Q&A: Paragon Capital Continues Winning Streak

Sep 16 2009 | 8:31am ET

Since its inception in 2005, New York City-based special situations hedge fund firm Paragon Capital has been generating average annual returns of 45%. Paragon employs a buy low, sell high investment strategy, enabling the firm to make opportunistic investments directly in public companies at a significant discount to their stock price while realizing on their investments in the short term.

We recently spoke with Paragon founder and portfolio manager Alan Donenfeld about his investment strategy and why his fund has performed so well despite the recent volatile marketplace.

What is your investment background?

Donenfeld: I’ve been investing capital for 30 years, and I’ve utilized dozens of different strategies, including private equity, leveraged buyouts and venture capital.  But, for the past four years, I’ve focused on special situation investments where I buy public stocks at a significant discount to their market prices.  This is the only strategy I’ve found that provides 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.  Over the last couple of years our initial investment capital has grown, and we’ve built an audit, administrative and investment management team to handle it.  We’re now accepting outside investors and capital. 

Before starting Paragon, I managed a private investment company named Bristol Investment Group, which invested in over 60 companies, including Energy Brands, the maker of Vitaminwater, which was sold to Coca-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 have degrees from Tufts and Duke Business School.

Our investment management team collectively has more than 100 years of experience in investments, finance and law, having worked at top firms like Bear Stearns, Lehman Brothers, Bank of America, CIBC and Sidley Austin. 

What are the advantages of your strategy?

Donenfeld: The main advantage of our strategy is that it can achieve high returns while reducing downside risk.  To accomplish this, we invest directly in public companies on highly negotiated terms that aren’t affected by gyrations in market conditions like the ones we’ve experienced recently.  In general, our investments are similar to Warren Buffett’s investments in Goldman Sachs and General Electric in 2008, where he purchased convertible preferred stock and warrants.  However, our investments are in smaller companies, and we typically use other structures, such as secured debt with additional terms that provide downside protection.

The centerpiece of each investment is the purchase of common stock or notes that are convertible into common stock at a price that is discounted 15% to 40% below the price at which the common stock trades in the open market.  This discount provides a built-in hedge that helps protect us from downside risk. 

How has your investment fund performed?

Donenfeld: We’ve had tremendous results and have generated a cumulative return of over 250% since inception in 2005 – without using any leverage.  Our investment returns have significantly outperformed the NASDAQ, S&P 500 and DJIA in 2005, 2006, 2007 and 2008.  We have every incentive to generate strong returns because more than 20% of the fund’s capital is our own money.

Those are tremendous returns–if you don’t mind me asking, what third parties verify your performance?

Donenfeld: We use best practices in investment management with top industry service providers, including our auditor Eisner LLP, our third-party administrator SS&C Technologies, Inc. and our law firm Seward & Kissel LLP.  We work hard to provide complete transparency and bona fide results.

What type of transaction do you look for?

Donenfeld: We’re focused primarily on three opportunistic investment areas. First, structured and event-driven investments, including capital restructurings and private investments in public equities (PIPEs); Second, reverse mergers and alternative public offerings; And third, registered direct offerings. And we’ve worked hard to gain expertise in these sophisticated areas.  Our expertise has allowed us to generate strong investment returns in ever-changing economic and market environments. 

From a qualitative perspective, is there a “secret sauce” to your investments that allows you to generate such compelling returns?

Donenfeld:  First, we’re extremely selective in the companies that we invest in and the investment structure of the transaction.  We source and evaluate more than 50 transactions a month, but typically only invest in the one or two companies per month that meet our key criteria.  Minimum qualifications include:  an attractive public growth company and having reasonable stock trading liquidity, which is important in order to ensure that we can realize on our investment.

Our typical investments are senior secured convertible debt instruments that pay a minimum of an 8% to 10% interest rate.  In order to establish a built-in hedge, we require the company to provide us with the right to convert the debt to equity at a price that is below the price that the stock is trading at in the public market when we invest.  If the price of the stock drops, say, 20%, we can still sell our position and make a profit.  In addition, we receive warrants as a kicker to generate an even higher return.  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. 

What are registered direct offerings and how do you make money in these investments?

Donenfeld: In our registered direct offering investments, we purchase stock from public companies at a discount to the market price, often up to a 15% discount, and then immediately sell the stock so that we have no capital at risk.  In these deals, we can reap the spread between the market price of the stock and our purchase price.  More importantly, we also receive upside in the form of five-year warrants or options.  Collecting pools of warrants for free can be lucrative because company valuations currently are extremely low.  Since the companies doing these deals have aggressive growth plans, these warrants can significantly increase in value over their five year lives.  We’re finding strong companies with market caps in the hundreds of millions of dollars offering the most attractive terms we have ever seen.

Looking at your third investment area, how do you profit from investing in reverse mergers?

Donenfeld: In our reverse merger transactions, we take profitable private companies public.  Private companies want to become public for many reasons, such as raising capital, compensating executives with stock options, making acquisitions with stock and having the valuable status of being a public company.  Paragon earns a piece of the spread between a company’s value as a private company and its higher value when it becomes publicly traded.  Many famous companies, including Texas Instruments, Radio Shack, the NYSE and Berkshire Hathaway went public through a reverse merger rather than an IPO.  The economics of a reverse merger are very attractive to us–as we can usually receive 5% to 10% of their stock in exchange for our sponsoring the transaction. 

Approximately 30% of the companies looking to go public through a reverse merger are Chinese companies.  We have a strong reputation in China – this year alone, we have spoken on China reverse merger investing at The Reverse Merger Conference, The 2009 China Cleantech Forum and The International PIPEs Conference in Shanghai.  Our team’s expertise in reverse mergers provides us with a huge edge over other investment funds that can’t capitalize on these lucrative deals.  We have developed a pipeline of profitable Chinese companies looking to go public in the U.S. and we believe that we can generate substantial returns in this area.

Is there a particular region that you favor?

Donenfeld: Although most of our investments have North American operations, we also invest in companies with overseas operations to take advantage of rapidly growing markets, such as China.  Not only is the macroeconomic environment in China highly favorable, but we can secure tremendous deal terms and invest at valuations as low as three times net income.  Many Chinese deals have a “make good” provision, which requires management to put a minimum of half of their stock in escrow with our attorneys.  If they don’t achieve performance targets, usually expressed in terms of net income or earnings per share, then their stock is released to us.  With this in place, management has a huge incentive to produce strong results.  And they’re confident that they will exceed performance targets because they plan to use our investment capital to grow significantly.

What are the advantages of investing in your investment fund instead of larger investment funds?

Donenfeld: First, we have the background and expertise to employ a successful niche strategy.  We can focus on sub-strategies that make the most sense at a given time.  And we’ve mastered our niche strategy of highly structured and negotiated transactions at discounted valuations. 

Second, we 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 huge gains. 

Third, we don’t have so much capital to invest that we’re compelled to invest like the large funds that must deploy their capital, which often results in these large funds reaching for deals and investing on less than optimal terms.   In contrast, we can be very selective in choosing deals, and we can often demand superior terms.

Fourth, because our typical investment is smaller than an investment by a larger fund, it’s much easier for us to exit our investments.  In contrast, larger funds may end up “stuck” in investments and have a substantially more difficult time accessing gains.

Fifth, reverse mergers, which can produce significant returns, are typically too small for larger funds.  For these reasons, we have far more flexibility and potential for higher returns than do larger funds.

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