Currently, Pershing Square Holdings (OTCPK:PSHZF) offers investors an opportunity that is very rare in the investment markets. The chance to invest with a hedge fund manager with a strong track record, without being subject to a performance fee.
Pershing Square Holdings [PSH] is the public hedge fund (IPOed in Amsterdam) run by Bill Ackman. The stock also trades on the US OTC market with the symbol PSHZF.
Ackman is a controversial figure. He is one of those 'love it or hate it' people in finance. Lately, as a result of his short on Herbalife (NYSE:HLF) and long in Valeant (NYSE:VRX), it has been mostly 'hate it'. Yet, that does not change the fact that his stock picking skills are very strong. Since starting Pershing in 2004, he has developed an enviable track record:
To make things simpler, let's call this 19% annual returns vs. 7.7% of the S&P 500. But that understates his returns because he charged the typical 2/20 structure of fees to his investors. An investment in PSH right now does not include a 16% performance fee (which was reduced from 20% to investors in the public stock) because the NAV of the fund is quite a bit below its high watermark ($25 a share). It does include an asset management fee but that fee was reduced to 1.5% for investors in the public hedge fund.
His gross returns, according to a Forbes Article, have been 1200% since 2004 to late 2014, which comes out at a 25.3% annual compounded return. This is more than triple the return of the S&P 500. Even if you take out an asset management fee, the return is still extremely strong. The chance that someone can produce these returns for so long through pure luck has to be lower than the chance of being eaten by a shark and struck by lightning at the same time.
But what about Gotham Partners?
Ackman did manage another hedge fund before Pershing Square. It was called Gotham Partners and it eventually was liquidated when illiquid investments and an investigation by an Attorney General soured his funds.
Yet his returns on Gotham were still good, even if the fund eventually failed. According to the WSJ:
"The decision to close the fund surprised investors, who were told only weeks ago that Gotham's performance was flat in 2002, not a bad outcome for a rough year for the market. Gotham, one of the most publicity-hungry hedge funds in a business with many secretive players, had racked up annual gains of 20% since its inception in 1993."
"Investors in the Gotham hedge fund may face losses of as much as 20% of its current assets in coming months if Gotham Golf is judged worthless. (Gotham Partners is no relation to Gotham Capital LLC, another hedge fund.)"
So, essentially if you invested in Gotham, you made 20% a year all the way to the last year, where you lost 20-30%. This is hardly a disaster. Even if you invested in Gotham in the last year, lost 20%-30% and then invested in Pershing Square, not only you would have beaten the market but you would have done so by a huge margin.
This was probably the biggest mistake Ackman ever made. Putting all fund money in one trade and trying to make it work by being an active investor simply did not match with expectations of his investors. His investors never expected they could have lost that much. But at the same time, if someone opens a new fund and tells you he is going to put 100% of the fund in one trade idea, you have all the warning that you need. Sending more than 5-10% of your funds there is simply not prudent. If someone put a substantial portion of their net worth to that fund and lost it all, they got what they deserved. Concentrated value investing does not mean you have to be stupid. Anyone who has studied compounding knows that avoiding significant drawdowns is a key element of good long-term returns. This is why Warren Buffett says rule one is to not lose money and rule two is to remember rule one.
Current state of Pershing Square Holdings
Another reason to be like PSH, in addition to no performance fee all the way to $25 NAV a share, is the fact that almost all of his holdings have been beaten down along with VRX. This has created a unique situation that Ackman describes in his letter to investors:
"While we believe that the portfolio's intrinsic value increased, the mark-to-market value of our portfolio has declined substantially since the beginning of the year. As a result of this divergence, we believe that the Pershing Square funds are trading at perhaps the greatest discount to their intrinsic value that we have seen since the inception of the firm."
So not only you can invest with one of the best stock pickers of his generation, not only you will pay no performance fee (and a reduced asset management fee), you will also pick up his portfolio at perhaps the largest discount to intrinsic value that he has seen since starting his fund.
This unique opportunity is too good to pass up.
But what about VRX?
I understand the concerns. Heck, I'm concerned too, not with the investment itself (I believe it will work out fine, even if it gets bumpy along the way), I'm more concerned about his size on the stock in relation to everything else. I estimate that his exposure is around 15% of his fund. I believe that is quite high and I'm not comfortable with that level of exposure. If that investment were to sour at the same time as other investments, it could create a problem for his funds.
According to the longs and shorts, VRX is either going to $200 or $0. That is a lot of exposure in a stock that in a reasonable scenario could be a zero. Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) are two other stocks that can go to $0 and he has a much smaller (and more appropriate) exposure to those stocks. What I did to get comfortable was to short VRX in a specific proportion in order to synthetically get his fund exposure down to 5-7%, which I'm more comfortable with. I'm still net long VRX, just in a smaller proportion.
What about HLF?
I wrote about this stock before; essentially, it is a very complex situation that I have no strong opinion about. But from a fund exposure perspective, he was forced to cut down his position by his prime broker and switch partially to put options. This makes the position less risky. I believe his prime broker is likely to do the same thing if HLF were to start some kind of big run. This effectively is like a stop loss and limits the riskiness of his exposure. As of right now, he has something like a 5% short in HLF (plus put options). Even if HLF were to pull a Volkswagen (that is, quintuple in price in a day), he would still survive. It would be a significant hit to the fund but he could survive it if redemptions were kept under control.
Despite all the cry from the likes of ZeroHedge about how Ackman might blow up, his fund is facing very little redemptions. This is from the latest letter to investors:
"With a large and growing divergence between intrinsic value and market value, the stability of our capital becomes an even more important factor in our long-term success. In recent years, we have made material improvements to the stability of our capital. With the launch of Pershing Square Holdings, Ltd. (PSH), substantial growth in employee investments in the funds, and the $1.0 billion bond offering by PSH, nearly half of our capital is effectively permanent.
The balance of our funds is also quite stable as the substantial majority of our private funds has one-eighth per quarter liquidity and is held by investors (other than several new investors who joined in the last year), who have made large profits over many years of investment in Pershing Square.
Despite the substantial decline in the funds' performance from August to the present, our net redemptions were nominal at $39 million or 0.2% of capital for the third quarter, and $13 million or 0.1% in the fourth quarter. As a result, we have not been forced to raise cash as the portfolio declined, but have been able to be opportunistic. The recent substantial increase in our economic exposure to Valeant at recent lows in the stock is a good such example"
It's important to remember that in the public hedge fund, there are no redemptions. Investors buy and sell the stock in the open market and the IPO proceeds stay with the company.
Buying Amsterdam stocks
Even though there is an OTC ADR of this stock, it is quite illiquid. The best way to buy this is to get the stock from the Amsterdam stock exchange. If your broker does not allow you to buy stocks there, try finding one that does. I used Interactive Brokers to acquire my stake.
US Tax considerations
This fund is considered a Passive foreign investment company. This creates different reporting and tax considerations for US citizens and US residents. Consult with an tax expert to learn further details.
Risk management and Final considerations
So essentially, right now, you have the chance to invest with a manager that has a strong record, paying very low fees and with a portfolio that has a significant discount to its intrinsic value. Yet, his strategy (concentrated value investing) is not a low risk strategy. I would not "go all-in" in his fund. I would limit any exposure to any one hedge fund or a specific risky manager to 10% or 20% of investable assets. Anything more and you run the risk of significantly damaging your long-term returns in case something goes wrong. If someone puts 15% of investable assets in opportunities like this (less if you are conservative), they would have something like six or seven high return low risk opportunities while retaining a decent level of diversification. Essentially, the best of both worlds.
This article does not constitute investment advice, do your due diligence and consult your financial advisor
Disclosure: I am/we are long PSHZF.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am not a registered investment advisor and do not provide specific investment advice. The information contained herein is for informational purposes only and I can't guarantee the accuracy of all the information presented in this article. Nothing in this article should be taken as a solicitation to purchase or sell securities. Investing and trading includes risks, including loss of principal.