Monday, March 25, 2013

4 Reasons for Declining Risk in Emerging Market Bonds

In Russ K’s most recent Market Perspectives report, he made the case for emerging market (EM) bonds in today’s investment portfolio, stating that several factors make this asset class more attractive than it was just five years ago.  Competitive yields, improving fundamentals and cheap currencies have helped to make this a more attractive investment.  But perhaps the biggest story in emerging market debt has been an improvement in credit quality – both in an absolute sense and, perhaps more interestingly, relative to bonds from developed markets. This last point comes as a surprise to most investors.  When you picture bonds from emerging economies, visions of defaults and currency devaluations are likely dancing in your head.  What you may not know is that the credit quality of this asset class has steadily improved over the past twenty years.  Many EM debt issuers have learned lessons from the past and as a result, have developed sound fiscal policies which have resulted in more stable economies and, in many cases, investment grade credit ratings (see below).  Today over 60% of the emerging market bond universe is rated BBB or above.
Emerging market bonds: Global market capitalization by credit buckets[1]
So what’s causing this improvement in credit risk among emerging market issuers?  There are four key drivers:
  1. Better fiscal management. In other words, living within one’s means.  For bond issuers this means raising revenue and reducing spending.  According to data from the latest IMF World Economic Outlook, emerging economies’ fiscal revenues as a percentage of GDP increased from the high-teens in the 1980s to slightly above 30% today.
  2. Stronger balance sheets.  It may surprise you to know that compared to the developed markets, emerging markets have been deleveraging.  Prior to the financial crisis, the average level of developed market gross government debt as a percentage of GDP was 74%; today, it stands at 110% – a number that, if not quickly reversed, could lead to a secular slowdown in growth.  In contrast, EM countries were already repairing balance sheets heading into the financial crisis and have maintained stable debt-to-GDP levels since then (see below)[2].
  3. Funded pension systems. Rather than pay-as-you-go systems (such as the Social Security program we have in the US), many emerging market countries have self-funded retirement systems.  So while the US fiscal position may begin to deteriorate by the end of the decade as the burden of an aging population pushes up pension and healthcare spending, most EM countries have limited this risk by reforming their pension systems.
  4. Rise of local currency bond markets. Because emerging markets have been issuing more obligations in their local currencies, rather than a hard currency like USD, they have a reduced reliance on external funding. While we still see active issuance in USD EM bonds, stronger EM issuers have lessened the potential for a currency crisis by matching their income and funding currencies through the issuance of local currency debt.
Composition of Emerging Market Debt

Meanwhile, in addition to the improving credit quality of this asset class, it’s also become increasingly available to investors in the form of ETFs.  Before the first EM bond ETF was launched in 2007, it was virtually impossible for an individual investor to get their hands on these securities.  And at the time, not many wanted to.  But as interest in EM debt has grown  the category’s assets under management have swelled to $13.6 billion, and there are now 16 EM bond ETFs to choose from ranging from broad to more country specific exposures.
Even with the improved risk profile, it’s still important to understand that emerging market debt is a volatile asset class compared to more traditional bond investments.  Investors should consider their personal risk profile and portfolio objectives when choosing how much to invest, if at all.  More conservative investors may want to avoid significant exposure to the category, while aggressive investors with high-income goals could allocate more (Russ K advocates 10-30% of a fixed income portfolio).  If EM bonds are right for you, the increasing number of EM bond ETFs can give you the opportunity to invest in a previously difficult-to-access market.
[1] G7 countries include France, Germany, Italy, Japan, Canada, the United States and United Kingdom.
[2] Credit ratings are assigned by Nationally Recognized Statistical Rating Organizations based on assessment of the credit worthiness of the underlying bond issuers. AAA bonds (investment grade) carry the highest credit rating. Below investment-grade is represented by a rating of BB and below. Ratings and portfolio credit quality may change over time. Unrated securities do not necessarily indicate low quality.
Sources: JP Morgan, Bloomberg, IMF

Which Risk-Parity Pension will Blow Up First?

 A real basic question: Is Risk-Parity Driven by the Long-Bond?

Yes: Click here -

Another basic question: which risk parity pension fund will blow up 1st?

A real basic answer: pension funds levering up US T-Bonds!!!
An intriquing WSJ article on the topic of risk parity:
Some extra special comments:
In Virginia, officials at the Fairfax County Employees’ Retirement System have revamped the entire $3.4bn portfolio around a risk-parity approach. About 90% of the pension’s portfolio now is exposed to bonds, when factoring in leverage. ”We think we can improve returns while reducing the risk level of the portfolio,’ said Robert Mears, the pension fund’s executive director.
Risk parity’s growing popularity comes at a fragile time in the bond market. Some critics warn the strategy may fizzle if interest rates rise and erode bond returns. There is “reasonable concern” that could happen once the bull market for bonds cools, said Mark Evans, a managing director at Goldman Sachs Asset Management, a unit of Goldman Sachs Group. That factor “isn’t likely to be there going forward for a number of years.”
The employee pension fund of United Technologies has gradually increased its risk parity-related investments to $1.8bn, or about 8% of its total assets, up from an initial 5% allocation in 2005. At the San Joaquin County Employees’ Retirement Association, in Stockton, California, risk parity now amounts to 10% of the pension’s overall portfolio of approximately $2bn. In an email, the pension fund’s chief investment officer said the fund “is aware of the leverage being utilised in their risk-parity strategies and has no misgivings.”

Some interesting food for thought:

It is well known that pension funds in the United States are underfunded even if they achieve their projected 8% rate of return. The scope of pension underfunding increases to an astonishing level when more probable future rates are employed. A reduction in the future rate of return from 8% to the more reasonable risk-free rate of approximately 4% causes the liabilities to explode by trillions of dollars. As bond yields declined over the past twenty years, pension funds moved toward more aggressive equity-based portfolios in an attempt to reach for this 8% return. By investing in a portfolio with uncertain outcomes, pension funds could experience increasingly volatile and even negative returns. Paradoxically, in an effort to chase the universal 8% rate, pension funds may be laying the groundwork for returns even lower than the risk free rate. In an effort to offer an empirical basis for this possibility, we conclude the paper with a relevant comparison – the return of a hypothetical Japanese pension for the past two decades. We believe that pension funds need to at least prepare for the unfathomable: 0% returns for 20 years. Most pension funds, regrettably, have not adequately stress tested their portfolios for these scenarios.
It is just a matter of time before the “liquidity event” hits the risk parity crowd. Meb has a nice list of the numerous players here. nuke

Thursday, March 21, 2013

The 10 activist investors you should know

Partly fueled by Carl Icahn outbursts, the age-old debate about whether activist investors are good or bad for companies and shareholders has cropped up again. Are they short-term bettors who cause drama and then get out of a stock as soon as shares see a pop? Or are they constructive critics who add value, partly by pushing executives and boards to do things they are too complacent to do otherwise?
The answer varies depending on the activist and which company he (it’s usually a he) is targeting. Here’s a rundown on 10 of the most important activists in the US, which is partly based on 13D regulatory filings they have to submit if they’ve amassed at least a 5% stake in a company. (However, investors can still play an activist role with a lesser stake, and some have enough credibility to do so.)
The data are from 13D Monitor and FactSet, and they are listed in alphabetical order. The basic takeaway is that activism pays, especially in down or stagnant markets. How a company’s long-term value is affected is a topic for another discussion—stay tuned.

Bill Ackman, Pershing Square

His public spat with Carl Icahn over Herbalife and his failing bet on JC Penney can make people forget that Ackman has made some shrewd investments. His other successes include the breakup of Jim Beam maker Fortune Brands. And he made a killing on mall operator General Growth Properties as he rode its recovery after bankruptcy; that represents the bulk of the fund’s 13D returns. Ackman has a reputation for arrogance, but also for being a persuasive salesman. Retail seems to be his Achilles’ heel, with investments in Borders and Target also losing out.

David Einhorn, Greenlight Capital

Einhorn isn’t normally an activist and he hasn’t filed a 13D in a few years, but he has been known to nominate directors, write letters to management and even offer to buy a company when he feels like it’s moving in the wrong direction. He has enough of a reputation that he has a voice without amassing a large stake. When Einhorn announced he was shorting Green Mountain Coffee and criticized the company’s strategy, shares immediately dropped. He’s been most noticed lately for his push to get Apple to return some of its more than $137 billion in cash to investors. He won a lawsuit in that fight and is sure to claim victory when Apple announces its cash plans, which it will likely do later this spring.

Carl Icahn, Icahn Enterprise

At 77, Icahn seems to be more active than ever, showing up so far this year in Dell, Herbalife and Transocean. Companies know they will have the spotlight on them when Icahn comes along. But sometimes he seems to have no rhyme to his reason,like his push for Clorox to sell itself in 2011 when there were no logical buyers. And lately he’s lost more proxy fights than he has won. People say that’s an example of “Carl being Carl” where he throws spaghetti at a wall and sees what sticks. Since he returned outside investor money in 2011, he seems to be in an even more rambunctious mode, and still keeps to his late night schedule, which means no morning meetings.

Dan Loeb, Third Point

Loeb’s fund mainly invests in non-activist situations but because of his high profile, his activist activities get a lot of attention. It was he who outed former Yahoo CEO Scott Thompson’s dubious college degree. That got him on Yahoo’s board, along with two other newcomers, and Marissa Mayer of Google is the new CEO. Loeb is also known for writing public letters that give a tongue lashing to executives and directors, while some of his phone conversations end with one of the parties hanging up on the other.

Nelson Peltz, Trian Partners

Peltz used to be known as a corporate raider with whom boards and CEOs usually did not get along. But he’s evolved over the years and is more open to working with companies. Prime example is Heinz, which recently got sold to Warren Buffett’s Berkshire Hathaway and Brazil’s 3G Capital. He and Heinz CEO Bill Johnson were mortal enemies during their proxy fight in 2006, but Peltz came to be seen as a helpful Heinz board member and he now praises Johnson. Like Icahn, Peltz hasn’t let his age slow him down (he’s 72) and can tell you in detail about how Wendy’s, a Trian investment, makes its burgers. But his son-in-law Ed Garden, who is chief investment officer, has played an increasingly bigger role. Trian president Peter May is also active, with board seats at Tiffany and Wendy’s.

Barry Rosenstein, Jana Partners

Rosenstein isn’t a household name like Icahn nor does he strive to be. But Jana does get involved in well known companies, like McGraw-Hill and Marathon Petroleum. Jana often comes armed with detailed white papers on a company’s financial and prospects. Although they are usually seen as constructive critics who are open to working with management, they are also known to be persistent and aren’t afraid to get into a fight, as they did with TNT Express and currently with Canada’s Agrium.

Paul Singer, Elliott Management

Elliott is known to be tough on companies and sometimes offers to buy the firms it targets, like Compuware (which said no). It has focused on several tech companies, like BMC Software, but also has investments in other sectors. It is currently embroiled in a fight with energy company Hess, pushing for board changes or a sale or spin-off of some assets. It hasn’t reached the 5% threshold to file a 13D, but recently increased its stake to 4.39%.

Jeff Smith, Starboard Value

Starboard is a young activist fund, having spun off from Ramius in 2011, and focuses on small-cap companies. But Ramius was known to cause a stir at many companies and that tradition seems to be carrying on. Despite its newcomer status, Starboard quickly went after well known companies like AOL, but lost its proxy fight there. More recently, it pushed Office Depot to cut costs and the office supplier later announced a deal with OfficeMax.

Jeffrey Ubben, ValueAct Capital

The fund isn’t as well known as some of its brethren but is very active in the companies it gets involved in, and is on the board of about half of its portfolio companies. It typically looks at companies that it thinks are undervalued, usually because the firms are going through a major transition or have fallen out of favor, but still have growth potential. Some of its targets include tech firm Adobe Systems, Moody’s (video) and Motorola Solutions. But companies usually don’t shudder when ValueAct comes along, since it has a reputation for working with management and boards.

Ralph Whitworth, Relational Investors

Although Whitworth is a well known name in the activist crowd, he isn’t seen as a lighting rod like Icahn or Ackman. Relational is known for doing its homework and usually presents a sober view of a company. Besides pushing companies on a break-up or sale, Relational also sometimes goes after corporate governance issues, like criticizing the pay for former Occidental Petroleum (paywall) CEO Ray Irani and his lack of succession planning. Whitworth has enough credibility that even when he has only a small stake in companies, like Hewlett-Packard or Pepsi, CEOs still listen.

Friday, March 15, 2013


In a world where formerly hated assets are on fire, gold miners remain hanging from the investment equivalent of the naughty-tree. Despite the hate mail that routinely stuffs my inbox from the people offended by my occasional mocking views of gold itself, I would highlight that my views on the shiny yellow metal have never been "personal", but are on par with the same healthy skeptical treatment I give to any asset class or investment that has been touted, bought, annointed with deity-like powers, spawning an entire industry of proponents whose opinions, by nature of their conflicted interest, are more than worthless to the would-be investor. As for the relative investment thesis, Mr Buffett did a fine job of articulating the advantage of attractively-price assets with cash-flow (and growth potential) versus inert but highly conductive lumps of metal dug out of the ground only to be re-buried.    
All of that said, the miners are cheap by any backward, forward or relative measure. Their businesses are enviable - despite rising costs, poor management and shooting themselves in the foot - insofar as costs remain low by comparison with what they sell their product for. And they are hated. Lowly-leveraged. And under-owned. All this while their natural admirers (who I have known to mock) are hoarding last-year's coins, bars and ingots. The investment non-sequitir, of course, is that the so-called great rotation into stuff, is ignoring this gold mining stuff. Now I understand the overcapacity in iron ore, and other non-ferrous things, on top of concern about the condition of their largest consumer. Yet, the market cannot have it both ways: bidding up stuff for debasement fear on hand, and avoiding it for the opposite fear on the other. Puzzling. Yet, if it be stagflation that emerges as our nemesis, it would seem to me that the spreads between certain heavy industrial cash-flow yielding assets on one-hand, and gold mining concerns on the other, would - in the medium term - be unsustainable. For you don't have to love gold to like gold miners: just not HATE (note the upper case emphasis) it.

The Big Short War

FACE-OFF Daniel Loeb and, William Ackman. “My understanding is that they dislike each other profoundly,” says a source.
The supremely confident billionaire hedge-fund manager Bill Ackman has never been afraid to bet the farm that he’s right.
In 1984, when he was a junior at Horace Greeley High School, in affluent Chappaqua, New York, he wagered his father $2,000 that he would score a perfect 800 on the verbal section of the S.A.T. The gamble was everything Ackman had saved up from his Bar Mitzvah gift money and his allowance for doing household chores. “I was a little bit of a cocky kid,” he admits, with uncharacteristic understatement.
Tall, athletic, handsome with cerulean eyes, he was the kind of hyper-ambitious kid other kids loved to hate and just the type to make a big wager with no margin for error. But on the night before the S.A.T., his father took pity on him and canceled the bet. “I would’ve lost it,” Ackman concedes. He got a 780 on the verbal and a 750 on the math. “One wrong on the verbal, three wrong on the math,” he muses. “I’m still convinced some of the questions were wrong.”
Not much has changed in the nearly 28 years since Ackman graduated from high school, except that his hair has gone prematurely silver. He still has an uncanny knack for making bold, brash pronouncements and for pissing people off. Nowhere is that more apparent than in the current, hugely public fight he and his $12 billion hedge fund, Pershing Square Capital, are waging over the Los Angeles–based company Herbalife Ltd., which sells weight-loss products and nutritional supplements using a network of independent distributors. Like Amway, Tupperware, and Avon, Herbalife is known as “a multi-level marketer,” or MLM, with no retail stores. Instead, it ships its products to outlets in 88 countries, and the centers recruit salespeople, who buy the product and then try to resell it for a profit to friends and acquaintances.
Ackman has called Herbalife a “fraud,” “a pyramid scheme,” and a “modern-day version of a Ponzi scheme” that should be put out of business by federal regulators. He says he is certain Herbalife’s stock, which in mid-February traded around $40 per share, will go to zero, and he has bet more than a billion dollars of his own and his investors’ money on just that outcome. (Ackman declines to discuss the specifics of his trade.) “This is the highest conviction I’ve ever had about any investment I’ve ever made,” he announced on Bloomberg TV. An interviewer on CNN reminded him that Herbalife had been around since 1980 and had withstood many previous challenges to its business plan. How long was he willing to “sit on this bet”? Ackman replied, “We’re not sitting. We’re shouting from the rooftops. They’ve never had someone like me prepared to say the truth about the company. I’m going to the end of the earth. If the government comes out and determines this is a completely legal business, then I will lobby Congress for them to change the law. I had a moral obligation. If you knew that Bernie Madoff was running a Ponzi scheme, and you didn’t tell anyone about it, and it went on for 33 years ... ”
Ackman says he suspected, when he “shorted” (i.e., bet against) Herbalife, that other hedge-fund investors would likely see the move as an opportunity to make money by taking the other side of his bet. What he hadn’t counted on, though, was that there would be a personal tinge to it. It was as if his colleagues had finally found a way to express publicly how irritating they have found Ackman all these years. Here finally was a chance to get back at him and make some money at the same time. The perfect trade. These days the Schadenfreude in the rarefied hedge-fund world in Midtown Manhattan is so thick it’s intoxicating.
“Ackman seems to have this ‘Superman complex,’ ” says Chapman Capital’s Robert Chapman, who was one of the investors on the other side of Ackman’s bet. “If he jumped off a building in pursuit of super-human powered flight but then slammed to the ground, I’m pretty sure he’d blame the unanticipated and unfair force of gravity.”
Lined up against the 46-year-old Ackman on the long side of the Herbalife trade were at least two billionaires: Daniel Loeb, 51, of Third Point Partners, who used to be Ackman’s friend, and Carl Icahn, 77, of Icahn Enterprises. Along for the ride are some smaller, well-regarded hedge-fund investors—who would like to be billionaires—John Hemp­ton, of Bronte Capital, and Sahm Adrangi, of Kerrisdale Capital.
It’s Ackman’s perceived arrogance that gets to his critics. “The story I hear from everybody is that one can’t help but be intrigued by the guy, just because he’s somewhat larger than life, but then one realizes he’s just pompous and arrogant and seems to have been born without the gene that perceives and measures risk,” says Chapman. “He seems to look at other members of society, even legends such as Carl Icahn, as some kind of sub-species. The disgusted, annoyed look on his face when confronted by the masses beneath him is like one you’d expect to see [from someone] confronted by a homeless person who hadn’t showered in weeks. You can almost see him puckering his nostrils so he doesn’t have to smell these inferior creatures. It’s truly bizarre, given that his failures—Target, Borders, JCPenney, Gotham Golf, First Union Real Estate, and others—prove he’s as fallible as the next guy. Yet, from what I hear, he behaves that way with just about everybody.”
Another hedge-funder describes the problem he has with Ackman in more measured tones. “There is a saying in this business: ‘Often wrong, never in doubt.’ Ackman personifies it. . . . He is very smart—but he lets you know it. And he combines that with this sort of noblesse oblige that lots of people find offensive—me, generally not. On top of that he is pointlessly, needlessly competitive every time he opens his mouth. Do you know about the Ackman cycling trip with Dan Loeb?”

It’s Not About the Bike

The story of the Ackman-Loeb cycling trip is so widely known in the hedge-fund eco-system that it has practically achieved urban-legend status, and Loeb himself was eager to remind me of it.
It happened last summer when Ackman decided to join a group of a half-dozen dedicated cyclists, including Loeb, who take long bike rides together in the Hamptons. The plan was for Loeb, who is extremely serious about fitness and has done sprint triathlons, a half-Ironman, and a New York City Marathon, to pick up Ackman at Ackman’s $22 million mansion, in Bridgehampton. (Ackman also owns an estate in upstate New York and lives in the Beresford, a historic co-op on Manhattan’s Central Park West.) The two would cycle the 20 or so miles to Montauk, where they would meet up with the rest of the group and ride out the additional 6 miles to the lighthouse, at the tip of the island. “I had done no biking all summer,” Ackman now admits. Still, he went out at a very fast clip, his hypercompetitive instincts kicking in. As he and Loeb approached Montauk, Loeb texted his friends, who rode out to meet them from the opposite direction. The etiquette would have been for Ackman and Loeb to slow down and greet the other riders, but Ackman just blew by at top speed. The others fell in behind, at first struggling to keep up with the alpha leader. But soon enough Ackman faltered—at Mile 32, Ackman recalls—and fell way behind the others. He was clearly “bonking,” as they say in the cycling world, which is what happens when a rider is dehydrated and his energy stores are depleted.
While everyone else rode back to Loeb’s East Hampton mansion, one of Loeb’s friends, David “Tiger” Williams, a respected cyclist and trader, painstakingly guided Ackman, who by then could barely pedal and was letting out primal screams of pain from the cramps in his legs, back to Bridgehampton. “I was in unbelievable pain,” Ackman recalls. As the other riders noted, it was really rather ridiculous for him to have gone out so fast, trying to lead the pack, considering his lack of training. Why not acknowledge your limits and set a pace you could maintain? As one rider notes, “I’ve never had an experience where someone has gone from being so aggressive on a bike to being so hopelessly unable to even turn the pedals…. His mind wrote a check that his body couldn’t cash.”
Nor was Ackman particularly gracious about the incident afterward, not bothering to answer e-mails of concern and support from others in the group until months later.
In a recent interview on CNBC, the blunt-talking and cagey Icahn hinted there would be a concerted effort to take Ackman down a peg or two in the Herbalife battle, which “could be the mother of all the short ­squeezes,” he said, referring to a technique that can be used by a group of traders who band together to try to clobber a short-seller.
Chapman agrees. “This is like Wall Street’s version of the movie Kill Bill,” he says. “Bill Ackman has been so arrogant and disrespectful to so many people, presumably on the theory that he would never be in a position where these subjects of his disrespect could actually act on their deserved hatred for him But now, with JCPenney [which is down 20 percent from Ackman’s 2010 investment] and Herbalife going against Ackman, his ‘stock’ has moved down, allowing once again, a decade later, for those holding their Kill Bill puts [i.e., options they have been waiting to cash in] to exercise them against him.”
Ackman got the idea to short Herbalife in the summer of 2011 from Christine Richard, who had left a job as a reporter at Bloomberg News to join Diane Schulman at the Indago Group, a high-end investment-research boutique. Schulman and Richard are known around Manhattan as the Indago Girls. They have a handful of hedge-fund clients—among them David Einhorn’s Greenlight Capital and Ackman’s Pershing Square—who pay around $10,000 a month, plus expenses, for their exclusive ideas.
Ackman listened intently to Richard’s pitch about Herbalife, but was busy at the time with a highly successful proxy fight for control of Canadian Pacific Railway. He turned the Herbalife idea over to two of his employees, Shane Dinneen, a young Harvard graduate—who bears an uncanny resemblance to Conan O’Brien—and to Mariusz Adamski, whom Ackman had met on the tennis court and then hired as an intern. The two read public documents, reviewed old lawsuits, watched strange selling videos, and learned about Herbalife’s bizarre, charismatic founder, Mark Hughes. They discovered that, a few years earlier, Barry Minkow, a convicted felon and founder of the infamous 1980s swindle ZZZZ Best, had in 2008 publicly called into question Herbalife’s practices. To avoid a costly legal battle, Herbalife had paid him $300,000. (Minkow is now in prison, for another scam.)
On February 22, 2012, the Indago Girls finished their 100-page report describing how Herbalife had billions in revenues and millions of independent distributors globally (3.2 million at last count, according to CNBC), and claimed to have created millions of jobs in its 33-year existence. But, the Girls summarized, “it would be an impressive American success story if it were not based on a lie. Far from being a shining example of corporate beneficence, Herbalife is a story of stunning deception. It is a pyramid scheme whose revenue comes not from retail sales of its products, as it contends, but from capital lost by failed investors in its business opportunity. Our research has shown that through manipulation and misrepresentation, Herbalife conceals its true business model from distributors and from the investing public. Herbalife is not selling a ‘healthy lifestyle’ through nutritional supplements and weight management products; it is selling a highly risky financial product: an investment in the business opportunity of recruiting more Herbalife distributors. The merchandise is little more than a vehicle for selling the financial investment in the pyramid scheme.”
Dinneen agreed, but Ackman remained cautious. In the best of circumstances shorting stock can be a risky business, even for hedge-fund big shots. To do it, you have to borrow someone else’s stock (paying them a fee to do so) and then sell it into the market, collecting the proceeds from the sale. If the stock goes down, you can “cover” your short position by buying it back at the lower price and returning the borrowed stock to its original owner, keeping the profits. While a stock’s price can never go below zero—Nirvana for a short-seller—there is no cap on how high a stock can trade. That’s what makes shorting so risky. If you are wrong and, instead of going down, the stock price goes up, you can end up having to buy the stock back at a higher price—perhaps a much higher price—than you sold it for originally, making the potential losses nearly infinite when you have to return it to the original owner.
As the old Wall Street saw goes, “he who sells what isn’t his’n must buy it back or go to pris’n.”
Herbalife had been around for 33 years and had withstood previous attacks from the likes of Minkow and others, as well as the fact that, in May 2000, Hughes—despite his clean-living image—died of a toxic combination of alcohol and Doxepin (an antidepressant he was taking to sleep), causing the company nearly to collapse.
Reeling from Hughes’s death and lawsuits related to its use of the stimulant ephedrine—which would be banned in the U.S. from all nutritional supplements in 2004—Herbalife agreed to sell itself, in 2002, to its management, who had joined with two private-­equity firms—Golden Gate Capital and Whitney & Co. The company went public again, in 2004, netting the private-equity firms a fortune estimated at $1.3 billion, a return of seven times their initial investment, according to the Indago Girls. Between 2005 and 2012, Herbalife’s stock increased 1,000 percent.
Taking on Herbalife would not be for the faint of heart.
The Indago Girls shared their Herbalife short idea with David Einhorn, and he too was skeptical at first. “Short-sellers had dashed themselves on these rocks, like, only 50 katrillion times,” says someone who knew Einhorn’s thinking. In the end, though, he was convinced by Schulman’s passion and detailed analysis, and he urged her to keep researching while he slowly built a short position in Herbalife. “Short-sellers have been attracted to multi-level marketers the way drunken sailors are always attracted to dirty girls at the end of the bar,” explains that person. “It’s just a match made in heaven.”
Einhorn and Ackman were once good friends. They met on a subway platform in 1998 after they both had attended an industry luncheon. In March 2010, when the two appeared together on CNBC, Einhorn said of Ackman, “Bill’s a phenomenal investor. . . . His returns are absolutely extraordinary. It shows there are a lot of different ways to go about things. He’s a fabulous investor.”
Without missing a beat, Ackman replied, “David is my marketing adviser.”
The relationship soured, however, around the time the Indago Girls were making their Herbalife pitch to both men. “David and I had what you might call a falling-out,” Ackman admits. It happened in June 2011, when Ackman was quoted in The New York Times revealing that Einhorn, a Milwaukee-area native, had wanted to buy the Milwaukee Brewers in 2004 but lost out to Mark Attanasio, another financial heavyweight. At that moment, Einhorn was trying to buy a piece of the New York Mets, and, Ackman says, Einhorn feared if the Mets knew of his previous interest in the Brewers they would conclude he was just another rich hedge-fund guy looking to buy a new toy, as opposed to being a serious Mets fan. Ackman says he was just trying to help show that his friend had a lifelong interest in baseball. There was some back-and-forth on e-mail between the two men, and that was that. “David and I are friendly, but it’s like we were boyfriend and boyfriend, and then one day we were just friends, and now we’re just friendly,” Ackman says. “I have enormous respect for him. But as a result of that, I stopped calling him and he stopped calling me, so that’s why I didn’t talk to him” about Herbalife. (Einhorn declined to discuss Herbalife or his relationship with Ackman, but lavishly praised Dan Loeb.)
On May 1, Dinneen was listening in on Herbalife’s first-­quarter-2012 investor conference call when suddenly Einhorn spoke up and started asking questions, mostly about what percentage of the company’s sales was merely to distributors, who are required to buy the product each month, and what percentage to genuine consumers. At first, Des Walsh, the company’s president, said “70 percent or potentially in excess of that” went to consumers or distributors “for their own personal use.” Einhorn pushed Walsh for a clarification, and Walsh said he didn’t have “an exact percentage” because “we don’t have visibility to that level of detail.” This was a surprising answer, since that information should have been readily available. By the end of the day, Herbalife stock had plummeted to $56 per share, from $70 per share.
Had Ackman waited too long to bet against the stock?
Dinneen alerted Ackman that Einhorn was on the call and asking tough questions. “David asks his question, the stock plummets, and then Shane [Dinneen] is all upset,” Ackman recalls. “He thinks he’s done all this work for nothing. I said, ‘No, no, you’re wrong. This is great. Clearly David shorted the stock.’ ”
Now, Ackman believed, Pershing Square didn’t have to be the so-called catalyst, the guy who says the emperor has no clothes—which generally causes the company being shorted to go on the attack against the short-seller. “It sounds like David is prepared to go public with it,” he told Dinneen. “He’ll be the catalyst, and we can be short and we don’t have to deal with all the headaches of being the active short-seller.”
During the conference call Ackman decided to pull the trigger and started shorting Herbalife shares through Goldman Sachs, Pershing Square’s principal prime broker. His position eventually grew to more than 20 million shares. The move took major cojones because with such a large percentage on the short side, around 20 percent, in the hands of one person, those on the other side of the trade—who are betting the stock will go up—can try to orchestrate the aforementioned “short squeeze,” by buying up shares. This causes the thinly traded stock’s price to trade up, forcing the short-seller to buy back stock at far higher prices than he had hoped, which sends the price of the stock higher still.
In addition, Herbalife would no doubt be able to defend itself by using some of the $320 million or so in cash on its balance sheet to buy back and retire its stock, reducing the number of shares outstanding and potentially adding to Ackman’s whiplash. (Since the end of 2012, Herbalife has bought back four million shares at a cost of around $150 million.)

The Sohn and the Fury

The annual Ira Sohn Conference, in Manhattan, is where the leading hedge-fund managers share their investing ideas. With the 2012 edition scheduled for May 16, Ackman suspected that Einhorn would use his presentation there to tout his short in Herbalife and become the catalyst for the trade. It’s a tried-and-true strategy, and smacks of insider trading, but stays just this side of legality. Ackman, Icahn, and Einhorn, among others, have all used appearances at Sohn to tout their short or long positions, after having already accumulated them, knowing that their very words will move the mar­ket in their favor. Talking your book, as it’s known on Wall Street, is not exactly kosher, but it’s done all the time.
According to Ackman, just before his presentation, Einhorn put up a slide with the letters “MLM” on it. The audience, he believes, immediately took this as an indication that he was about to slam “multi-level marketers,” such as Herbalife. But Einhorn’s pres­entation turned out to be about Martin Marietta Materials, a company with the stock symbol MLM. When the market realized this, Herbalife stock moved smartly to finish up more than 10 percent.
“He did that kind of as a joke,” Ackman says.
Einhorn wasn’t going to be the Herbalife catalyst after all, so over the summer and fall Ackman and his team worked tirelessly to put together their version of the Herbalife story. Ackman wanted to unleash his monster on the world before Thanksgiving, but his team wasn’t ready, even though it had been working around the clock. So Ackman arranged with Douglas Hirsch, a co-chair of the Sohn Research Conference Foundation, for a special session to present the Herbalife idea on December 20.
“I go back to first principles for me, personally,” Ackman says. “The single most important thing to me, personally, is the ability to speak my mind. I’m a change-the-world guy, and I know that sounds like bullshit or whatever. I don’t like to make investments that are not good for America. You can say I’m self-righteous. You can say that I’m disingenuous. I have more money than I need. I don’t need to work for a living. I do this because I love what I do.”
After graduating from Har­vard College and follow­ing a stint working for his father at the family’s commercial-­mortgage real-­estate business, Ackman went to Harvard Business School, the only program to which he had applied. As he had in college, Ackman rowed crew. He was co-captain of the business-school team that generated national controversy by wearing
T-shirts with dollar signs on the backs and painting dollar signs on the oars. At the annual Head of the Charles race, spectators booed the H.B.S. crew boats, causing Ackman to defend the decorations in an opinion column in the Harbus, the business-school newspaper. “Let’s face up to what Harvard Business School represents,” he wrote. “We spend 90 percent of our studies at HBS pursuing the maximization of the dollar.”
At Harvard, Ackman met David Berko­witz, who had studied engineering as an undergraduate at M.I.T. After graduation Ackman and Berkowitz formed Gotham Partners, their own hedge fund, in a windowless office in Midtown Manhattan. Starting with $250,000 from Marty Peretz, a college professor of Ackman’s and the then editor and owner of The New Republic (and the father of V.F. contributing editor Evgenia Peretz), they raised $3 million. “We did incredibly well for five years,” Ackman recalls. Most important, in 2002, Ackman made a huge bet that M.B.I.A. Inc., the publicly traded municipal-bond insurer, was fatally overvalued. The company protested that Ackman was trying to manipulate its stock price. Both the S.E.C. and Eliot Spitzer, then the New York State attorney general, investigated. “Not to put it too impoliticly,” Spitzer told The New York Observer in 2011, “but we put [Ackman] through the wringer.”
Ackman recalls he told the investigators, “If you guys don’t pursue M.B.I.A., and you allow it to continue, there will be a financial crisis of unbelievable proportions. That’s what will happen.” No charges were ever filed against Ackman, and he was proven correct after M.B.I.A. nearly collapsed during the financial crisis. Ackman and his investors made around $1.4 billion in profit. By that time, though, he and Berkowitz had parted company, and Gotham was dissolved.
On his own in 2004, and then with people he had met serendipitously—one sharing a cab in a rainstorm, another while bone-­fishing in Argentina—Ackman started Pershing Square, named after the area just south of Grand Central Terminal. Over the years, Ackman has had some notable wins—with Canadian Pacific Railway (doubling his $1.4 billion investment in less than a year), Fortune Brands, McDonald’s, Burger King, and General Growth Properties—and some notable mistakes, namely Borders (which went bankrupt) and the call options of Target Corporation, an investment that declined, at its nadir, 90 percent, according to Ackman, costing him and his investors some $1.5 billion. The loss caused Ackman to issue a rare apology: “Bottom line, [the Target investment] has been one of the greatest disappointments of my career to date,” he wrote his investors.
Faced with the hedge-fund fire­power lined up against him—to say nothing of Herbalife’s wrath—someone with a lesser ego might have had some doubts. Not Ackman. Although Herbalife is his first activist short since the M.B.I.A. war—which took nearly seven years for him to win—he claims he is not even remotely worried that he might be wrong. “By the way, there is no other investment in my portfolio about which I feel better,” he says. “I can give you all the concerns I have about everything else we own. JC­Penney … Canadian Pacific has gone from $46 to $117 a share. O.K.? Are there risks? Absolutely, absolutely. Every one of my other investments. Not this one.”
The day before Ackman’s presentation at Sohn, he called CNBC reporter Kate Kelly. “We wanted the right people there,” he says. “We wanted the right people to listen. And if you don’t know what company it is, you’re not going to just go [to a presentation] randomly. But I wanted everyone who owned Herbalife stock watching, and I wanted people who were interested in the story, and I wanted Hispanic media there. They’re not going to come to some hedge-fund presentation.”
By around two p.m. on December 19, Kelly was reporting on-air that Pershing Square had “a major new short position,” and, she explained, Ackman would be making a full presentation the next day. Ackman’s media ploy worked. Some 500 people assembled at the AXA Equitable Center, in Midtown Manhattan—along with another 1,300 people watching online—as Ackman, Dinneen, and David Klafter, Pershing’s general counsel, denounced Herbalife for more than three hours, without interruption, using some 330 slides. The title of the presentation was “Who Wants to Be a Millionaire?”
Ackman was smooth, confident, and unrehearsed. “Tennis, I practice,” he tells me. “Presentations, I don’t. Never.”
Onstage, Ackman said he would donate any money he personally made from the trade—“blood money,” he called it—to his foundation, the Pershing Square Foundation, which gave $7 million to Andrew Youn and his One Acre Fund, to relieve hunger and poverty in East Africa, and $25 million to the Newark, New Jersey, public schools (to which Mark Zuckerberg gave $100 million). Ackman also announced—on the spur of the moment, he says—that he would donate $25 million to the Sohn foundation, which supports pediatric cancer care and research. “You know what?” he says he told Douglas Hirsch. “It’s time for me to do something for cancer.” He later explained to me, “By the way, I was diagnosed with skin cancer. Within a week of the event. Basal cell carcinoma, and I had it removed. You’ve got to see this scar.”
Throughout the presentation, CNBC’s Kate Kelly kept ducking out to report what Ack­man was saying, and after it was over Ackman himself hit the airwaves, talking up a storm to Andrew Ross Sorkin, on CNBC, and on Bloomberg TV. He positioned him­self as the champion of the vic­tims of the alleged scheme. “You’ve had millions of low-income people around the world who’ve gotten their hopes up that there’s an opportunity for them to become millionaires or hundred-thousand-aires or some number like that, and they’ve been duped,” he told Sorkin. “We simply want the truth to come out. If distributors knew the probability of making $95,000 a year—which is the millionaire team, as they call it—was a fraction of 1 percent, no one would ever sign up for this. And we simply exposed that fact. The company has done their best to try to keep that from the general public.”
Chapman counters, “If anybody buys this ‘He’s out to save the little guy’ routine, they’re just outright gullible and na├»ve. Arguably, the number of Herbalife employees, suppliers, and their employees, and of course non-complaining distributors who may be harmed by Ackman’s quest for profits massively outnumber those distributors who fail to succeed as they had hoped.” (As for Chapman, Ackman says, “He’s a lunatic. And I think, by the way, that he’s proud to be a lunatic, and he’s even said as much, that it’s part of his strategy, as an activist, to make the other side think you’re crazy.”)
But the presentation did work as Ackman had planned: Herbalife’s stock went from $42.50 per share on December 18 to a low of $26 on Christmas Eve.
Not surprisingly Herbalife began fighting back. “Herbalife operates with the highest ethical and quality standards,” the company wrote in a press release. “Herbalife also hires independent, outside experts to ensure our operations are in full compliance with laws and regulations. Herbalife is not an illegal pyramid scheme.” (The company’s C.E.O., Michael Johnson, declined an interview request.)

The Long and Short of It

Dan Loeb watched the December 20 pres­entation with amazement and thought the entire hedge-fund industry would look at Ackman’s highly promoted announcement as an opportunity to take the other side of the bet. Loeb met with me in his serene, art-filled Lever House office, on Park Avenue. He is a yoga enthusiast and surfer from California, a cool customer, and more than a tad condescending. “It took us a little while to do our work, because we had no reason to think he was right or wrong,” Loeb explained. “We just wanted to understand the company. And we weren’t like super-focused on it, but sometime during the holiday we got very, very focused on it.”
Most of Loeb’s Third Point enterprise is based in Manhattan. But one of his key partners, Jim Carruthers, works in Silicon Valley, where he and an analyst, Scott Matagrano, research potential short ideas. “They have a massive fucking budget for research and analysis,” says an observer, who knows them. “They are deepwater shorts,” meaning that, when they get a conviction about a short idea, they put a lot of money behind it and stick with it. As the Indago Girls had during the summer of 2011, Carruthers and Matagrano studied the multi-level-marketing industry in depth. “Their opinion is very point-blank,” says the observer, adding that the “industry is shot through with lies, deceit, and fraud.” At the end of their research, they decided to short two publicly traded multi-level marketers, Nu Skin and Usana, but they weren’t sure what to do about Herbalife, in part because it appeared others had lost money shorting the stock in the past. When they heard that Einhorn had shorted it, they decided not to join him. “They backed off of Herbalife because it’s just too big, and once Einhorn started sniffing around it was going to become a very crowded trade immediately,” this person continues.
But on December 20, when the Herbalife stock fell to $26, Loeb decided that Ackman had created a unique opportunity for him and other hedge-fund investors to go long Herbalife—in part because Herbalife was a cash machine that had been around for 33 years, in part because even if the Federal Trade Commission closed down Herbalife’s U.S. business (a prospect that Loeb considered highly unlikely) it represented only 20 percent of the company’s total, and in part because of the short-squeeze opportunity on Ackman.
Loeb consulted with Carruthers, who told him he didn’t like Herbalife but didn’t hate it enough to want to short it. “This is a company that should be a normalized $40 to $50 stock trading in the 20s,” Loeb argued, according to the observer. “And Ackman has created a situation where if this company buys back stock and declares a dividend or two it can run up into $60 or $70.” With the understanding that Loeb was just looking to make some quick money for his investors, Carruthers endorsed Loeb’s plan.
There was also the matter of the growing antipathy between Loeb and Ackman. “My understanding is that they dislike each other profoundly,” the observer says. In 2007, with the market booming and Third Point’s assets growing considerably, Loeb invested around $200 million of Third Point’s $6 billion in a blind pool of money that Ackman had assembled. Ackman had promised investors it would be as successful as his McDonald’s investment, which had earned hundreds of millions of dollars, but it turned out to be the notorious Target loss of nearly 90 percent, leaving many unhappy investors, especially Loeb. He says he had invested with Ackman, who was coming off a super-hot hand with his McDonald’s investment, because he trusted Ackman’s judgment and process. In retrospect he believes he was crazy to do so and has vowed never to do anything like it again.
Loeb’s funds eventually lost around $175 million with Ackman, and today Ackman remains contrite. “Dan was very unhappy, as he should be, when the thing went down,” says a person who knows both men. He adds that Loeb was the angriest of Ackman’s investors about the Target debacle and got out of it as soon as Ackman made that possible; had he been more patient and stayed in he would have gotten most of his money back as the investment rebounded.
Loeb says his decision to invest in Herbalife was not about getting revenge on Ackman. “Everything I do is driven to generate returns for my investors, so the fact that Bill is involved here is coincidental,” he claims.
On January 9, Loeb filed a 13-G report with the Securities and Exchange Commission, announcing that he had acquired 8.9 million Herbalife shares, or 8.24 percent of the stock—making him the company’s second-largest shareholder—at a cost of around $300 million. That same day he wrote a letter to his investors explaining he had acquired most of the stock “during the panicked selling that followed the short seller’s dramatic claims.”
In his letter, Loeb refuted them and wrote that he believed the stock “could easily” return to its April 2012 price of around $70 per share. At a minimum, he wrote, the stock should be valued at between $55 and $68 per share, offering Third Point “40–70% upside from here and making the company a compelling long investment.”
The market took notice of Loeb’s purchase and sent the stock up around 10 percent.
Sahm Adrangi was one of the traders who agreed with Loeb. “After you’d done your work on Herbalife and you viewed Ackman’s three-and-a-half-hour presentation, you could see the holes in his argument,” says Adrangi. “Ackman has three points: the F.T.C. is going to shut it down because they’re in regulatory violation of pyramid-scheme laws, distributors are going to jump ship because they’re going to realize that they’re being duped, and you’re going to see an unwinding of the business because of the ‘pop-and-drop’ dynamics [where sales shoot up when Herbalife enters, and then quickly subside]. Those three points are very easy to debunk. Is the F.T.C. going to shut it down? MLMs have been around for 30 years. There’s really no evidence that Herbalife is the worst of the bunch, and the government would also have to shut down Amway, Avon, Tupperware. The second point, that distributors are going to view his video and quit in droves—I mean, 80 percent of the business is outside the U.S., so to think that lower-income Brazilians and Paraguayans and Malaysians will view his video and decide to quit becoming Herbalife distributors is very silly. And his third thesis, that the pop-and-drop dynamics are going to cause an unwind internationally, is also absurd. The reason Herbalife and these other global MLMs are very sustainable businesses and grow year after year at impressive rates is because they’re very diversified.”
Ackman was on his private Gulfstream 550 jet, on the way to Myanmar for some exotic scuba diving, when he got the news of Loeb’s purchase, via the onboard high-speed Internet. “I had no idea Loeb was about to do that,” he says, though he could have had an inkling something might be up, because, the day before, Chapman, who had also built a long position in Herbalife equal to “35 percent of his fund” (the size of which is unknown), had had an exchange with Charlie Gasparino, of Fox Business, in which Chapman had claimed there would be “big news” coming shortly on Herbalife—about which Gasparino tweeted.
Ackman thought Loeb was in Herbalife merely to make a quick buck: “While Dan’s investment letter gave the impression that he’s in Herbalife for the long term, I think he’s too smart for that. I think it’s just a trade.” Within weeks he said he suspected Loeb had already started selling his stake. “I don’t know if it’s true,” he said. “I have no idea. But I think if he’s selling he’s got problems.” Ackman was too diplomatic to say on the record he meant that Loeb could be accused of a “pump and dump” scheme, in which a prominent investor talks up a stock he owns, then sells it, making good money. (Loeb declined to comment.)

Grudge Match

Matters got even more interesting on January 16 when news reports claimed that Carl Icahn, whose net worth has been estimated by Bloomberg to be $20.2 billion, had acquired a “small” stake in Herbalife, joining forces with Loeb in the battle against Ackman.
That Icahn would do so was clearly sport for him. He and Ackman first met in 2003, when Ackman was in the process of liquidating Gotham Partners. One of the companies in which he owned a large stake, Hallwood Realty, was trading for around $60 per share. Ackman believed the stock was worth $140, but he decided to sell, and he approached Icahn with a deal. “I checked him out,” Icahn told The New York Times in 2011. “He was in trouble with the S.E.C.; he had investors leaving him. A few of my friends called me up and said, ‘Don’t deal with this guy,’ ” but, Icahn says, he ignored their advice.
He and Ackman agreed to a deal for $80 a share for Hallwood, along with a contract that gave Ackman “schmuck insurance” in the form of a written agreement to split any profit above a 10 percent return for Icahn if Icahn sold Hallwood within three years. In April 2004, Icahn merged Hallwood Rea­l­ty with HRPT Properties Trust for nearly $138 per share in cash—surprisingly close to what Ackman thought Hallwood was worth in the first place. Under the terms of their agreement, Ackman believed he was owed another $4.5 million. He waited a few days and then called Icahn to try to collect.
“First off, I didn’t sell,” Icahn told him. He said he had voted against the merger, but his shares were cashed out anyway.
“Well, do you still own the shares?” Ackman asked.
“No,” Icahn replied, “but I didn’t sell.”
Ackman threatened to sue Icahn for the money.
“Go ahead, sue me,” Icahn told him.
Ackman did, in 2004. The case was finally resolved in Ackman’s favor in October 2011, and Icahn paid Ackman $9 million, including several years’ worth of accrued interest.
Speaking at a conference in March 2012, Ackman mentioned Icahn and said he didn’t respect him. Icahn returned the favor later that day in an interview with The Wall Street Journal: “Any criticism from Bill Ackman I consider a compliment.”
On January 24, after taking his stake in Herbalife, Icahn went live on Bloomberg TV. “It’s no secret to the world and Wall Street that … I don’t like Ackman,” he fumed. Telling Trish Regan, the anchor, that he didn’t approve of Ackman’s approach, he elaborated: “I think if you’re short, you go short, and, hey, if it goes down, you make money. You don’t go out and get a roomful of people to bad-mouth the company. If you want to be in that business, why don’t you go and join the S.E.C.”
He said he was also critical of Ackman’s announcement at the Sohn Conference that he would give any profit he made on the short to charity, because Ackman’s limited partners would still benefit, which would then accrue to Ackman’s benefit as well. “I dislike the guy,” he continued. “I don’t respect him. . . . I don’t think he did this in the right way Don’t be holier than thou and say, ‘Look, I’m doing this for the good of the world and I want to see sunshine on Herbalife.’ I mean, that’s bullshit.”
The gloves were off.
The next afternoon on CNBC, when Ackman was defending himself against Icahn’s claims, Icahn called in to the show, and the CNBC producers, realizing they had all the makings of cable-TV fireworks, patched him in. Suddenly Icahn and Ackman were going at it live, causing electrified trading floors all over New York to stop dead in their tracks as the traders whistled, stomped, clapped, and guffawed at the two billionaires mixing it up on national television.
“I’ve really sort of had it with this guy Ackman,” Icahn said. “He’s like the crybaby in the schoolyard. I went to a tough school in Queens, and they used to beat up the little Jewish boys. He was like one of these little Jewish boys, crying that the world was taking advantage of him. He was almost sobbing, and he’s in my office, talking about this Hallwood, and how I could help him.”
Einhorn announced in late January that he had made money on his Herbalife short, but, tellingly, he added that he had closed out the position in 2012.
But Ackman says he is in it for the long haul. On January 29, he told me he was just days away from sharing with the world several bombshell announcements that would blow the lid off Herbalife once and for all and send its stock to zero. But on February 20, he softened his language some, saying he believes there will be more market-moving news to come.
His convictions, though, are as strong as ever. “Every day is a happy day for me,” Ackman tells me. “You don’t know me well enough. But I know Herbalife is a pyramid scheme. It is a certainty. It’s just a question of when the rest of the world figures it out.”
Adrangi is not persuaded. “We have high-conviction ideas, and, oops, it doesn’t work out,” he says. “But what’s important is to pay attention to what the other side is saying, and to revise your thesis. . . . Since Ackman’s pres­en­ta­tion, more information has come out. Bob Chapman put together a very good, five-page letter on why Herbalife is a long. Dan Loeb has done the same thing. The company’s response presentation was excellent Ackman is making this moral,” Adrangi continues. “He runs a hedge fund, right? His duty is not to the world. If you want to save the world, go donate some money to charity. I’m pretty confident that if he does not cover his short position his fund will be smaller, materially, in two years’ time.”
Icahn seems to be doing his best to make Adrangi’s prophecy come true. On February 14, Icahn announced that he had accumulated a surprisingly large, 12.98 percent stake in Herbalife and that he intended to meet with the company’s management to discuss “enhancing shareholder value,” including possibly a going-private transaction. Herbalife’s stock soared throughout the day on the Icahn news and traded as high as $46.22, a 21.4 percent increase from the previous day’s close. “Carl Icahn just delivered Bill Ackman a valentine he’ll never forget,” Chapman gleefully e-mailed me. The soaring stock price allowed some of the more risk-averse traders to make some money. Chapman, for one, sold his entire Herbalife position in mid-February at a tidy profit, while Loeb, who had been selling Herbalife stock for weeks, his spokesman admitted, also sold another portion into the Icahn-induced rally.
But Ackman, who knew some of his biggest hedge-fund rivals were still lined up against him, remains unflappable. We’d been sitting together in the conference room just off his spacious office. Grabbing a banana from a bunch on a table, he said of Herbalife’s stock, “I’ll be happy at zero,” and smiled.

Debunking Myths about Activist Investors

Activist investing has become quite the rage in the equity marketplace. Activist investors are proliferating, and there is a marked inflow of new capital to this asset class. The discipline of activist investing is popping up in more conversations about the nature and role of equity investors. As a result, it is occupying the thoughts, and sometimes the nightmares, of an increasing number of corporate executives and their advisers. The phenomenon has even become a topic du jour of academics, who are busily finding sufficient economic value in the function of activist investing to justify urging the SEC not to shorten the historic minimum time frames for reporting accumulations of more than 5% of a company’s stock explicitly to permit activists to accumulate larger blocks before disclosure of their activities results in a rise in market trading values for the stock in question.
Activist investing has a long pedigree in the equity markets dating back to the late 1970’s. Back then and throughout the 1980’s, activist investors were known by less flattering sobriquets such as corporate raiders, bust-up artists and worse. Activist investing has changed since those heady, junk bond fueled days. Then, the favorite game plan of activist investing was to threaten or launch a cash tender offer for all, or at least a majority, of the target company’s outstanding stock with funding through an issuance of high yield bonds. Today, activist investors rarely seek equity stakes in target companies above 10%, and their financing comes not from the public debt or equity markets but rather through private hedge funds that they sponsor and manage.

Even though activist investing and company responses to it have changed dramatically during the 40+ years of the existence of activist investing as a recognized, if not always lauded, investment style, one aspect remains the same. Just as in the 1970’s, activist investing, its practitioners and company defenses against activist investors remain surrounded by myths that often get in the way of reality.
Myth Number One:
Today’s activist investors have a single, basic game plan—to force companies to make imprudent changes in their capital structure resulting in a large dividend or share buyback program or, worse, to force a sale of the company.
Activist investors are “one-trick ponies.” Most follow the same game plan, without regard to the realities of a given target’s actual situation.
As underscored by some of the current prominent activist campaigns, including the Icahn/Ackman battle over Herbalife and the JANA Partners – Agrium situation, activist investors’ game plans come in many shapes and sizes.
Among the more common strategies advocated by activist investors are:
  • Returning excess cash on the balance sheet to shareholders.
  • Restructuring the balance sheet by leveraging the company and distributing resulting cash to shareholders.
  • Restructuring company assets by selling one or more “underperforming” business units and distributing proceeds to shareholders.
  • Restructuring company assets by spinning off one or several distinct business units to optimize the combined trading value of the resulting companies’ stock.
  • Restructuring company operations to create efficiencies and achieve higher margins.
  • Selling the company to realize superior value in the M&A market compared to the trading market.
Moreover, activist investors are not always buyers of target company stock. In many instances, their game plan is to sell short the company’s stock and to wage a very public campaign explaining why they have done so. (Pershing Square’s campaign regarding Herbalife is an example of such a short sale strategy.) Instead of uncovering hidden value in a company, this strategy is premised on a directly opposed investment thesis of uncovering hidden over-valuation in a company.
Myth Number Two:
Activist investing is the epitome of “short-termism” as an investment style and is inherently bad for this reason.
A common misperception is that activist investors’ sole modus operandi is to take an equity position in a company, rattle their sabers to induce immediate actions contrary to shareholders’ best interests, reap quick profits, and then cut and run.
While it is true that activist investors like quick returns, this is true of all investors. The quicker the return on an investment, the higher the IRR and the faster the investment funds can be re-invested for further gain. But the fact that activist investors understand IRR math does not make them slaves to short-term results. Many activist investors have advocated strategies that require significant time to implement. Moreover, most activist investors understand that there is an unpredictable time frame between an initial proposal for a change at the target company and acceptance and implementation of the change. Whatever the reasons, many activist investors have undertaken investments with durations measured in years not months.
Moreover, although there is substantial sentiment that US equity markets fundamentally need more long-term focus from institutional investors, thereby encouraging and enabling long-term strategic planning by public companies, that belief should not result in automatic condemnation of strategies that create shareholder value in the short-term. As long as those strategies do not destroy more value in the long-term, they should not be dismissed simply because they produce short-term gains.
There also is the reality that a strategy some may believe is value-destroying turns out to be value-creating and vice-versa. For example, take the strategy of adding leverage in a company’s capital structure. If the forty year history of LBO’s has taught us anything, it is that increasing leverage on a balance sheet can be value-creating if done at the right time at the right company. Condemning all recommendations by investors to increase leverage at a given company as an example of inappropriate short-termism simply makes no sense. The same, of course, can be said for each of the typical activist investor’s strategy recommendations. They are neither inherently good nor bad, whether or not they are short-term or long-term in nature.
Myth Number Three:
Activist investors may be successful, but they should not be viewed as beneficial to our equity capital markets or as economically useful.
Another common misperception is that activist investors are more akin to a necessary evil standing in the way of responsible long-term corporate strategies than a beneficial influence contributing to shareholder value.
Activist investors act as important intermediaries in the equity markets. Activist investing is often a useful contributor to good corporate governance and a force for company implementation of strategies that enhance shareholder value.
Shareholder participation in corporate strategy and operations is essentially passive. While in theory shareholders elect the board of directors, which is in a position to shape corporate policy and performance, in practice shareholders do not and cannot use their franchise to improve board performance through election of more effective directors, unless there is an active proxy contest. The simple reality is that the institutional shareholder community, which dominates share ownership of most public US companies, is ill-suited to influence company performance through dialogue with management or proxy contests and very rarely tries to do so. Institutional investors lack the resources and skill set to study a company and its operations in sufficient depth to develop better corporate strategies. Moreover, they are not hired by their clients to do so. Instead, in the absence of a well-founded campaign by an activist, institutions have no practical recourse against an under-performing management other than the “Wall Street Walk”—that is to say, if they are unhappy with a company’s performance or management, their only redress is to sell the company’s stock.
Activist investors are cut from a different cloth. Rather than managing large and diverse stock portfolios, activist investors concentrate on one company or a relatively small number of companies at a time. Moreover, they do so in depth so as to discover alternative strategies to increase the company’s value and, having developed an alternative game plan, to persuade the company to adopt it. Put another way, activist investors function to create market-based discipline for underperforming companies. Their function, like that of M&A acquirers, is to arbitrage the value gap between poor company performance and good company performance. And like other arbitragers, they play an economically justified role in discovering value equilibrium in the equity markets.
Myth Number Four:
Conventional institutional investors will tend to support a target company against a challenge by an activist investor.
Companies, particularly those with effective IR programs, usually have credibility with and the trust of their institutional investors. This is particularly true of their longer term investors and new investors. Unless a large number of investors are unloading their holdings of a company’s stock, management can assume these shareholders will side with them in a fight with an activist investor, especially an activist with an aggressive short-term agenda.
While an inherent bias in favor of management may once have existed among conventional institutional investors, this is no longer the case in many situations. In fact, perhaps the most important change in the activist investor game plan over the past several years has been the increasingly sympathetic hearing activists receive from conventional institutional investors. Institutional investors are, for better or worse, chained to the wheel of quarterly performance statistics. As activist investing has become more common and as it has resulted in realizable value creation, institutional investors have become far more sympathetic to activist investors, and the economic utility of the activists is now well understood by the institutional investor community.
Myth Number Five:
If a company is in touch with its institutional shareholders through quarterly earnings calls and similar outreach to portfolio managers and buy-side and sell-side analysts, it will know whether there is reason to fear a successful raid by an activist investor.
Although most activists begin their campaign with a claim of widespread institutional investor support, if a company’s financial officers and IR people haven’t perceived widespread dissatisfaction by its key investors, there is no reason for a company to believe an activist’s claims.
In most cases of activist investing, management has not been reading the pulse of its institutional investors correctly. Activist investors rarely concentrate on a target company without first engaging in dialogue with at least some of the company’s key investors. After all, if the basic strategy of the activist is to acquire a relatively small block of stock and rely on broad support from the company’s larger shareholders, the activist is unlikely to amass its block first and then test the waters with the shareholder community.
Today’s institutional investors are not only typically ready to talk to activist investors about their investment thesis for potential target companies, but they also are usually candid in their response to activists. It is not in the interests of the institutional investors to encourage activists to engage in campaigns that the institutions will not support. When an activist claims wide institutional investor support, it may exaggerate the extent of the support, but a target company should not naively discount its claims entirely.
The reality is that institutional investors may not be as candid with management as they are with an activist. No one likes to be a messenger carrying bad news, particularly when an activist is more than happy to deliver the message in the first person. Also, institutional investors may feel that they haven’t been given an opportunity to express their views to management or that they haven’t been listened to when they tried to do so. The very fact that an activist campaign takes a company by surprise suggests that the company’s management has been somewhat tone-deaf in its dealings with its investors.
The bottom line is that when an activist claims wide institutional support, the company should take its assertions seriously and recognize the likelihood that the activist investor has received significant encouragement from the company’s larger shareholders.
Myth Number Six:
A company has no way of knowing whether and when it will be a target of an activist investor.
Activist investors rely on stealth in building their ownership stake and in plotting an activist campaign against target companies. Current SEC regulations are inadequate to give companies fair notice of their being the target of an activist investor. As a result, companies are frequently victimized by activists who have been able to amass large share positions without fair warning.
Of course, activists don’t want to reveal their game plan until they are ready to broach it to the company privately or publicly. And, of course, activists will use the existing rules to maximize their freedom of action and to retain the initiative.
But that doesn’t mean companies have no ability to anticipate the possibility of an activist attack. The best early warning device a company has is an honest and candid “look in the mirror.” Activists do not target high-performers. They seek out the low-hanging fruit. The obvious best, and in many ways only, defense is for management to recognize when its company is under-performing and to address the reasons for under-performance promptly and decisively. Proactive, management-initiated strategies to improve performance (which, along with a clear plan for achieving them, have been widely communicated) will have far more credibility with investors than actions clearly taken in response to a well-reasoned challenge by an activist.
Myth Number Seven:
There is no point in trying to engage with activist investors because they will not listen.
Activists are predators. Any attempt at dialogue with an activist will be perceived by it as a sign of weakness and will only heighten its blood lust.
Activist investors, at least for the most part, are rational and thoughtful. Most do not pick a fight for the sake of it, nor will they insist on strategic or other changes at a company if they can be convinced the changes will not lead to value creation or that the company has an equally good or better answer. Accordingly, a target should try dialogue first. It may not be successful, either because the activist investor has the better of the merits or because it is stubborn and set on its strategy. Even if dialogue with the activist is not successful, if properly handled management should be able to gain useful insights into the activist’s business case, its sophistication and expertise, and its personality. Finally, it is almost always better to talk than to fight, at least in the first instance (taking care, of course, to ensure that the case management takes to the activist investor is the one it is prepared to take to the broader investor community). Refusing to talk first serves no purpose and precludes any opportunity for a quiet and constructive solution before the onset of a battle which is inherently somewhat destabilizing, even if management wins.
Myth Number Eight:
The best defense against an activist investor is an aggressive structural defense.
Conventional wisdom is that a company in the cross-hairs of an activist should revise its existing poison pill to better target activist investors or, as is more likely in today’s world of fewer and fewer poison pills, implement a pill with a relatively low trigger threshold to protect itself against the activist. Conventional wisdom also holds that a target company should tighten its advance notice bylaws to give it maximum protection against an imminent proxy contest, as well as revise other bylaws, for example, to guard against a call for a special meeting or other proxy contest shenanigans.
While out of prudence a company should review its structural defenses, it should be cautious in rushing to introduce new defenses or tighten existing ones. Structural defenses are of marginal value, at best, in deterring an activist investor and in hindering its tactics.
  • It is rare that an activist investor or group of activist investors will exceed the most common poison pill trigger of 15% of the outstanding stock. Lowering the trigger below 15% will increase a company’s vulnerability to shareholder litigation and quite possibly backfire in the contest for the hearts and minds of uncommitted shareholders.
  • Most activist investors simply will not be fazed by amendments to advance notice bylaws that extend deadlines for proxy contest proposals or establish higher informational requirements for insurgents. The amendments, however, will probably be read negatively by other shareholders as being too defensive and a sign of weakness, not strength, on the part of the target company.
  • Other defensive bells and whistles are most often even more incidental and ineffective. They, too, are likely to create an impression of vulnerability on the part of the target company and could hinder efforts to convince other investors to take the company’s side in a forthcoming proxy contest.
More fundamentally, looking to structural defenses for protection mistakes the nature of the contest. Unlike a hostile bid where poison pills are useful, and perhaps necessary, to uncover higher value in the target company, an activist campaign is not about seizing control of a company for less than a market clearing price. Rather, an activist campaign is about ideas—strategies for creating additional values. The true battle is about whose view of the company is more likely to produce better shareholder returns—management’s or the activist investor’s. The winner of the contest will be the side which at the end of the day captures the adherence of a majority of the shares. Defenses which ignore this reality are at best a distraction and at worst a negative factor in the war of competing strategies for bettering the company’s performance.
Myth Number Nine:
The best defense against an activist investor is running an aggressive, negative campaign that highlights the past failures of the activist investor and/or its proposed candidates for director.
The prevailing wisdom is that dealing with an activist investor is like running a political campaign. And like political campaigns, proxy contests have a long history of demonstrating the value of negative campaigning. As a result, the best defense should rely first and foremost on attacking the bona fides and credentials of the activist investor and its candidates for the board.
While proxy contests traditionally have featured negative campaigning over assertion of positive programs and strategies, the tradition is simply outmoded. There may be a place for negative messaging, but it should not be the starting place. The key to any successful political campaign is understanding what messages – positive or negative – will resonate most with the particular audiences you need to influence to win. The bulk of the shareholders of an underperforming target company will be sophisticated institutional investors, receptive to a credible change message that improves the prospects for value creation.
Accordingly, the most effective campaign strategy to ward off the threat of a proxy contest, and to win the proxy contest if it cannot be warded off, is presenting institutional investors a more compelling and substantive narrative than the activist. Since the activist’s chief weapon is its proposed changes in company strategy or operations, a target company needs to fight this fire with fire of its own. Its overarching goal must be a more credible, company-developed strategy and/or better operating policies. Unlike modern political contests in the US where substance is far too often eclipsed by superficial arguments and sound bites, the institutional investor community, on the whole, will be focused on substance, and so must the company.
Myth Number Ten:
If a company has better ideas than the activist, it will win the battle.
Substance is what counts, not presentation frills. Accordingly, the key is getting the company’s proposal in front of institutional shareholders.
Substance is the key, but only if it is communicated effectively and persuasively to shareholders and, importantly, all of the target’s other stakeholders. Communication of the company’s ideas is at least as important as the ideas themselves, and many would argue more important.
Facing a challenge by an activist investor, a company should not hesitate to pull out all of the communication stops in its campaign to regain the trust and confidence of its investor base. This typically means a well-crafted and fully-integrated communications program that recognizes the need to reach all of the relevant decision makers for the company’s investors (including both portfolio management and corporate governance personnel at institutional investors and ISS and Glass Lewis) and takes advantage of multiple communication channels to the extent feasible and appropriate.
Also importantly, a target company needs to communicate effectively with its other stakeholders: its employees, customers, suppliers, regulators and communities where the company has facilities, in the US and abroad. An activist investor campaign, particularly one culminating in a proxy contest, can be very destabilizing for every company constituency. Focusing solely on the activist and other investors can be akin to winning the battle but losing the war. If, as almost always, performance is the name of the ultimate game, the target needs to muster the understanding and active support of all of its other stakeholders, who, unlike investors, are the ultimate drivers of performance.
The target’s communications arsenal should include not only SEC filings and traditional investor “decks,” but also different (although carefully coordinated) presentations to other key constituencies, in-person meetings with senior managers and town hall meetings for larger employee groups, telephonic and email outreach, the use of social media, and polling techniques and audience segmentation where targeted audiences are particularly large or diverse.
Being a target of an activist investor requires a company to run the same gauntlet as a hostile bid, particularly if the activist investor threatens or launches a proxy contest. It is a crisis situation and requires a crisis response team, including experienced legal counsel, investment bankers, proxy solicitors, and communications specialists to assist management in countering the activist. The challenge for management and its crisis team, then, is to craft the most compelling substantive rebuttal to the activist’s challenge and to communicate that rebuttal effectively to all of the company’s constituencies.

Lunch is for wimps

Lunch is for wimps
It's not a question of enough, pal. It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another.