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Editor’s Note: Think Tank is a periodic column written by industry leaders and other critical thinkers. Today’s column is written by Robert L. Chapman Jr., managing member of Chapman Capital LLC.
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Recent developments within Pershing Square Capital Management’s portfolio have exposed several precarious cracks in the foundation of shareholder activism. In William Ackman’s defense, the very same traps that snared Pershing’s long investment totaling nearly 20 percent of J.C. Penney Co. Inc.’s outstanding shares and short positioned speculation estimated at over 20 percent of Herbalife Ltd.’s share count — limited liquidity and nearly unlimited visibility — are the same that led me to refocus my own investment style toward entirely passive and “sub-13D” activism and away from the hostile shareholder activism that Chapman Capital trail-blazed some 17 years ago.
Before I address those two high hurdles of shareholder activism, let’s take a step back and define the three primary forms of value added, or “alpha,” that managed hedge and mutual fund portfolio managers claim to provide. The most common of the three is Due Diligence Alpha, which at its peak performance can be CIA-level investigations that provide a research edge without crossing the line as defined by the SEC. Secondly and most common amongst micro-small capitalization fund managers is what I call Dislocation Alpha, capitalizing on stock/market “quakes” to buy positions via liquidity provision when there are few other bids to be found. The third and most relevant to Penney’s is Shareholder Activism Alpha, which in essence involves the liberation of targets from entrenched, inept management or valuation-limiting public market status.
In theory, shareholder activism, when practiced correctly, allows the portfolio manager to reduce investment risk while accelerating reward. The activist should create both a) Containment — something akin to a “probation officer” who injects restraint upon potentially reckless or negligent corporate fiduciaries, and b) Marshall Plan — the activist is like a “drill sergeant,” hastening the closure between private/restructured and public market value. However, like a certain type of individual with his-her unique, particular physical and psychological makeup, certain companies are less pliable and thus less changeable. Around Chapman Capital we’ve always made it a priority to determine early on if the variable requiring change is a state (which can be modified) or a trait (which is hard-wired to the target company’s “DNA”). If the problem is of the trait variety, it is typically prudent to move on to the next name on the hit list.
So what are the activist shareholder’s obstacles to liquidity and visibility? Essentially, when an activist like Pershing Square has filed a Schedule 13D in a target company but then realizes that, for whatever reason, the investment was a mistake and should be reversed, unwinding that position delicately becomes nearly impossible. Liquidity more often than not is a serious problem, as odds are the activist desires to remove outsized (more than 5 percent of outstanding shares) exposure to his investors from a public company’s shares for the same fundamental reasons and at the same time that Wall Street’s masses are punting as well. Moreover, due to the prior 13D filing made by the activist, every sale of 1 percent or more of the target company’s shares must be reported promptly on a 13D Amendment until the activist takes his position below 5 percent of the target’s outstanding shares.
Consider these issues of liquidity and visibility as it relates to Ackman’s Penney’s fiasco. The 39 million shares of Penney’s that Pershing Square sought to sell required the hiring of investment bank Citigroup to handle what equates to an underwriting for Pershing Square. As compared to a sub-13D activist who, after realizing the excessive risk of maintaining his investment, can gently distribute his position via open market positions over a brief period of time, Pershing Square did not have that luxury as the market cannot easily digest that big of a sale. Making matters worse, there is no legal way for Ackman to hide the vomiting of the Penney’s shares onto the market without making public disclosures. This visibility into Ackman’s reversal from his target and Ron Johnson’s number-one cheerleader to a guy (with nearly perfect inside information) bolting for the exits just exacerbates the activist’s troubles in getting out alive.
Bill Ackman not only lived by the bazooka gun of a big-game hunter, but he thrived with both barrels swung over his shoulder. However, when the beast of the market turned on him, his heavy hunting shoes and the weight of that gun made a graceful escape nearly impossible. Though the story of his Penney’s debacle is now officially over, he still claims to remain short more than 20 percent of another public company with 10 to 20 percent revenue growth, more than 20 percent earnings per share growth, a quickly shrinking/repurchased share base and two of Wall Street’s legendary hedge fund managers, Carl Icahn and George Soros, on the other side of Ackman’s Herbalife trade. Odds are high that by the time Bill Ackman has gone through the hell of covering his Herbalife position, he’ll look back at his days with Penney’s as a slice of heaven.
Robert L. Chapman Jr. is managing member of Chapman Capital LLC, a trailblazer in activist investing and a specialist in takeovers and turnarounds. Chapman more recently has been on the opposite side of Pershing Square’s trades in Herbalife Ltd. and J.C. Penney Co. Inc. Chapman has long position exposure to both stocks.
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