Billionaire hedge funders play poker over an activist target
At an investor conference last December, hedge fund activist Bill Ackman spent 3½ hours explaining why Herbalife, the 33-year-old direct marketer of nutritional supplements, was nothing more than a Ponzi scheme whose stock was worthless. Ackman told the audience that he had shorted $1 billion of the stock and, within a week, Herbalife’s share price tumbled from $42.50 to $26, an almost 40% drop.
After the stock plunged, Dan Loeb, an equally persuasive hedge fund activist, challenged Ackman’s conclusion on Herbalife and publicly disclosed his purchase of more than 8% of the company for $300 million. Herbalife’s stock quickly rebounded 10%.
Then, Carl Icahn, the gutsy 77-year-old corporate raider, hedge fund manager and now activist, joined the high-stakes poker game by acquiring 13% of Herbalife for $600 million. Icahn insisted that Herbalife was not a pyramid scheme and, given its current depressed price, presented a compelling investment opportunity. To make the deal even sweeter, Icahn also revealed that supporting Herbalife gave him a chance to avenge a decade-old contract dispute with Ackman that he lost in 2011.
Icahn’s dramatic entry into the contest over Herbalife triggered a 21% spike in the company’s stock price, bringing it back to the level at which the stock was trading just before Ackman made his presentation. It also induced Dan Loeb to cash out of his investment and pocket an easy $50 million profit (an almost 200% return on an annualized basis). Icahn, on the other hand, determined to stay in the game, at least in part to avoid triggering the short-swing profit rule* which would require his disgorging to Herbalife any gains he might have made from buying and then selling his stock in such short order. In fact, Icahn may even raise the stakes via an option he recently negotiated with Herbalife to buy up to 25% of the company. He also got Herbalife to add two of his representatives to its board.
What the Herbalife kerfuffle clearly illustrates is how much market power hedge fund activists actually wield. Top guns like Ackman, Loeb and Icahn can now easily and substantially pump up or deflate the stock price of a target company by merely announcing their intentions or stock positions (see The First Ten Days of an Activist Campaign).
Prior to Herbalife, activism was considered a long-term play. The whole idea was to make money by pressuring target companies to improve their governance structures or restructure their businesses in ways that would eventually lead to increases in their stock prices.
Prior to Herbalife, activism was considered a long-term play. The whole idea was to make money by pressuring target companies to improve their governance structures or restructure their businesses in ways that would eventually lead to increases in their stock prices. That objective aligned the interests of hedge fund activists with those of passive shareholders and earned activism the reputation of being a public good.
What socially-beneficial purpose, however, was served in what Dan Loeb was cleverly able to pull off with Herbalife? Was it fair to the investors who unwittingly sold their stock to him before he publicly challenged Ackman’s huge short? For that matter, how do we justify Ackman’s and Icahn’s enormous accumulations of Herbalife stock before they disclosed them to the public? Knowing in advance what effects their activist announcements would have on the market, couldn’t all three billionaires be likened to ‘inside traders’?
Obviously, Ackman, Loeb and Icahn were not trading on what is conventionally understood to be material, nonpublic information. Their intentions to either attack or defend Herbalife came from them and not from others, so their trading on that “information” violated no duty and their MNPI was in no sense misappropriated. To call their stock accumulations “securities fraud” would therefore be misplaced.
Nevertheless, something does feel wrong about letting powerful activists have their way with the market prices of their targets. Although they aren’t appropriating price-sensitive information from anyone, they are definitely using it to their advantage and the disadvantage of unsuspecting others. Perhaps the way to reallocate that seeming unfairness is to extend the short-swing profit rule to announced activists with smaller than 10% long positions. In that way, activists could still accumulate stock without violating the law, but they could not quickly turn those positions over at a profit and abandon whatever useful management-related purposes their campaigns were supposed to serve. It would feel a little like forcing derivatives players to keep real skin in the game.
*Under US law, anyone who owns more than 10% of a publicly-traded stock has to disgorge to the issuer any profits made on any combination of purchases and sales of that stock during any six-month period. Interestingly, the short-swing profit rule does not apply to Ackman’s greater-than-10% interest in Herbalife because it is a short position.