The Billion Dollar Bet – A Reconstruction of Ackmans Battle against Herbalife

Last February, billionaire and activist investor Bill Ackman’s hedge fund, Pershing Square Capital Management, exited their short position in the nutrition company Herbalife (HLF), putting and end to Ackman’s $1 bn. bet that Herbalife’s stock price would crash.

This all started about six years ago. In 2012, Bill Ackman, the CEO of Pershing Square Capital Management, took a short position in the company Herbalife of about $1 bn. Initially, the stock tanked about twenty per cent in three days’ time, only to rebound later. Ackman’s crusade against Herbalife had begun, as he called the company “a well-managed pyramid scheme”. At the same time, however, Carl Icahn, another Wall Street heavyweight, was building up his stake in the company. With his holding company Icahn Enterprises, he gained over 25 percent of Herbalife’s shares, opposing Ackman’s strategy.

The two even get in a verbal fight with each other on CNBC News, after Icahn attacked Ackman on his allegations about Herbalife’s pyramid scheme. While Ackman was being interviewed about these attacks, Icahn called in to the broadcast and called him a liar, “cry-baby” and having “one of the worst reputations on Wall Street.” Two years later, they make up for the fight, but still continue their fiercely opposing strategies.

Herbalife is a global corporation that develops, sells and markets different kinds of nutrition supplements and other nutrition solutions. Contrary to many other brands, Herbalife does not sell its products in regular stores, but through independent distributors that market and sell the products. On top of a percentage of sales, distributors get a type of performance pay if they recruit new distributors. According to Ackman, this is the precise point at which the business model becomes shady. In December 2012, he claimed that distributors “primarily obtain their monetary benefits from recruitment rather than the sale of goods and services to consumers”, resembling a pyramid scheme.

In a pyramid scheme, people are being recruited by a business under the promise of benefits for recruiting others, instead of payments for selling products or services. As the number of recruitments increases rapidly, most members are unable to profit as the pool of potential recruitments dwindles quickly. As the directors of the business receive a part of the payments per customer, running a pyramid scheme is potentially very lucrative for them.

Herbalife has always denied these allegations of running a pyramid scheme. In 2016, however, without mentioning the specific words of a pyramid scheme, Herbalife agreed to pay $200 million and change its business model after an investigation by the U.S. Federal Trade Commission (FTC). According to the FTC, the settlement entailed a significant change in how Herbalife would operate. It required the company to pay its distributors according to retail sales, instead of the recruitment bonuses. This represented a major blow for Ackman, but he continued his battle to bring down the company as he argued that Herbalife would collapse under the new operating constraints. Pershing Square reported to the media that “We expect that once Herbalife’s business restructuring is fully implemented, these fundamental structural changes will cause the pyramid to collapse as top distributors and others take their downlines elsewhere or otherwise quit the business.

Over the course of the last 5 years, Herbalife stock has been in a roller coaster, trading as low as $27 and slightly off $80. The big collapse, that Ackman predicted did not come true, however. The company kept existing and as Herbalife shares were up more than 50 percent over the first eleven months of 2017, partly due to Herbalife’s aggressive share buybacks, Ackman revealed a new bearish strategy. Claiming that Herbalife was trying to trigger a short squeeze, a situation where share prices rise rapidly and force investors with short positions to close them, Pershing Square Capital converted its short position in put options. The advantage of buying put options, is that it limits potential losses. In the case of Ackman, potential losses will be capped at 3 percent of the total capital of Pershing Square Capital, according to Reuters. In February 2018, Ackman announced that he exited his position in Herbalife and cut his losses. Herbalife shares were up more than nine per cent after the news that Ackman’s betting war was finally over.

Ackman is no stranger to these kind of activist investments. In 2004, he established his notorious hedge fund Pershing Square Capital Management. More than once, he has launched activist campaigns against companies like McDonald’s and Wendy’s. For example, in 2005 Pershing Square pressured Wendy’s to sell its doughnut chain and profited substantially after Wendy’s raised about $700 bn. with the IPO of its spin-off. Moreover, Ackman earned his reputation as cowboy investor during the 2008 financial crisis. As one of the first investors, he spotted that the mortgage market would collapse because of the excessive trade in collateralized debt obligations (CDO’s) and shorted big players in the mortgage market, such as Fannie Mae. When the bubble burst, Pershing Square made a profit of over one billion dollars.

On the other hand, Ackman has suffered some big losses. Next to his failed attempt to profit from his position in Herbalife, he lost big amounts of money on his investments in the pharmaceutical Valeant and retailer Target.

Whereas it is impossible for small investors to invest in hedge funds, because of their huge entry and management fees, you can place your bets on Ackman by buying securities of Pershing Square Holdings Ltd., a public closed-end fund designed to track Pershing Square’s performance. So, if you do believe in Ackman’s activist philosophy, but feared his major stake in Herbalife, now is the time to put your money where your mouth is and place your bets on Pershing Square.

Written by Joppe de Bruin