Since its inception in 2005, the New York City-based Paragon Capital has been generating audited average annual returns of approximately 30%, net of all fees and expenses. We recently spoke with Paragon Founder and President Alan Donenfeld about his investment strategy and why his fund has performed so well despite the recent volatile marketplace.
Q: Alan, thank you for speaking with us today. Can you give us a brief overview of Paragon Capital?
A: Paragon Capital is an event-driven investment firm with both onshore and offshore funds. Our funds are focused on achieving a high return while reducing downside risk and having a low correlation to the market. We have every incentive to generate strong returns because a significant percentage of our fund’s capital is our own money.
Since its inception in 2005, our flagship fund, Paragon Capital LP, has generated an audited cumulative return of over 325% – without using any leverage. Paragon Capital LP has generated positive returns every single year, including in 2008 when the major market indices were down well over 30%. Since its inception in late 2009, our offshore fund, Paragon Capital Offshore LP, has generated average annual audited returns of approximately 20%, net of all fees and expenses. Our unique strategy, highly experienced team and strong returns have enabled us to maintain long-term relationships with many investors in our funds. In addition, our funds use top service providers, which provide the transparency that investors deserve.
Q: What is your investment background?
A: I’ve been investing capital for more than 30 years and I’ve utilized dozens of different strategies, including private equity, leveraged buyouts and venture capital. But, since 2005, I’ve focused on event-driven investments that provide all of the upside return with true downside risk protection. I started Paragon to invest my own capital utilizing this strategy. As I began generating strong returns, my family and friends asked me to manage their money. We then built a team of investment experts and used top legal, accounting and administration service firms to provide our investors with the transparency and efficiency that they deserve. We’re now accepting new outside investors and capital.
Before starting Paragon Capital, I managed a private investment company names Bristol Investment Group, which financed many successful companies, including VitaminWater, which was sold to Coco-Cola for $4 billion. Before Bristol, I spent 10 years at Bear Stearns, Shearson Lehman Hutton and SG Cowen, primarily in mergers and acquisitions. I received my undergraduate and MBA degree from Tufts and the Fuqua School of Business at Duke University, respectively.
Our investment team is experienced with a proven track record and collectively has more than 100 years of experience at firms that include Bank of America, Bear Stearns, Lehman Brothers and Sidley Austin, and has been educated at schools that include Wharton, Duke, Vanderbilt and Tufts. Our team repeatedly has been interviewed live on Bloomberg TV and been quoted in numerous publications, including the Financial Times, The Wall Street Journal and Bloomberg, to share our insights and investment experience. We are very proud of our team of investment experts and our strong team has been instrumental in our producing high returns.
Q: Your returns indeed are high–if you don’t mind me asking, what third parties verify your performance?
A: We use best practices in investment management with top industry service providers. Our third-party administrator, SS&C Technologies, Inc., determines our returns each month and sends those results directly to investors in our funds. SS&C works with thousands of funds and has approximately $225 billion in assets under administration. Our law firm for our domestic fund is Seward & Kissel LLP, which often appears in hedge fund law firm rankings as one of the top three law firms. Our law firm for our offshore fund is Ogier, also a top-ranked law firm. Our tax and audit firms, EisnerAmper LLP and Acquavella, Chiarelli, Shuster, Berkower & Co. LLP,are highly regarded firms based in the New York City-area and work with a sizable number of investment funds. Our trades are cleared through Merrill Lynch and JPMorgan Chase is our bank. We work hard to provide investors in our funds with complete transparency and bona fide results.
Q: How would you summarize your event-driven strategy?
A: Paragon makes event-driven investments to capitalize on undervalued and mispriced investment opportunities. We utilize proprietary research to uncover catalyst events in the capital markets such as financings, acquisitions and arbitrage situations. We analyze these catalyst events for the degree of likelihood that they will create substantial undervalued or mispriced securities. We capitalize on the best opportunities (highest likelihood with greatest potential gain) through: open market long / short purchases, structured investments made directly into public companies, and investments in pre-IPOs and alternative public offerings where an arbitrage of private to public values exists.
Our team is able to successfully execute our strategy because we have unique legal and financial skills and capabilities, a deep understanding of public company securities transactions and documentation, and extensive experience analyzing fundamentals and trading associated with securities transactions. Our team is committed to structure transactions with unlimited upside while downsizing the risk.
Q: What is your investment secret for achieving high return?
A: We’re extremely careful in selecting the companies in which we invest and the investment structure of each transaction. We source and evaluate more than 50 transactions a month, but typically only invest in one or two that meet out demanding criteria. The ideal investment candidate for us has a strong business model, an attractive market, excellent management, significant historical net income and a high growth rate. At the end of the day, I have a level of experience to pick the good companies from the average companies. In many large hedge funds that get to be several hundred million or even several billion dollars, the founder of the fund cannot possible manage the whole fund, so junior portfolio managers in their 30’s or even their 40’s handle segments of the portfolio. Sometimes they just do not have the required level of experience.
Q: What types of investments have you been most focused on?
We have been very focused on pre-public transactions. Everyone knows about the upcoming Facebook IPO, but there are a sizable number of excellent companies that are under the radar and not large enough to go public through an IPO. These companies want to become publicly traded for numerous reasons, including achieving a higher valuation, being able to use stock options to attract and retain key management and employees, using publicly traded stock for acquisitions and having the prestigious status of being publicly traded. Fortunately for these companies, we provide them with an alternative approach to become publicly traded – an alternative public offering.
Q: What is an “alternative public offering”?
A: In an alternative public offering, a company raises capital and goes public by merging into a publicly traded company and acquiring a significant majority of the shares of the publicly traded company. The newly merged company then takes on the name of the private company, installs the private company’s directors and officers, and files with the appropriate regulatory authorities. This transaction and change of control completes the transaction, transforming the formerly private company into a publicly traded company. Many famous companies, including Texas Instruments, Radio Shack, the NYSE and Berkshire Hathaway went public through this process rather than through an IPO.
Q: What types of economics can you receive from taking attractive private companies public through alternative public offerings?
A: The economics of an alternative public offering are very attractive to us as we can usually receive an attractive percentage of a company’s stock, as well as warrants, in exchange for our sponsoring the transaction. We earn a piece of the spread between a company’s value as a private company and its higher value when it becomes publicly traded. In other words, there’s an arbitrage in value between the value of a private company and the value of that same company once it is publicly traded.
We typically invest in companies that are looking to become publicly traded within a short period of time. We invest at a low valuation, typically in senior secured convertible debt instruments that pay a minimum of an 8% to 10% interest rate. In addition, we receive warrants as a kicker to generate an even higher return.
When we invest, these companies become obligated to have us take them public at terms that are highly advantageous to us. Our goal is to have these companies become publicly traded and then help them grow and achieve high valuations. These companies have a huge incentive to become publicly traded because if they fail to do so in a timely manner our investment terms provide for us to receive a significant piece of their companies effectively for free.
The upside from these transactions can be tremendous for us. One recent investment that we made was in a private medical device company with solid revenues. We invested at a valuation of $10 million and also received cashless warrants. Today that company is in negotiations to raise additional capital from high caliber venture capital firms and other investors at a valuation of up to $40 million. The company also has turned down a buyout offer at a valuation of nearly $80 million. Once the company becomes publicly traded, we expect the company to trade at a valuation far higher than the $10 million valuation that we invested at, likely providing us with gains of several hundred percent.
Q: What downside protections do you have in your investments?
A: We structure our investments to motivate management teams to achieve their expected results with our growth capital. Accordingly, along with enhancing our potential upside, we often obtain downside protection with terms that include, senior collateralization to secure the debt we hold, full ratchet anti-dilution, make good provisions, lock-up of management stock and most favored nations status.
For example, in one recent investment our collateral included not only management stock and the assets of the company, but also the stock brokerage account of the CEO, which was worth a multiple of the total investment made in the company. To us, transaction terms that include these types of provisions offer greater principal protection than a more common strategy, such as strategy of merely buying and selling stock in the market.
Q: How do you find attractive private companies to take public?
A: Our team’s expertise in alternative public offerings provides us with a huge edge over other investment funds that can’t capitalize on these lucrative deals. We have developed a huge pipeline of strong companies looking to become publicly traded. Lawyers, accountants, venture capital firms, bankers and other professionals come to us with opportunities because they know that we have a strong reputation and can structure investments that highly motivate management teams to succeed.
Q: What is your due diligence process?
A: To highlight a few areas of importance, it’s critical that a company’s management checks out. We want to ensure that they’re raising the right amount of capital, they have the knowledge and capability to execute, and their compensation is significantly tied to growth of their company’s stock price so that all of our interests are aligned.
It’s also critical that a company’s capital structure is optimal. We want to make sure that there aren’t a lot of options and warrants that are struck below the price at which we’re purchasing a stock. Deal terms also are important: We want to maximize our potential for returns while minimizing our risks. These risks include illiquidity, companies failing to perform, management failing to perform and just general risks associated with any investment opportunity.
Q: What are the advantages to investing in your fund instead of larger funds?
A: First, given the large stake that my family, my friends and I have in the fund, I have a very strong incentive to generate high returns while downsizing risk. By comparison, larger funds have a different set of incentives – they are less motivated to seek high returns because they can earn sizable management fees with just mediocre performance.
Second, larger funds may have so much capital to put to work that they’re compelled to invest in many of the deals that they see, including the less attractive ones. Larger funds that have a half a dozen younger and less experienced portfolio managers have many mediocre investments because they are compelled to push out the capital. In contrast, we can be very selective in deciding which deals to invest in and accordingly we simply have a higher ratio of strong investment ideas per dollar of capital.
Third, we can invest in deals that are too small for larger funds to focus on. These deals often offer better terms and a significantly higher potential for tremendous gains. For example, most sizable funds cannot focus on alternative public offerings because the size of these deals is relatively small for them to invest the time, resources and expertise required. In contrast, at our current fund size not only do we have the time, resources and expertise required, but we also can achieve higher returns for our investors given the percentage gains that we can produce are far more meaningful to us at our fund size than to a larger fund. In addition, due to a continuing lack of investment capital, particularly for the sub-$500 million market cap companies, we can capitalize on mispriced or undervalued securities that offer us lower downside risk, but potential for huge gains.
Fourth, we have the investment, financial and legal background, and expertise to employ a successful event-driven strategy. We develop and use proprietary information and knowledge and can move faster than larger funds to identify tremendous opportunities and capitalize on them.
Fifth, because our typical investment is smaller than an investment by a larger fund, it’s much easier and quicker for us to exit our investments and realize our investments. In contrast, larger funds may end up “stuck” in investments given the larger size of their investments and have a substantially more difficult time accessing gains.
For these reasons, we have far more flexibility and potential for higher returns than do larger funds. In addition to these advantages, we work harder than larger funds to get to know our investors on a personal basis and to communicate and follow up with our investors to support and maintain our close relationships with them.
Clearly, there can be huge advantages to investing in a fund like ours. Not only do we have a highly talented team with great incentive to perform, but we also have demonstrated year after year that regardless of market conditions we can outperform the market and most other funds.