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Special Report: Phil Falcone's riskiest trade ever?

By Matthew Goldstein and Svea Herbst Bayliss

NEW YORK/BOSTON (Reuters) - Investing with hedge fund manager Philip Falcone, who oversees about $8 billion at his Harbinger Capital Partners, has required an awfully strong stomach or a fistful of Dramamine.

In 2007, Harbinger registered an astounding 116 percent gain, only to lose 22 percent as the financial crisis took hold the following year. In 2009, the New York-based fund was back in the green, posting a 46 percent return. And this year? Harbinger is sucking wind again, falling 14 percent through the middle of August.

But Harbinger's wealthy flock may need more than intestinal fortitude going forward. They must also have faith -- and perhaps some suspension of disbelief -- that Falcone's big and risky bet on wireless broadband technology will pay off.

Harbinger's two main investment funds are the owners of LightSquared, an upstart Reston, Virginia-based telecom company that plans to use two orbiting satellites to bring high-speed Internet service to some 260 million in the U.S. by 2015.

Roughly $3 billion or 40 percent of Harbinger's assets are tied-up in LightSquared, say people familiar with the funds. Formerly known as SkyTerra Communications, the telecom company is the hedge fund's single largest and most concentrated bet.

Falcone's wager on the future of satellites and mobile telecom is more daring than his highly profitable bet on the collapse of the U.S. subprime housing market in 2007, which made the 48-year-old former college hockey star an instant billionaire, say several people familiar with Harbinger.

By any measure, it is an ambitious venture. If LightSquared proves to be the next big thing in mobile telecom, it would cement Falcone's reputation as a visionary trader.

If the company crashes, however, Falcone risks destroying the funds he has spent the past nine years building into one of the better-known names in the $1.7 trillion hedge fund industry.

"Whenever there is any kind of concentration the risk is higher," said Louis Margolis with the money-management firm Select Advisors, which isn't invested with Harbinger. "If he had 4 percent of his fund involved we wouldn't be having this conversation."

TELECOM INCUBATOR

In some respects, Falcone's LightSquared gambit is one of the riskiest hedge fund trades ever. And that's saying a lot for an industry where brash managers are famous for making outsized bets on everything from oil to gold to natural gas to lumber.

The difference is few hedge funds have ever staked so much on the success of a single business -- especially one a manager is trying to build himself largely from scratch in the protean technology field.

Harbinger's gradual metamorphosis from a fund that specialized in distressed debt investing to a mobile telecom incubator is a stark example of how some big hedge funds are looking more and more like private equity firms or even venture capital shops.

Yet it is not clear just how many of Harbinger's more than 200 investors -- which include individuals, pension plans, insurers and other money-managers -- are truly in sync with this shift in strategy. For the past two years, many investors have been limited as to the amount of money they can pull-out of the funds Falcone operates.

Falcone announced the restrictions in an email message to investors on Christmas Eve in 2008, the height of the financial crisis. The idea was to avoid a proverbial run on the bank that would saddle Harbinger with only hard-to-trade assets like distressed bonds and equity stakes in private companies.

The upshot is that many investors cannot vote on the wisdom of Falcone's telecom dream with their pocketbooks.

Harbinger investors are reluctant to publicly voice their displeasure about the funds' direction, if only because Falcone has delivered strong results in the past.

But several investors contacted by Reuters, none of whom wanted to be identified, said they'd redeem more of their money from the funds if Falcone would permit it. The main reason? Concerns about LightSquared, they say.

"We are being paid to be more skeptical these days and we are quite frankly concerned by what he seems to be doing," said a representative for an institutional investor.

4G OR BUST

It's easy to see why.

For better or worse, Falcone is essentially going it alone in putting together the expensive pieces for a so-called 4G, or fourth-generation, wireless network that relies on satellites and ground-based transmission facilities to provide consumers with high-speed mobile broadband access to the Internet.

LightSquared, which was cleared to begin operations earlier this year by the Federal Communications Commission, casts itself as a lower cost alternative to wireless titans AT&T and Verizon. In its application to the FCC, Falcone's attorneys said that a mix of technologies "will enable Harbinger to bring the latest 4G terrestrial wireless broadband technology to underserved areas."

But telecom analysts said LightSquared already lags behind Clearwire, its closest domestic rival, in the 4G arms race. By some estimates, LightSquared will need to raise at least $6 billion to meet its goal of launching two satellites by early next year and then begin building thousands of earth-bound transmission towers to relay those signals across the United States.

"For him to raise all the money he needs, we will need to see either investments from a strategic partner like another wireless operator or someone buying capacity from LightSquared," said Tim Farrar, a telecom industry consultant and analyst. "Without either of those, the whole story becomes more difficult to sell."

That said, Falcone, who declined to sit down for a formal interview, can point to some early successes with LightSquared.

In July, LightSquared announced it had reached a $7 billion deal with Nokia-Siemens Networks to provide the hardware for constructing much of its broadband network. In conjunction with that deal, LightSquared said it had secured another $1.75 billion in financing but offered no specifics.

The speculation is that Nokia-Siemens might provide LightSquared with vendor financing to pay for some of the build-out costs. But telecom analysts said LightSquared can't rely simply on financing from its suppliers and vendors to meet its ambitious goals.

Recently, investment bank UBS arranged a $400 million loan package for Harbinger that was backed by billions of dollars of the hedge funds' assets, including Falcone's flagship funds' equity interest in a holding company that owns LightSquared.

Telecom experts say LightSquared will need a lot more money. But the odds are against it, especially with investors and financiers wary of taking on too much risk in the wake of the worst financial crisis in decades. The current climate is difficult to raise billions in debt for an unproven company and an initial public offering would appear to be premature.

"The best case for them is they need some sort of strategic partner, maybe that could be T-Mobile," said Macquarie Capital telecom analyst Philip Cusick. "But I don't think they (T-Mobile) are in any rush to do this."

In the meantime, LightSquared's rival Clearwire, which offers mobile Internet service in 40 markets across the United States, already has its strategic partner. The upstart mobile broadband company is majority owned by Sprint Nextel Corp.

Eliot Hoff, a Harbinger spokesman, dismissed the skepticism and said LightSquared is on target with its business plan.

"Our strong management team and strategic approach to the business puts us in a good position to take advantage of advances in telecom," said Hoff.

SATELLITE GRAVEYARD

Falcone can not take much solace in history. LightSquared is competing in an industry where many upstart telecoms -- especially those with satellite dreams -- have been buried under an avalanche of debt and insufficient revenues to pay the bills. Right now, TerreStar, a cash-strapped mobile telecom company with a similar business plan as LightSquared, is teetering on the verge of bankruptcy.

Sources say Harbinger, which owns 30 percent of TerreStar's voting shares and a good chunk of its debt, is lining up to provide the company with debtor-in-possession financing -- basically, a loan that enables a company to keep paying bills as it tries to restructure in bankruptcy. LightSquared, meanwhile, has a deal that allows it to purchase minutes for voice and data transmission from TerreStar's telecommunications satellite.

If Falcone is troubled by the financing woes of his competitors, he isn't showing it. People familiar with the fund say he believes LightSquared has an ace in its hand: the license it has received from the FCC to operate in a high-value transmission spectrum, which is vital to building any mobile broadband network. They say Falcone insists he has a valuable asset in the transmission license no matter what happens with LightSquared's business plan.

"DO THE MATH"

There is some truth to that. In the world of 4G networks, it's all about the spectrum. Better transmission bands make it easier to zap data through the airwaves so it can be picked up on cellphones and other wireless devices.

Broadly stated, spectrum consists of the right to transmit and receive radio signals within a specified frequency range. LightSquared, for instance, has a license to operate in the so-called L-band portion of the spectrum. In the United States, the FCC regulates access to spectrum and often auctions off the right to operate in specific bands to suitable bidders.

But telecom experts said coming up with a proper valuation for a telecom company's operating spectrum is tricky. Estimates often vary widely and end up being hotly debated in bankruptcy proceedings.

In an email exchange with a Reuters reporter, Falcone suggested that even a bankrupt TerreStar might be worth between $1.5 and $2 billion because of the value of its spectrum license. Using those rough figures, Falcone would appear to be valuing LightSquared at a minimum of between $3 billion and $5 billion based solely on the size of its transmission spectrum -- which is twice that of TerreStar's.

When asked whether a $3 billion to $5 billion valuation figure for LightSquared based on it spectrum assets is appropriate, Falcone responded in an email: "I've been offered more but u r getting warm." He didn't elaborate but in another email he implored: "Do the math."

Yet a $2 billion spectrum valuation for TerreStar would be quite rich. That is twice the value of the outstanding debt for a company with a market-capitalization under $50 million.

By comparison, DBSD North America, a telecom company that filed for bankruptcy last year and has a similar spectrum and satellite capacity to TerreStar's, was given a potential post-bankruptcy valuation of between $492 million and $692 million. The judge in the case chose that range after hearing expert testimony from witnesses who offered valuations that began as low as $140 million and went as high as $3.1 billion.

"There are some arguments for putting a high valuation on the spectrum but a lot of it comes down to supply and demand," said Farrar, one of the experts in the DBSD bankruptcy. "If there were plenty of buyers and not many sellers a fairly high valuation could be realistic, but that isn't the case right now."

Then again, Falcone is a true believer.

One of his UBS investment bankers said as much at a hearing in the DBSD bankruptcy. When asked about Falcone's interest in mobile wireless companies, the banker, Yuri Brodsky, said: "He's an investor in satellite because he believes (there is) significant asset value in spectrum and he's a long-term believer in this."

Indeed, more than a few admirers are willing to give Falcone the benefit of the doubt. They point to not only his successful bet on the collapse of the subprime housing market, but also his wager on a rally in mining stocks and investment in consumer products company Spectrum Brands.

"He is really, really good about identifying where the growth is going to be and at the same time he has that independent streak that we really liked," said one Harbinger investor, who asked not to be named because he isn't authorized to discuss his firm's investments.

RAGS TO RICHES

Others point to Falcone's ability to rise from his humble roots to become a successful Wall Street trader as evidence of his uncanny ability to see value where others don't.

Falcone was raised in Chisholm, Minnesota, an old iron mining town of 5,000 people located 100 miles south of the Canadian border. The youngest of nine children, he grew up poor in a three-bedroom home.

"Not everyone who runs a hedge fund was born on 5th Avenue," Falcone proudly told the House Committee on Oversight and Government Reform during a November 2008 hearing into the role of hedge funds in the markets.

A good student and star high school hockey player, Falcone caught the eye of college recruiters and was accepted into Harvard University. He graduated in 1984 with a degree in economics and was a standout hockey player.

After college, Falcone briefly played professional hockey in Sweden. But his career was ended by an injury. He returned to the United States and promptly got a job on Wall Street working as junior junk-bond trader for the old Kidder Peabody. Eventually he'd become the head of high-yield trading for Barclays Capital in New York.

In 2001, he left Barclays to team-up with Harbert Management, a Birmingham, Alabama investment management firm that was looking to launch a New York hedge fund specializing in distressed debt. Harbert gave Falcone $25 million in seed capital to begin trading and helped manage much of back-office operation for what was originally called the Harbert Distressed Investment fund.

Five years later, the fund changed its name to Harbinger, a precursor of bigger changes to come. In March 2009, Falcone reached a deal to buy-out his Harbert partners and the Alabama investors are gradually winding down their involvement.

Still, up until three years ago, Falcone wasn't particularly well-known outside of the world of distressed investing and bankruptcy workouts. He largely skirted the limelight, even though Harbinger had grown to $5 billion in assets under management by the end of 2006 and its funds had posted solid double-digit returns in each of their first five years.

It wasn't until Harbinger got to collect on Falcone's big subprime housing market bet in 2007 that he joined the ranks of hedge fund luminaries such as SAC Capital's Steve Cohen, Citadel's Ken Griffin and Farallon Capital's Thomas Steyer. Harbinger's assets under management briefly ballooned to about $26 billion and the fund became one of the world's hottest hedge funds.

Overnight, Falcone went from being a successful trader to one of the industry's best paid managers. His savvy subprime wager earned him a personal payout of $1.7 billion, according to AR magazine, a hedge fund trade publication. He and his wife, Lisa Marie, a former model who grew up in Spanish Harlem, quickly went from being just another anonymous Wall Street couple to regulars at society and charitable events around New York City. Last year, the couple donated $10 million for a new park in lower Manhattan.

He now has all the trappings of a hedge fund star. He and his wife paid $49 million a couple of years ago for a 27-room Upper East Side townhouse that used to be Manhattan home of former Penthouse publisher Bob Guccione. It may not be a house on 5th Avenue, but the five-story mansion with an indoor swimming pool is one of the most expensive townhouses to ever change hands in Manhattan.

Evidently, it is also well-protected. A Reuters photographer taking pictures of the home from across the street was pushed and jostled by a security guard.

Falcone's personal wealth has helped him return to his hockey roots. He's the minority owner of the National Hockey League's Minnesota Wild. And more recently, he's acquired the Dubuque Fighting Saints, a minor league hockey franchise in Dubuque, Iowa.

Now with LightSquared, Falcone is bent on adding the title of telecom magnate to his mantle.

MATZAH and KOSHER WINES

For that to happen, the technology gods will have to smile on him. Falcone must also show that he can run a company, not just invest in it. And his track record in that regard is mixed.

Consider his acquisition of a controlling interest in kosher food company Manischewitz in 2007. Harbinger has sunk more than $100 million into the manufacturer of Passover goods and religious wine for Jewish ceremonies. But people familiar with the company say the deal has been a disaster for Harbinger and it is one of the illiquid investments sitting in a so-called sidepocket -- a special fund Falcone set up in late 2008 for hard-to-sell assets.

It's not clear why Falcone, who isn't Jewish, got interested in Manischewitz. In 2005 he began buying up some of its distressed debt in the secondary market. Eventually he bought out the former owner, RAB Foods. Over the past three years, the company has had three chief executive officers.

Bruce Bossidy, who served as Manischewitz's CEO from January 2008 to January 2009, declined to comment. On his LinkedIn page, however, he offered up a negative assessment of his brief tenure at the company. He wrote that Manischewitz "was not cash flow positive and suffered from high seasonality, high fixed costs and poor system/process development."

Bossidy added that the plan to turn around the company "was substantially more challenging than originally planned based on the direction and limitations imposed by financial owner."

Hoff, the Harbinger spokesman, said Manischewitz is making "progress toward reaching its business goals." He added that drawing any conclusions about LightSquared from the operation of Manischewitz is "liking comparing apples to oranges. The businesses are completely unrelated in almost every way."

Of course, running a small food company is a far cry from running an upstart telecom. The dismal results at Manischewitz don't necessarily mean the same fate will befall LightSquared. Indeed, Falcone has staffed LightSquared with seasoned telecom professionals. The chief executive officer is Sanjiv Ahuja, the former CEO of Orange, a French mobile telecom company. Frank Boulben, the chief marketing officer, comes from Vodafone Group, the mobile telecom giant based in London.

In one sense, there is something refreshing in Falcone's desire to build a company in an emerging industry. All too often hedge fund managers are criticized for profiting from misery by shorting stocks, or simply feeding off market volatility.

Then again, it's not clear if Falcone is a hedge fund manager anymore, at least in a literal sense. Given how much his funds are committed to LightSquared, he may be more aptly described as a telecom entrepreneur who is building a company with other people's money.

(Reported by Matthew Goldstein and Svea Herbst-Bayliss; editing by Jim Impoco and Claudia Parsons)

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