Tucked into his recent investor letter, William Ackman reveals his hedge fund is going public, but what is his motivation?
William Ackman’s Pershing Square is taking his hedge fund public, according to a letter to investors reviewed by ValueWalk.
Ackman announces Pershing Square Holdings’ IPO
In announcing the initial public offering of Pershing Square Holdings, Ltd. (PSH), targeted for later this year, Ackman addressed his logic in the move. “Because we are an active, control and influence-oriented investor, we have avoided being fully invested because of the risk of investor redemptions,” he wrote, as pointing to a primary motivation.
It is the inability to fully deploy the capital which points to Ackman’s next target, in my opinion: activism in large, Goliath firms. Based on the muted statements throughout the investor letter, Ackman appears to see an opportunity to hunt for goliath game that requires massive amounts of capital.
“As a large capitalization activist investor, we believe our strategy benefits from a large opportunity set, sizable barriers to entry, and limited competition,” he wrote much later in the letter. “We believe that the largest companies offer the most opportunity for corporate change because they are typically held by passive shareholders and are too large to be vulnerable to private equity buyouts.”
Ackman likely to take his aggressive tactics to large caps
Connect the dots between these two statements located in different parts of the letter is to understand Ackman is likely to take his aggressive tactics, into a larger arena where they typically don’t respond to activist investors.
When David Winters attacked The Coca-Cola Company (NYSE:KO) hedge fund insiders might have whispered that Winters was correct on the issues, but he was too small to make a difference. Truth is, there is not a hedge fund around large and aggressive enough to go into a major corporation and start throwing around their weight. Ackman appears to want to change that by going public, raising assets and becoming a larger than life hedge fund goliath.
Ackman is said to be considering launching the fund on the London Stock Exchange and might initially seek $4 billion, but this number could go higher under the appropriate market conditions. Speculation is adding $10 to $20 billion in investors in the stock — who can’t withdraw their funds as easily as fund investors — might need such capital to take on multiple large cap activist projects.
Ackman might be considering that performing for stock investors, where the capital is locked in place to a large degree, might be easier than at times fickle institutional investors who often require significant hand holding during inevitable draw-downs and can sometimes force strategy changes to accommodate liquidity requests.
It is unclear in this new corporate structure how Ackman will be compensated or if separate management, operation and incentive fees may apply to the new publicly traded entity.
Ackman’s further attack on Herbalife
The letter touched on many other aspects, including an interesting discussion on why shareholder activism is good for corporate America (sounded like Carl Icahn’s recent rant), his thoughts on Allergan, Inc. (NYSE:AGN) (they violated a fiduciary trust by not properly considering the Valeant Pharmaceuticals Intl Inc (NYSE:VRX) (TSE:VRX) offer) and further attacks on Herbalife Ltd. (NYSE:HLF) (he wants to pound the stock to zero).
Ackman’s letters have become stop the presses events, providing his hand is considerably hot right now. This points to another potential Ackman goal, not stated in the investor letter. With Ackman set to cash out at the height of the IPO craze and with strong recent performance through highly visible trades at his back, he could be engaging in an old trader strategy: sell at the highs.
Below readers can find the full text in both scribd and text format
Pershing-Sqr-1Q-2Q-2014-Investor-Letter-1 (1) by ValueWalk
firm. We will forever be indebted to Ian Cumming and Joe Steinberg, then Chairman and CEO of Leucadia, who backed us when few others would. As a thank you gesture at the time, we offered Leucadia a substantial minority interest in the management company for no additional consideration, but they asked for nothing but good investment results in exchange for their investment, and for that we are very grateful.
Returns Since Inception
Over the last ten and one-half years, we have generated net returns to our investors of 626.7% or 7.3 times day-one investor capital. Over the same period, the S&P 500, our principal benchmark, as it has historically comprised most of our holdings, has returned 118.8% or about 2.2 times. Expressed as a compounded annual return, the funds have returned 21% net per annum versus 8% for the S&P 5002. In a world in which investors are pleased to earn returns that are one or two percentage points per annum above the S&P over 10-year periods, our approximate 13 percentage point annual net margin over the index is notable.
We are proud of our record and how that record has been achieved. While our returns have been strong, our downward volatility (the only kind of volatility investors really care about) has been minimal. We have had two negative years in our history, 2008 when the funds declined 12% to 13%, and 2011, when the funds declined approximately 2%. While the S&P index is by design a fully invested index, we have generated our returns with negative leverage, i.e., cash has averaged 14% of invested capital since inception. Some might therefore criticize us for the inefficient use of our balance sheet, for clearly the liquidity and nature of our holdings would have allowed us to be more invested over time. Indeed, we could have comfortably supported a modest amount of margin leverage without taking undue risk.
Because we are an active, control and influence-oriented investor, we have avoided being fully invested because of the risk of investor redemptions. For example, during 2009, despite a relatively strong 2008 and a 41% net return in 2009, we had to keep a substantial portion of our assets in cash because of the large amount of investor redemptions we received. We will hopefully begin to address this issue with the initial public offering of Pershing Square Holdings, Ltd. (PSH), targeted for later this year, which will increase the amount of our capital that is permanent.
Our investment performance is particularly striking when one considers our compound annual gross return of 27.7% for the past 10 and one-half years. This is a particularly large number in light of our investment universe which is comprised of the largest and most well-covered companies in the world – large cap North American equities – which according to the efficient market hypothesis should not offer investors above-market returns. Our returns also reflect a substantial drag from our historically large average cash position since inception. These results beg the obvious question. Have our returns been a function of good investment analysis, or have
our results been driven by a strategy that has a unique competitive advantage? The answer, we believe, is both.
Corporate Control, Influence, and Control Premiums
Private equity investors pay large premiums for the right to control a portfolio company’s governance, management, competitive strategy, operating strategy, capital allocation, and the timing of exit. Despite having to pay control premiums, successful private equity investors have earned attractive returns for their investors. The fact that opportunities exist for private equity investors to pay substantial premiums and earn high returns is evidence that the companies that they have acquired were not optimally managed and/or capitalized at the time of purchase.
If an investor can effect corporate change without having to pay a control premium – or better, buy at a discount due to shareholder dissatisfaction – that investor would have an extraordinary advantage. A rational investor is unlikely, however, to sell control at a discount. The good news is that on occasion, minority stakes in high quality businesses can be purchased in the public markets at a discount. These discounts principally arise because of two factors: shareholder disaffection with management, and the short-term nature of large amounts of retail and institutional investor capital which can often overreact to negative short-term corporate or macro factors. Such an environment creates an opportunity for the proactive investor to buy a minority stake in a public company and work to effect corporate change to create value on behalf of all shareholders.
Why Shareholder Activism is Good for Corporate America
Activist investing is inherently healthy for the markets, particularly in a world where the substantial majority of investment capital is indexed, in ETFs, or is explicitly or implicitly passively managed. Prior to the arrival of shareholder activism, when shareholders were disappointed with management, they had no choice but to sell because they had little if any recourse. Today, they call a shareholder activist.
While not all shareholder activists have long-term, shareholder-oriented agendas, only those that do are likely to have substantial influence because the activist can only succeed with majority shareholder support. While the advisors to entrenched management teams have attempted to limit the impact of activists with poison pills with decreasingly lower thresholds and attempts to change the 13D rules, non-activist institutions have aggressively pushed back as they recognize that shareholder activism is one of the few means they have to unlock value in a long-term underachieving company.
The popularity of activism as a strategy has increased due to the potential it offers for substantial returns. In light of the attractive returns achieved and the growing number of participants, we are often questioned about the sustainability of our strategy in an apparently more competitive environment. The good news is that the opportunities for shareholder activism are only limited to the extent all corporations optimize their business models, operations, and capital allocation and become efficiently priced by the markets. We believe that corporate inefficiency and security mispricing will continue for the foreseeable future and present a continued rich opportunity set for Pershing Square. In light of our strategy’s high degree of concentration, our
approach to shareholder activism needs only a few opportunities each year to generate returns for our investors.
Our Strategy’s Structural and Competitive Advantages
As a large capitalization activist investor, we believe our strategy benefits from a large opportunity set, sizeable barriers to entry, and limited competition.
We believe that the largest companies offer the most opportunity for corporate change because they are typically held by passive shareholders and are too large to be vulnerable to private equity buyouts. Large cap businesses are typically high quality companies, as they would not typically achieve high valuations without substantial revenues, profits, and free cash flow. After decades of high profits and cash flows, many large businesses become less disciplined about cost control and capital allocation, and may otherwise lose focus. The number of large cap companies is substantial, particularly when compared to a strategy which, due to its concentration and long-term holding periods, requires that we identify only one or two new ideas per year to generate attractive returns for our investors.
Large capitalization shareholder activism has the benefit of significant barriers to entry to prevent large capital flows into the strategy. If one wishes to be a large cap activist, one has to raise large amounts of capital, which is difficult for a start-up investment manager to achieve. More significantly, the greatest barrier to entry for the strategy is the requirement that one build reputational equity among the community of investors who represent the largest shareholders of corporate America. It takes years to build a track record with institutions such that they are willing to back an activist seeking control or substantial influence over a corporation. It takes years of doing what we say we are going to do and strong investment performance to get the institutional and retail backing required to effect change at large cap companies. Our large and growing reputational equity will therefore remain a very significant moat for Pershing Square in the future. One of our additional barriers to entry is less tangible, but no less significant. It is best deemed creativity. Many of our most successful investments have been in situations and used transaction structures that were previously unprecedented.
Doing large unprecedented transactions attracts attention, some number of detractors, and enormous media and other public scrutiny. As we have said before, it requires a very thick and calloused skin. It also requires some tolerance from our investors who are likely to read periodic criticisms from those who resent our success and would like to see us fail, from our adversaries, and from members of the media who are often not that well informed of the facts, or otherwise fail to check so-called “facts” presented by our adversaries. We tolerate the enormous volumes of press and the occasional attacks as a necessary and unfortunate evil of a high-profile activist strategy.
There are Those that Argue Shareholder Activism Must Be Stopped
A few have argued that shareholder activism should be stopped or curtailed.
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