across the capital structure and preserving capital.
Colleagues describe Perlman as being meticulous by nature but also as having a gut instinct. Like many managers, Perlman is singularly focused, continually gathering research about investment situations. A case in point: Although Enron filed for bankruptcy on Scottwood’s opening day, it would be more than a year before Perlman found enough clarity to make an investment.
Despite his meticulous research, Perlman isn’t immune to mistakes. Although he has produced an annualized return of 15.01% since inception and managed to make back his high-water mark last year, his convictions were tested in early 2008.
Heading into that year, the fund was net short. But in April of that year, the fund suffered its worst-ever month at the time, falling 4.89% in a month when the market experienced a short-lived rally after the government bailed out Bear Stearns. Scottwood got squeezed in both its equity and credit shorts. Thinking the government would continue to bail out financial institutions, Perlman made the decision to abandon all the fund’s short positions and shift the portfolio, taking long positions in corporate loans that were historically cheap. “We are not double downers,” Perlman says. “From a risk tolerance standpoint, that draw down was intolerable.”
However, continued government announcements and fast trading in the market, coupled with continued losses, led Perlman to again abandon his corporate loan positions. In June he returned to financial and consumer companies again, but on the short side. Though that may have been the right call intellectually, the fund got squeezed in mid-July when Wells Fargo reported better-than-expected numbers and the government issued a temporary ban on the short-selling of specific bank stocks. Perlman ended up closing out those positions, but the fund still lost 3.76% in July and another 1.46% in August.
Thinking back, Perlman says that the rapid market moves and the government intervention created a lack of clarity around a lot of positions. He believes the firm’s initial conviction on the short side was correct, and according to back-tested data, the fund would have survived if Perlman had stuck to his guns. But the performance would have been extremely volatile, he adds.
“A lot of managers will tell investors they are unemotional when it comes to investing,” says Perlman. “That’s not who I am. I have emotions and I can’t stomach that type of volatility.”
Some people familiar with Scottwood have criticized the firm, arguing that Perlman may have jumped the gun too soon by dumping positions, but Perlman believes that many of the investors who handed in redemption notices in August would still have redeemed because the fund has historically had very little volatility.
The down months ended in September, when he and his team began making money on their short positions in names such as AIG and State Street and casinos MGM Mirage and Las Vegas Sands. That month, the fund gained 2.54%. Luckily, the firm was sitting on a chunk of cash for its September 30 redemption date.
Fans of Perlman point out that his ability to not be married to his convictions has allowed him to exit positions swiftly when they started to turn against him.
“Eddie has always been a very clever and ethical manager,” says one Scottwood investor. “I respect him for doing what he thinks is right and not taking any short cuts.”
However, his cautious nature and strong ethics can sometimes lead to criticism. Perlman has been questioned many times over the years by investors and staff for missing out on opportunities because he couldn’t get comfortable enough in time to benefit from a position.
“I am afraid to lose money, and sometimes I kick myself because it’s caused me to miss a lot of things,” says Perlman.
He also believes Scottwood has been unfairly compared over the years to similar funds that were producing outsize returns because they were using excessive leverage. And while he says he needs to have strong convictions before he makes an investment, Perlman is also not afraid to admit when he has made the wrong move.
That was evident early in 2009, when Perlman made money in the first three months from the short side but then exited those positions when they started to move against him. The fund was down 1.4% in April, a reflection of Perlman’s decision to cover the fund’s short positions.
“The thing about Ed that makes him good is that he never falls in love with his own thesis,” says Loeb’s King. “It makes him nimble and, in the end, more competent.”
But like many smaller funds, Scottwood suffers from key-man risk. While Perlman has created a collaborative environment between himself and his analysts, he is still the sole portfolio manager and sole partner.
The most significant departure has been of co-founder Weiss, who left at the end of 2007. Weiss left to pursue other opportunities on the West Coast, according to Perlman, who added that investors were notified before the redemption notice period in case any wanted to redeem. Weiss did not return a call for comment.
Despite the rough start to 2008, Scottwood emerged relatively unscathed, which allowed Perlman to focus on growth last year, when many firms were still trying to make sense of losses. He recently moved to new, larger offices in Greenwich, Conn., invested in new software, systems and equipment and managed to scoop up some talented new employees. Scottwood now boasts 16 employees, including Perlman.
His efforts may already be paying off—the firm is now on the short list of at least one consultant, which is actively recommending Scottwood to institutional investors. And the fund’s performance is looking like it could match that of 2009. To date, Scottwood is up 3.49% for the year through February and at press time was on track for one of its best quarters ever mid-way through March.
Perlman hopes his relatively consistent behavior over the eight years he has been in business—apart from the difficulties he faced in 2008—will continue to attract long-term investors.
As he wrote in Scottwood’s year-end letter to investors in 2008, “We think of ourselves as a ‘sleep at night’ fund, a fund whose investors sleep well, while many of us do not.”
