By Stephen Taub
Photographs by Grant Delin
president and portfolio manager of 28-year-old Baupost Group,
is considered the dean of value investing among hedge fund
pros, and such a devotee of Benjamin Graham and David Dodd that
he was the lead editor to the reissue of their classic,
"Security Analysis," in 2008. With his wire-rimmed glasses,
graying beard and kindly smile, the 53-year-old Klarman has a
gentle, professorial air about him—and a reputation as
a cautious investor who is more likely to be found sitting on a
mound of cash than taking big risks in frothy markets.
That being the case, it might be surprising to learn that
Klarman's Baupost bested Carl Icahn in the tussle over CIT
Group last year and helped wage a successful activist campaign
in a merger battle for a small biotech company. But if Baupost
has been able to throw its weight around recently, it's not
just because beaten-down markets provided tremendous
opportunities for value investors. It's also because Klarman
has been on such an asset-building binge that Baupost has
become the sixth-largest hedge fund firm in the United States,
with $21 billion under management—three times the $7.4
billion Klarman managed just three years ago. After raising
more than $4 billion in early 2008—the first time in
eight years that he had opened his fund to new
investors—the founder of once-obscure Baupost has
become a hedge fund titan.
To hear Klarman talk about these matters, the success and
the deals all flow from the value-investing philosophy he first
popularized in his book, "Margin of Safety: Risk-Averse Value
Investing Strategies for the Thoughtful Investor," now out of
The CIT deal became one of last year's highest-profile hedge
fund trades, but Klarman was way ahead of the crowd. He began
to buy distressed credits, especially in the reeling financial
sector, during spring 2008, and thought the senior debt of the
shaky middle-market lender, looked especially attractive. After
all, he remembered that he'd made a successful investment 10
years earlier in another diversified loan company, Finova
Group. So Klarman's team scooped up CIT's bonds, which were
yielding 12% to 14%, for 65 cents to 75 cents on the
"It had some loan problems, decent quality assets and an
equity cushion that would need to be burned through before the
bondholders would be impaired, which made for an attractive
risk-return," says Klarman, recalling his initial thinking on
the CIT trade on a recent morning in early April at his office
on St. James Ave., just a few blocks from Boston Common.
During 2008 the bonds fell to the low 40s, and Baupost
bought more all the way down. But by July 2009, CIT was in such
poor shape that Baupost and five other hedge funds ended up
lending it an additional $3 billion. To help buy some time, the
facility was expanded by an additional $4.5 billion.
Klarman says he was confident the deal would offer him a
comfortable margin of safety. A first-lien loan, the debt was
collateralized by assets worth four times more than the face
amount of the debt, and in exchange Baupost got a fat 12%
yield. "We don't usually lend money at par," concedes Klarman,
who for a short period agreed to sit on an unofficial steering
committee of CIT's creditors before it went into bankruptcy.
"But how often do you make a loan that is exceptionally safe
and you get to make 12%?" Nor did the prospect of bankruptcy
worry him. If it were to occur, Baupost calculated that the
assets would recover at least 80 cents on the dollar to the
In late October, as CIT seemed headed for a prepackaged
bankruptcy, the deal looked so good to Icahn, who claimed to
own $2 billion in CIT bonds, that he opposed it. Icahn called
it a sweetheart deal for the large bondholders like Baupost and
the other five hedge funds and countered with a $6 billion loan
But a week later Icahn backed down, paving the way for CIT
to enter into a prepackaged bankruptcy from which it emerged in
just 38 days. And Klarman's analysis turned out to be spot-on:
Baupost wound up receiving a package of securities with a
market value of about 80 cents on the dollar for its CIT
Around the same time the CIT deal was playing out, Klarman
took a sizable stake in Facet Biotech—a small biotech
company spun off in December 2008 from PDL
BioPharma—for an average cost of $9 even though it had
$17 per share in net cash at the time of the spinoff. "We liked
the discount and pipeline of products," Klarman recalls. "We
knew that when small caps are spun off, they are frequently
ignored and become cheap."
Biogen Idec tried to acquire Facet in a hostile deal for
$14.50 per share, raising the offer later to $17.50. When Facet
allowed its largest shareholder, Biotech Value Fund, to buy up
to 20% of the company, Baupost asked for identical terms,
essentially becoming a poison pill. Baupost then told Facet it
did not intend to tender its shares in the $17.50 per share
offer. Eventually Biogen backed off, and Facet accepted a $27
per share offer from Abbott Laboratories.
Klarman's high-profile roles last year in both the CIT and
Facet Biotech deals helped him generate average returns in 2009
of nearly 27% in the 11 partnerships of Baupost, with the
oldest recording a 19% annualized return since inception in
1983. Klarman has succeeded by deftly exploiting undervalued
markets, whether they are equities, junk bonds, bankruptcies,
foreign bonds or real estate. His long-term performance is
especially impressive since he is not afraid to place as much
as 50% of his assets into riskless cash if he can't spot a good
deal, preferably one with a catalyst.
"Seth is a student of the doctrine of Benjamin Graham, but
he is not wedded to it," says James Grant, editor of Grant's
Interest Rate Observer, who has known Klarman for nearly three
decades. "He has a very good understanding of not only what
makes an attractive valuation but also what makes an attractive
opportunity. Seth looks for value in a 360-degree circle of
markets and geographic regions. He is one of the all-time
In his characteristically understated manner, Klarman simply
smiles and says, "I'm not the best, but I am on the all-star
After the debt
and equity markets rallied sharply over the past 14 months,
Klarman is seeing many fewer good values—and that's
despite the market's huge sell-off that began in mid-May. He
thinks junk bonds are no longer attractive now that spreads
have narrowed sharply, and he has selectively sold down his
corporate debt holdings over the past year. As a result,
Baupost was only up about 3.25% to 6.4% in the partnerships net
of fees through April; Baupost now has 30% of its assets in
cash, and Klarman expects that number to drift higher.
Baupost's returns this year have been hurt by the huge cash
position, but that doesn't deter him.
Says Klarman: "We are concerned by the high degree of
optimism over the past few months."
Baupost's recent growth spurt has come at the same time that
more recognizable names—such as Louis Bacon's Moore
Capital Management, Kenneth Griffin's Citadel Investment Group
and Paul Tudor Jones II's Tudor Investment—have seen
assets shrinking from losses or investor withdrawals of
capital. By contrast, investors have been clamoring to get into
Baupost. "I felt Baupost could handle more money than ever,
given the magnitude of opportunities that we were
anticipating," Klarman recalls.
Like John Paulson—whose Paulson & Co. also very
quickly became one of the biggest hedge funds—Klarman
smelled trouble in the global markets as early as 2006. He
thought stock prices were too expensive and that excesses in
the credit markets, resulting from heavy borrowing by
countries, companies and individuals as lending standards were
relaxed, were ominous. "Some things made little sense," he
As credit conditions tightened in 2007 and holders of
securitized mortgage debt and collateralized debt obligations
were forced to take huge write-offs, he noticed that credit
spreads had started to widen. At the same time, he realized the
housing market was deteriorating and figured trillions of
dollars in mortgage-backed securities were not worth par
Klarman's view was prescient. Paulson and Klarman, however,
responded to the impending credit crisis in distinctly
different ways. In 2006 Paulson shorted risky pools of CDOs and
bought credit-default swaps on mortgage assets on the cheap.
His aggressive bets were life changing, as he personally made
$3.7 billion in 2007.
The risk-averse Klarman, on the other hand, placed nearly
half his assets into cash. Then, as the financial world was
imploding, he started scouring the markets for distressed debt.
In late 2007 he started putting cash to work, reducing his
cache to 25% to 30% by the beginning of 2008. "We were
patient," he recalls.
Klarman reckoned the game changed at the end of February
2008, when London hedge fund firm Peloton Partners was forced
to liquidate its $1.8 billion asset-backed fund. "That was like
a bell going off for us," he says. "That was when we made our
decision to raise capital. We realized there were a lot of weak
holders out there," he adds, referring to struggling funds that
needed to raise cash.
He scooped up some of Peloton's senior mortgage bonds for
about 65 cents to 70 cents on the dollar. Shortly thereafter,
their value fell further as the market worsened. But Baupost's
team saw other large sellers and developed relationships with
Wall Street, letting various firms know that if anyone was
looking to sell, Baupost was interested in loan portfolios,
nonperforming debt, toxic assets of any sort, private
investments or so-called tier-three assets.
Sensing so much opportunity, Klarman also decided to open up
his funds to new investors for the first time in eight years,
raising about $4 billion. He raised the money only from
foundations and educational institutions—including the
Ivy League—as well as existing investors, all of whom
he deemed more likely to stick with Baupost for the long haul
regardless of short-term performance swings. Baupost is noted
for eschewing fund-of-fund investors, who tend to redeem at the
first sign of trouble.
Throughout 2008 Klarman was on the lookout for bargains. And
after Lehman filed for bankruptcy and AIG was rescued in
September, Baupost made new investments virtually every day,
often shelling out $100 million on a single day. Klarman bought
the beaten-down securities from others who were reeling from
the markets, including many hedge fund managers who were forced
to raise cash to meet a surge in redemptions. He didn't escape
unscathed from the carnage: his funds lost between 7% and the
low teens during 2008.
But the comeback was worth it. For example, Klarman bought
covered bonds of Washington Mutual at an average price of 74
cents on the dollar. He made money on them after JPMorgan
assumed the bonds as part of its takeover of WaMu. By early
2009, yields on some of the depressed paper surged to as high
as 25%. His firm also bought distressed corporate debt,
including nonbank financials such as CIT and Sallie Mae and
mortgage securities, mostly the senior bonds, which were
yielding about 12% to 16%. He was able to make double-digit
returns on some of this nonequity paper in 2009.
As in the case of Peloton, Klarman continued to buy up the
heavily marked-down senior mortgage securities from collapsing
fixed-income funds. Baupost picked up pieces of nonperforming
debt and private investments from large sellers. Klarman also
bought credit default swaps, but unlike Paulson, he used them
sparingly and solely as a hedge against calamity. At the same
time, he was lightening his equity load, reducing his stock
portfolio from $2 billion in June 2008 to $1.2 billion by
By October 2008, he drew down the rest of the newly
committed money. "As the world blew up in the fall of 2008, it
was business as usual for us," he says with more than a small
degree of pride. "It was a fortuitous time because we were
Klarman admits he may have begun buying a little too early,
as the returns of 2008 would suggest. However, since March
2008, when he began to take in the new money, he is up more
than 30% through April. "Seth has an extraordinary sense of
patience and discipline, which not many people have," says Ray
Jacobson, chief investment officer at Davidson College, who
made his initial investment in Baupost in January 2009. "He is
flexible and opportunistic."
The elder of two boys, Klarman was born in New York City.
His family moved to the Mt. Washington section of Baltimore
when he was six, but his parents divorced shortly afterward.
His father was a professor of health economics at Johns Hopkins
University, and his mother taught English in a Baltimore high
school before returning to graduate school to earn her master's
degree in social work.
Growing up in the shadows of Pimlico Race Course, he
frequently spent his teen years there and developed an interest
that would lead to him to buy race horses when he became
wealthy enough to do so. And he was always into numbers.
Klarman says he loved tracking baseball statistics, and by the
age of eight had become fascinated with the stock tables in the
back of newspapers. Like so many hedge fund managers, he
started investing at an early age. Klarman bought his first
stock—Johnson & Johnson—with money he had
saved when he was 10. His analysis was simple. Given that he
was a big user of the company's Band-Aids, he figured he would
stick to something he knew well. Shortly afterward, the stock
split three for one.
When Klarman headed off for college at Cornell University,
in Ithaca, N.Y., he initially planned to major in math, the
subject in which he had received the best grades. However,
after taking a number of economics and history classes, he
earned a BA in economics in 1979, graduating magna cum
In the summer of his junior year, Klarman had a fateful
experience when his uncle helped get him an internship at New
York's Mutual Shares, the legendary value-driven mutual fund
firm founded in 1949 by Max Heine, and also headed by Michael
Price, who in his 20s had become a Heine protégé.
During a summer working at Mutual Shares, Klarman learned the
value philosophy that today is the bedrock of Baupost's
investment principles. "I learned the business from two of the
best, which was better than anything you could ever get from a
textbook or a classroom," he says.
Klarman likes to describe the connection he made to value
investing as an inoculation. Either it takes or it doesn't.
"Ultimately, it needs to fit your character," he explains. "If
you are predisposed to be patient, disciplined and
psychologically appreciate the idea of buying bargains, then
you're likely to be good at it. If you have a need for action,
if you want to be involved in the new and exciting
technological breakthroughs of our time, that's great, but
you're not a value investor, and you shouldn't be one."
Upon graduation, Klarman returned to Mutual Shares. Price,
who now runs his own family office, MFP Investors of New York
City, recalls one of the first stocks Klarman bought was a
Baltimore meatpacking company called Schluderberg-Kurdle,
subsequently renamed Esskay, before it was acquired by
Smithfield Foods. Mutual Shares wound up holding the position
for several years and made a pretty good profit, Price recalls.
"Seth left us a true believer," says Price.
After 18 months Klarman left the firm for Harvard Business
School, where he earned his MBA and was named a Baker Scholar,
an honor given to the top 5% of the graduating MBA class. There
he took a real estate course with professor William Poorvu, who
says Klarman was the smartest person in his class. "I realized
he was a special guy," Poorvu recalls.
The decision to go to Harvard—and to take a real
estate course—was also fortuitous. One day Poorvu
invited his student to lunch with some of the professor's
friends. At lunch Poorvu told Klarman how he had just made a
lot of money selling his interest in a local television station
to then-media giant Metromedia. Poorvu added that he and
several friends wanted Klarman to help them invest their
considerable sums of money earned from that and other
interests, including a computer consulting firm.
In 1982 they created Baupost, an acronym of the names of the
four founders of the firm—Poorvu, Howard Stevenson,
Jordan Baruch and Isaac Auerbach—with initial capital
of $27 million. Klarman, who came in later and got left out of
the acronym, was initially paid just $35,000 per year, not
exactly Wall Street compensation.
The initial plan was for Klarman to serve as portfolio
manager, while Stevenson, who taught an entrepreneurial
management course, served as part-time president. He is now
co-chairman of the advisory board. They also planned to farm
out the money to other money managers, creating an expanded
family office. However, after meeting with several, they had a
change of heart.
The Baupost founders were turned off by what they deemed to
be a big disconnect between how the prospective money
management firms were investing their clients' money and how
they were dealing with their own money. They also frowned on
the herd behavior they saw, as most of the managers generally
invested in the same stocks. Meanwhile, Poorvu and his friends
were impressed with the kinds of questions Klarman was asking.
So they decided he was the best person to manage their money.
"They were taking a big risk on a relatively inexperienced
person," Klarman says.
Poorvu and his friends didn't think so. Poorvu recalls how
he was drawn to Klarman's curiosity and desire to explore
things in depth. Klarman, he saw, was not afraid to challenge
anyone. "He was fearless," Poorvu adds. "He had strong
opinions. There were discussions more than arguments. It was an
enthusiasm for what he was doing. We realized he was on a
different level than they were."
Those attributes have not disappeared. Grant describes
Klarman as ferociously smart, notoriously prickly and not one
to engage in a lot of soft preliminaries in a business context.
"His intellect can be hugely intimidating," he elaborates,
stressing that Klarman has earned a great deal of respect in
the investment community. "He comes out and says what is on his
mind and expects you to be blunt and direct as well."
Grant recalls how, years ago, Klarman would aggressively
press Goldman Sachs salesmen on their investment ideas with a
flurry of detailed questions. He was so fierce, Grant muses,
that the Goldman guys were afraid to answer the phone if they
saw it was someone from Baupost calling.
When Baupost was created, Klarman determined that one of the
best ways to make money is to avoid buying stocks that are
widely covered on Wall Street and owned by many managers. In
general, he tries to buy everything at a big discount. "What
you are buying is a margin of safety," he explains, invoking
the name of his book written in 1991, which laid out his value
philosophy. The book has found its own secondary market, and
currently can be purchased for $1,700 new or $775 used on
Managing risk and determining the margin of safety are the
backbone of Klarman's investment process. He and his team look
at what could go wrong in a company, the economy, how some
event or issue could affect the company or the security. "You
can like a company but not find opportunity in its securities,
or not like a company but find opportunity in the securities,"
Ultimately, he says, money managers must pick their poison.
They are going to be wrong sometimes. The question is, what are
they going to be wrong about? They can take a risk and then
possibly lose their client's money, or the client could see
their money remain intact but wind up not liking you because
you missed a great opportunity. "Our bias is to buy when we
have a high degree of conviction and wait patiently when we
don't," he stresses. "That's the core of our approach, which
has kept us out of trouble."
In other words, he prefers being wrong by missing
opportunities rather than losing money chasing them. This is
why Baupost, on average, has 30% of its assets in cash, and it
is not unusual for Klarman to sit on 40% or 50% cash, as was
the case in 2006 and 2007. This makes the fact that he
outperformed the S&P 500 virtually every year in the past
decade even more remarkable. In 2006 Baupost was up 22%,
compared with 15.8% for the benchmark, despite holding a huge
amount of cash. The following year it had an explosive 54%
return, compared with just 5.49% for the S&P, again with
nearly half its portfolio in cash.
But Klarman has never felt pressure to put money to work,
especially during the late 1990s, when Internet and tech stocks
were surging out of control and critics were asserting that
Warren Buffett was a relic unable to adapt to new markets.
Klarman's willingness to underperform over short periods of
time when he does not see value also explains why he refuses to
take money from funds of funds. He prefers educational and
philanthropic groups. "If making money right away is important
to you, please take your money out," he says.
"When he doesn't see things he likes, he doesn't buy," says
Price admiringly. "He sits on cash. He is very
When mulling a specific investment, Klarman says, he looks
at an anticipated return, although he won't cite a specific
level because Baupost's required return depends on the
Klarman tries to figure out what something is worth, drawing
in part on the usual metrics treasured by traditional value
managers: price-to-book-value, price-to-cash-flow,
price-to-earnings, dividend yield and replacement cost. Unlike
most value investors, however, he does not put heavy weight on
these measures. For example, if a stock is trading at a deep
discount to book value or some other standard, he does not
automatically buy it, since there is no guarantee the stock
will go back to that level and no way of knowing how long it
would take to reach that level. It could go to a deeper
discount before it narrows again, or the value itself could
change. "Book value is not a good proxy if the inventory is
subject to obsolescence," he adds.
And unlike many value managers, he does not look at what a
private buyer might pay for something because that deal might
Rather, Klarman tries to figure out what he would be willing
to pay for the business today if it had to be liquidated or if
the various parts of the business were sold. He says this does
not mean the future is not important. "A dirt parcel in the
middle of Boston is worth more than a dirt parcel in the middle
of a desert," Klarman says. But it is difficult to navigate
between the present—for example, valuing current cash
flow—and the future, such as projecting future
subscribers for a cell phone company. "We would have a hard
time making optimistic bets about the future," he says. "You
have to worry about your margin of safety, which value
investors always want."
In general, Klarman runs what he calls a sensitivity
analysis. He likes to determine the best possible scenario, the
worst case, and the base to find that margin of safety.
How far does he take it? Pretty far, or so it seems. Grant
muses that shortly after he launched his newsletter in the
1980s, Klarman requested a meeting to determine whether to
commit $200 for an annual subscription. "He grilled me to see
if it was a good investment for his fund," Grant says,
laughing, stressing that Klarman has been a subscriber ever
Baupost's investment team consists of about 40
people—including six other partners—who
investigate different asset classes, geographies and securities
types. They are all generalists, except for the commercial real
estate specialists. Although Klarman does not make every
investment decision, he does make a point of saying he approves
the concept of what they are doing.
Klarman, who spends most of the time sitting on the trading
desk or in conference room meetings with his other investment
professionals rather than in his office, must approve every
trade, although he does not personally execute them. "If I am
hard to reach on vacation, they can take a position," adds
Klarman, stressing that most of his key people have been with
the firm for a number of years.
Value investors are typically thought of as stock investors,
but Klarman says most of the time he prefers to buy bonds.
Bonds are a senior security, offering more safety, and they
have a catalyst built into them. Unlike equity, debt pays
current principal and interest. If the issuer doesn't make that
timely payment, an investor can take action. "Catalysts can
reduce your dependence on the level of the market or action of
the market," he explains. For example, defaults are specific
incidents affecting the company regardless of what is going on
in the overall market.
Over the past two years, Klarman's preference for debt has
been even more pronounced. After peaking at just $2 billion in
June 2008, Baupost's total equity assets shrank to around $1.2
billion from the fourth quarter of 2008 to the first half of
2009, before turning up slightly at year-end 2009 to nearly
$1.6 billion. That puts equities at just a little more than 7%
of total assets under management.
These days Klarman is not very bullish. One of his concerns
is the record dollar amount of junk bonds that were sold in
March and April—$69.8 billion during that eight-week
period. And that comes right after a record year for junk bond
issuance in 2009, when $185.9 billion was sold.
Klarman is also concerned that the leverage that has
weakened the consumer and corporations in recent years has now
been added to the government, whose debt has been skyrocketing
over the past decade. Meanwhile, interest rates are close to
zero percent. "I don't know how we wean ourselves off that," he
warns. "It is time for caution."
As spreads on the debt have narrowed, he has been selling.
Over the past year, Baupost has sold corporate debt at or near
par after buying it for 40 cents or 50 cents on the dollar.
He's still selling, stressing that he's waiting to buy when he
can be adequately paid to take risk.
The value pro is still looking at troubled companies,
mortgage securities and select equities. But he is not buying
much at the moment. Klarman says there are some opportunities
in commercial real estate on the private side, but not as much
as would be expected, given the depressed levels of the market.
"That's why we want to be patient," he stresses.
Baupost is 30% in cash now, its long-time average. Klarman
stresses that the cash position is residual—the result
of a search for opportunity and not the result of a macro view.
He says he can find great opportunities to buy at the same time
he has a bearish view on the world. "We're good at finding
bargains, good at doing analysis," he emphasizes. "We're not
good at calling short-term movements in the markets."
And when the markets started to crumble in mid-May, he
mostly stood pat, asserting that the 5% to 8% drop in prices
did not unleash a torrent of bargains, mostly because of the
market's surge from its March 2009 bottom. "The market has gone
up so much that, based on valuation, it is overvalued again to
a meaningful degree where the expected returns logically from
here can be as low as the low single digits or zero for the
next several years," he says.
For Klarman, the overriding concern is valuation in
individual investments, not the macro state of the market. And
given today's turmoil and financial distress, one might have
expected more opportunities. "But, the opportunity set has been
diminished by all of the government intervention," he adds,
referring to the current 0% interest rates, TARP and TALF. If
financial institutions started selling these assets,
opportunities would open up, he says.
Another high-profile investment he has made in the past year
was in the Boston Red Sox, buying the minority stake of
advertising mogul Ed Eskandarian for an undisclosed sum. "It's
a tiny little sliver," insists Klarman. "It's been fun. The
other owners have been incredibly gracious in welcoming me."
His biggest perk: better access to extra seats at hometown ball
Living next to Pimlico as a child may have been the impetus
for a great career in finance, but ironically it seems
Klarman's worst investment has been in race horses. He bought
his first one in the early 1990s, and in 1993 he started
Klaravich Stables with longtime friend Jess Ravich, a West
coast investment banker. Klarman's crowning achievement came in
2004, when Read the Footnotes, his horse, ran in the Kentucky
Derby. One of the worst moments was when he finished seventh.
Horse ownership, he acknowledges, is "almost certainly a
negative present value situation."
In 2008, Breederscup.com estimates Klaravich Stables earned
less than $34,000. That's a far cry from the roughly $275
million to $300 million Klarman probably earned last year as a
hedge fund manager, a topic he won't comment on.
Klarman will say that he gives away most of his money to the
Klarman Family Foundation, which his wife Beth runs, or to
individual charities, except for an undisclosed sum squirreled
away for his three children. His foundation gives out
considerably more than the standard 5% each year, focusing on
alleviating poverty and improving education in the inner city.
He also gives money to health care and science causes; he has
created an eating disorders center and a funding program
for scientific grants in the field of eating disorders.
Klarman, who is Jewish, gives money to causes such as Boston's
Combined Jewish Philanthropies.
"It's easy to write checks," he says. "It's hard to be
thoughtful philanthropists. My wife Beth and I try to make our
money go a long way." What else would you expect from the dean
of value investing?
FACT FILE: BAUPOST GROUP
Assets under management: $21.8 billion
Baupost (oldest partnership): 19%
annualized since inception
Founders: Bill Poorvu, Howard Stevenson,
Jordan Baruch & Isaac Auerbach
Office: Boston, Mass.