Paulson Goes Old School After Billions in Losses: Street Whispers

NEW YORK ( TheStreet) -- After earning Wall Street fame by betting against subprime mortgages in the 2008 financial crisis, John Paulson has gone cold -- his financial and gold investments have lost clients billions of dollars.

But Paulson's roots in merger arbitrage -- the art of guessing which companies will be taken over -- is standing out as the biggest success for his hedge fund Paulson & Co. and its attempt to regain glory.

Three of Paulson's investments, a new stake in engineering specialist Cooper Industries ( CBE) and increased positions in Quest Software ( QSFT) and Gaylord Entertainment ( GET ) -- the owner of the Grand Ole Opry in Nashville -- were M&A targets last quarter.

Cooper Industries was sold to Eaton Corp. ( TN ) in May for $11.8 billion, the largest U.S.-based acquisition of 2012. Quest Software was sold to Dell ( DELL ) just after the quarter's end for $2.4 billion. Meanwhile, Gaylord Entertainment, an oft-speculated M&A target, sold rights to operate its hotels to Marriott ( MAR ). In each instance, the shares soared.

In the second quarter, Paulson & Co. bought 1 million shares in Cooper Industries worth $68 million, and he raised his holdings by 47% and 60% in Gaylord Entertainment and Quest Software, respectively, according to 13F filings submitted to the Securities and Exchange Commission and compiled by Bloomberg after the market close on Tuesday.

Although disclosures on Paulson's investments are imprecise because filings don't specify when the hedge fund made the purchases, share gyrations of the three companies indicate a classic merger arbitrage. That's because in all three investment instances, the shares have gained significantly even after each company disclosed M&A activity.

The investments show that amid a poorly timed bet on financials -- highlighted by Paulson's sale of Bank of America ( BAC) and Citigroup ( C) stock ahead of a 2012 rally and a $142 million-plus investment in JPMorgan ( JPM) -- Paulson may be wise to revert to merger arbitrage, the strategy he used before he shorted the U.S. mortgage market.

In the three arbitrage investments, Paulson appears to have backed conventional M&A plays. Cooper Industries was widely considered a takeover target after Swiss engineering giant ABB ( ABB) bought electrical systems specialist Thomas & Betts ( TNB) earlier in 2012, and both Quest Software and Gaylord Entertainment were the focus of consolidation speculation within their respective cloud computing and hotels sectors.

Outside of merger arbitrage, Paulson added to his gold bet, buying nearly $600 million worth of the SPDR Gold Trust ( GLD) fund, while he pared a leading stake in Hartford Financial ( HIG) -- an insurer he pushed to break up -- by nearly 20% to $552 million.

Meanwhile, the fund pared stakes in successful distressed investments like Delphi Automotive ( DLPH) and got out of financials Capital One Financial ( COF) and Suntrust Bank ( STB).

Paulson also exited an underperforming investment in coal sector takeout candidate Walter Energy ( WLT) and liquidated a $500 million investment in Anadarko Petroleum ( APC).

The fund's M&A arbitrage success also comes as his newest foray into the world of insurance is off to a loss-making start.

In April, he teamed with Validus Holdings ( VR) on a $500 million-plus joint investment to create PaCRe, a Bermuda-based reinsurance company with policies underwritten by Validus and an investment portfolio managed by Paulson & Co.

So far, the venture is down sharply, as Paulson suffers from losses in many of his largest funds.

According to Validus' second-quarter results released July 26, the joint venture lost roughly 10% of the initial investment during the quarter.

Paulson's poor start in the reinsurance business is notable because other hedge fund managers like Daniel Loeb of Third Point LLC and Steven A. Cohen of SAC Capital Advisors have also entered the reinsurance business -- which is essentially insurance for insurers -- as they look for new ways to grow investing capital in an environment marked by investor withdrawals and weak returns.

The fund's investing struggles are well-documented. In July, Bloomberg reported that Paulson & Co. lost money across all of its funds during June. While roughly $50 million in new reinsurance-related losses are unlikely to make a big dent in the performance of Paulson funds, which manage $22 billion in client assets, it is an inauspicious start for the hedge fund manager who is looking for a little luck.

>>View John Paulson's Portfolio

-- Written by Antoine Gara in New York

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