HEDGE-FUND bosses rarely double as cult authors. But an out-of-print book by Seth Klarman, the boss of the Baupost Group, sells for as much as $2,499 on Amazon. A scanned version of “Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor” has been circulating around trading floors. One hedgie likens Mr Klarman’s book to the movie “Casablanca”: it has become a classic.
Why are Wall Street traders such avid readers of Mr Klarman? Baupost, which manages $25 billion, is the ninth-largest hedge fund in the world. Since 2007 its assets have more than tripled, as other funds have wobbled. Baupost has had only two negative years (in 1998 and 2008) since it launched in 1982, and is among the five most successful funds in terms of lifetime returns (see chart), a particularly striking record given its risk aversion. Long closed to new investors, Baupost counts elite endowments like those of Yale, Harvard and Stanford among its clients.
Soft-spoken and based in Boston, a safe distance from the Wall Street mêlée, Mr Klarman keeps a low profile and rarely speaks at industry shindigs. He is probably the most successful long-term performer in the hedge-fund industry who has managed to stay out of the spotlight.
Mr Klarman is a devotee of “value investing”, a discipline forged by Benjamin Graham (see article) and popularised by Warren Buffett, which involves buying stocks at a discount to their intrinsic value. He will look beyond equities for bargains—a good example is Lehman Brothers, which at the end of last year was Baupost’s largest distressed-debt position. But in every investment he insists on a “margin of safety”, the buffer between what investors pay for the stock and what they think it is worth, so they are protected against unforeseen events or miscalculations.
Mr Klarman first became an acolyte of value investing when he worked at Mutual Shares, a value-investing mutual fund, as an intern and again after he finished Harvard Business School. One of his former Harvard professors then recruited him to run a family office for him and three other families, with an investment pot of $27m (Baupost is an acronym for these families’ surnames). Although the fund is significantly larger today, Mr Klarman still runs Baupost like a family office. He is extremely risk averse; his primary goal is not stellar returns but preservation of capital.
In other ways, too, Baupost is not a typical hedge fund. It uses no leverage, which is partly why Mr Klarman is not famous for one stunningly profitable trade, like George Soros’s bet against sterling or John Paulson’s against the housing bubble. Baupost has few short positions and often holds its positions for years, rather than days or months. Mr Klarman is patient and confident enough to do nothing. He currently has around 30%—and has been known to have as much as 50%—of his portfolio in cash. In 2008 Baupost was one of the few firms that had the scale and the available capital to buy up lots of assets from distressed sellers. “The ability to be one-stop shopping for an urgent seller is very advantageous,” he says.
Given Baupost’s allure, it could easily make a killing on fees. But Mr Klarman eschews the generous “2 and 20” compensation structure typical of most hedge funds, which take 2% of capital as a management fee and 20% of gains. Instead, old investors pay “1 and 20”, and newer ones (he has let them in twice, in the early 2000s and 2008) no more than “1.5% and 20”.
That is not the only way Mr Klarman has positioned Baupost in contrast to other funds. He thinks one of investors’ greatest mistakes is chasing short-term performance and obsessively comparing returns with those of competitors and with benchmarks. In the year to April, Baupost was up by around 2%, trailing the S&P 500 (which was up by 11.9%) and the average hedge fund (4.4%). He is probably the only hedge-fund manager ever to tell investors that he does not want to be their best-performing fund in a given year, as he did in a recent letter. He has deliberately maintained a sticky investor base composed almost entirely of endowments, foundations and families, which understand his investment philosophy and will not redeem after a few negative quarters.
Some have nonetheless expressed concern about Baupost becoming a behemoth. The bigger a hedge fund, the more its investments become restricted to bigger companies and the harder it is to generate profits. Returns could flag. “He’s pretty damn big. That doesn’t excite me,” says the chief investment officer of a large American endowment with money in Baupost. Mr Klarman himself says he remains “convinced that unlimited size is a bad idea.” Two-thirds of the firm’s approximately $17.6 billion in growth over the past five years comes from compounded profits, as opposed to new money coming in. In 2010 Baupost returned 5% of investors’ capital, because he did not think there were enough ways to put it to work.
Hedge funds are notoriously monotheistic and usually suffer if the founder leaves. Mr Klarman, who is 55, has already started working with his team on succession planning. Last year he promoted someone to serve alongside him as manager of the portfolio. Mr Klarman has also hired coaches to work with him and some of his team on devising strategy and maintaining the firm’s culture.
In 2011 Baupost opened a London office, its first outside Boston in its 30-year history, to buy assets as European banks deleverage. That has happened more slowly than expected. Mr Klarman has been critical of governments propping up markets through stimulus and keeping interest rates low, all of which has perverted markets. But this is the type of environment where bargains will eventually surface. “Whatever investment success we achieve will take place against a troubled backdrop,” he wrote in January. Last year “felt like we were playing a great hand of cards in the basement of a condemned building filled with explosives during an earthquake.” He did not get where he is now by being an optimist.