Bill Ackman’s Pershing Square 2016 Letter to investor is out. Below are highlights and full letter at the bottom.
Photo by NCinDC
The Board has delegated the task of managing the Company’s assets to the Investment Manager, as set out in the Investment Management Agreement (the “IMA”) entered into by PSH and PSCM at inception of PSH. However, as described in the Corporate Governance Report on page 23, although the Board does not approve individual investment decisions, the Board is still accountable for the performance of the Investment Manager and the system of internal controls used to manage the risks to which the Company is exposed. The Board undertook a formal review of the Investment Manager’s performance in 2016, along with a review of the Investment Manager’s investment processes, particularly in connection with the investment in Valeant. The lessons learned from the investment have been discussed at length in prior communications with PSH shareholders and a further update is given in the Investment Manager’s Letter to Shareholders in this report. The Board appreciates the openness of the Investment Manager in analyzing the reasons for the Valeant losses, and welcomes the impact which the lessons learned will have on future investment decisions. The Board is satisfied that it is in the best interests of PSH for the Investment Manager to continue to manage our portfolio and create value for our shareholders. News about the Investment Manager has been dominated by events at Valeant. I would also like to draw your attention to progress made by the Investment Manager in other areas. In the June 30, 2016 Interim Financial Report, I commented that the Investment Manager might make one or more new investments. During the second half of the year, PSCM exited two successful but mature investment positions and freed up capital for two new investments. Also, PSCM implemented a long-term compensation arrangement for eligible Pershing Square employees. After a period of negative investment performance, it is important that the Investment Manager’s employees are committed to creating long-term value for the shareholders of PSH.
High water mark
INVESTMENT MANAGEMENT FEES/HIGH WATER MARK
The Board is aware that there has been much discussion in the media and elsewhere about the level of fees paid to investment managers. For many years the industry standard has been a 2% asset-based management fee and a 20% performance fee paid on annual profits. The terms of our IMA with PSCM (a 1.5% management fee and a 16% performance fee) are substantially below this level, and include a variable performance fee (the “Variable Performance Fee”) provision that is unique in the industry. The Variable Performance Fee has the potential to further reduce the 16% PSH performance fee by an amount equivalent to 20% of the performance allocation/fees generated by PSCM and its affiliates from its affiliated fundsiii.
In 2016, the Investment Manager offered a new fee structure to its private fund investors that will increase the level of total fees paid in years in which the gross return exceeds 16.5% and decrease the level of total fees paid in years when the gross return is less than 16.5%. PSCM has generated an annualized gross return of 20.6% since the inception of its fund with the longest track record. Over the long run the Investment Manager believes that it will earn higher performance fees from this share class, and this in turn will benefit PSH shareholders by reducing the 16% PSH performance fee.
The terms of PSH’s IMA with PSCM also have a “high water mark” feature such that investors in PSH only pay performance fees on increases in NAV above the highest NAV at which a performance fee has previously been charged. As a result, PSH investors will not incur any performance fees until PSH’s NAV exceeds the high water mark of $26.37 per share.
Despite negative performance for the year, 2016 was an important year of progress for Pershing Square. Our progress is reflected in the 16.3% increase in NAV from the bottom on March 31, 2016 through the end of 2016 despite a further 390 basis point headwind from our investment in Valeant. More importantly, with the benefit of the perspective which comes from looking in the rear view mirror, we have had the opportunity to understand and learn from our mistakes, to reaffirm the core principles that have driven our substantially above-market returns since inception, and to make a number of important human resource and process changes to the organization that should serve us well going forward.
Viewed in its entirety, our 13-year performance since the inception of our strategy (as represented by Pershing Square, L.P., our fund with the longest-term record) has been strong, despite the recent period, as we have generated a compound annual return of 14.8% compared to the S&P returns of 7.7% for a cumulative total return of 503.1% vs 163.4% as depicted in the chart on page 8 of this report. While our long-term record has been strong, this is not helpful to investors who have joined us more recently due to the large loss we incurred in Valeant over the last 20 months.
While Valeant was initially a passive investment, after the stock price collapsed, in March 2016, our Vice Chairman, Steve Fraidin, and I joined the board. Over the past year, the company has replaced senior management with new executives, recruited 10 new directors, refinanced and renegotiated covenants on the company’s debts, initiated a non-core asset sale program which has resulted in asset sales at value- and credit-accretive prices, provided improved investor transparency, increased R&D investment, and achieved major new product approvals. Normally, one would have expected this progress to be reflected in an increase in share price, but that has not yet materialized.
We have grown to admire Joe Papa and the new, extremely hard-working, Valeant management team. We have enormous respect for the other very talented members of the Valeant organization who have stayed at the company through this challenging time. Valeant would not exist without the commitment of these individuals. The new board, which includes a few members of the original board, is doing an excellent job overseeing the company and navigating a difficult situation.
With a new senior management team, new board, and the company’s recently executed debt transactions, we believe that Valeant has been stabilized and now has sufficient resources to enable it to recover to its full potential. In addition, we continue to believe that the company owns high quality non-core assets which can be sold at prices which will enable the company to reduce debt on an economic and credit-accretive basis. We wish Joe, the new board, and the entire Valeant team great success in the future.
We recently sold Valeant at a price that may end up looking cheap. Why?
At the time of sale, Valeant represented about 3% of the Company. If the stock price had increased even very substantially from here, the impact on our overall performance would have been modest, and would not compensate us for the human resources and substantial mindshare that this investment had and would have continued to consume if we had remained a shareholder. Furthermore, while Valeant has made significant progress and we expect management to continue to do so, there is still a lot of work to be done.
Clearly, our investment in Valeant was a huge mistake. The highly acquisitive nature of Valeant’s business required flawless capital allocation and operational execution, and therefore, a larger than normal degree of reliance on management. In retrospect, we misjudged the prior management team and this contributed to our loss. We deeply regret this mistake, which has cost all of us a tremendous amount, and which has damaged the record of success of our firm.
While there are many lessons from our investment in Valeant which we have previously discussed at length, we highlight a few important reminders from this experience:
Fannie Mae (FNMA) / Freddie Mac (FMCC)
The 30-yr fixed rate mortgage is a unique feature of the US mortgage market that significantly improves affordability and is vital to maintaining current home values. Fannie and Freddie have historically been, and continue to be, essential to allowing for widespread access to the 30-year fixed rate mortgage at a reasonable cost.
Since Fannie and Freddie were put into conservatorship in 2008, there have been a variety of proposals to replace or wind them down, however, none of the proposals have been adopted because there is simply no credible alternative to Fannie and Freddie. Fortunately, there is a relatively quick and simple solution to the current situation: Fannie and Freddie’s business models can be reformed by significantly increasing the GSE’s capital requirements, eliminating their fixed- income arbitrage business, substantially strengthening their regulatory oversight, and developing appropriate compensation and governance policies.
We believe the new administration has the willingness and ability to make the necessary changes to Fannie and Freddie’s business model to preserve widespread access to the 30-year fixed-rate mortgage. The new Treasury Secretary, Steven Mnuchin, is a mortgage market expert, and his recent public comments highlight his desire to reform Fannie and Freddie:
“[We have got to] get Fannie and Freddie out of government ownership. It makes no sense that these are owned by the government and have been controlled by the government for as long as they have. In many cases this displaces private lending in the mortgage markets and we need these entities that will be safe. So let me just be clear we’ll make sure that when they’re restructured they’re absolutely safe and they don’t get taken over again but [we have got to] get them out of government control.” (Footnote: Nov. 30, 2016)
“[…] it’s right up there in the top 10 list of things that we’re going to get done and we’ll get it done reasonably fast.” (Footnote: Nov. 30, 2016)
“For very long periods of time, I think that Fannie and Freddie have been well run without creating risk to the government, as well as they’ve played an important role…I believe these are very important entities to provide the necessary liquidity for housing finance and what I’ve committed to is that I will work with both of the Democrats and Republicans. What I’ve said and I believe, we need housing finance reform, so we shouldn’t just leave Fannie and Freddie as is for the next 4 or 8 years under government control, without a fix. I believe we can find a bipartisan fix for these so on the one hand we don’t end up with a giant bailout, on the other hand that we don’t run the risk of completely limiting housing finance.” (Footnote: Jan. 19, 2017)
In 2016, Fannie and Freddie’s total shareholder returns were 137.8% and 130.9%, respectively, as the share prices rose dramatically after the election. In the first two months of 2017, Fannie and Freddie’s share prices have declined nearly 25% after a ruling in the appellate court upheld most of the original rulings of the D.C. District Court in September 2014. We think the market has overreacted to the recent ruling, and several other legal cases, including the Court of Federal Claims case under Judge Sweeney, continue to proceed favourably.
We believe that Fannie and Freddie offer a compelling risk-reward as there are various scenarios which will generate a many-fold multiple from current levels. While a total loss is possible, we believe the probability of a total loss is relatively modest, and has become lower in the new political environment.
Herbalife Ltd. (HLF) Short
On July 15, 2016 the FTC filed a damning Complaint against Herbalife and simultaneously entered into a Stipulation to Entry of Order for Permanent Injunction and Monetary Judgment (the “Permanent Injunction”). The FTC alleged that Herbalife operates illegally and alleged violations of Section 5(a) of the FTC Act. Notably, the findings of the FTC substantially agree with our long held assertion that Herbalife operates as a pyramid scheme. Select assertions by the FTC include that:
“[Herbalife] does not offer participants a viable retail-based business opportunity.”
“Herbalife’s business model primarily compensated members for recruiting new distributors to purchase product, not for selling product at retail…”
“[P]articipants’ wholesale purchases from Herbalife are primarily a payment to participate in a business opportunity that rewards recruiting at the expense of retail sales.”
“The overwhelming majority of Distributors who attempt to retail the product make little or no net income, or even lose money, from retailing the product.”
The Permanent Injunction, as described by the FTC, represents Herbalife’s agreement to engage in a “top to bottom” restructuring of its business model in the United States to “start complying with the law.”
In November 2016, Herbalife announced that Michael Johnson will transition to Executive Chairman in June 2017 (shortly after the FTC Permanent Injunction takes full effect in May) at which point Rich Goudis, the current COO, will take over as CEO.
Also in November, John Oliver’s Last Week Tonight aired a 30-minute segment on multi-level-marketing companies with a specific focus on Herbalife which has been viewed more than 9.5 million times on YouTube (including 2 million views in Spanish). We believe this segment, coupled with the recent theatrical release of “Betting on Zero” on March 17, 2017 (with AppleTV and Amazon distribution to follow in April), will continue to shape the public narrative and highlight the tremendous harm Herbalife has and continues to inflict upon millions of Americans.
From a financial perspective, HLF’s operating results in 2016 were disappointing to long investors as mid-single-digit topline organic growth was negatively impacted by significant foreign exchange headwinds causing sales to be relatively unchanged vs. 2015. Organic growth decelerated across most regions as the year progressed, declining 1% in Q4. The deceleration of Herbalife’s China business was particularly notable, posting a -6% organic decline in Q4 (-12% actual). Adjusted EPS, which for Herbalife substantially overstates economic earnings, declined modestly in 2016.
Management has guided to 4% to 7% 2017 constant currency revenue growth and currency neutral EPS growth of -13% to – 5%. HLF’s 2017 EPS guidance of $3.65 to $4.05 implies realized EPS declines of -25% to -16%. This guidance includes the incremental interest expense associated with the company’s $1.3 billion refinancing completed in February 2017, but does not include any benefit from potential share buybacks (the board has put in place a $1.5 billion normal-course authorization). Actual EPS will likely be better than current guidance if the company repurchases shares.
In February 2017, Herbalife disclosed a new investigation by the SEC and Department of Justice related to Herbalife’s anti-corruption compliance in China. While it’s difficult to know the specific focus of the probe, any disruption to Herbalife’s China business would likely impact the company’s financial performance given the large size of the China market for Herbalife (~19% of revenue). Pyramid schemes are confidence games. The newly disclosed SEC/DOJ corruption probe, the CEO departure, declining earnings, and the deteriorating popular perception of Herbalife will likely impair distributor confidence. Furthermore, we believe the injunctive relief demanded by the FTC is likely to affect Herbalife’s financial performance beginning in the second quarter of 2017. With decelerating growth in many international markets, Herbalife’s earnings will likely decline in 2017. We remain short Herbalife because we believe its intrinsic value is meaningfully below the current share price, and we believe the stock should eventually decline to zero.
Herbalife’s total shareholder return was -10.2% in 2016.