The Alpha Masters: Unlocking the Genius of the World's Top Hedge Funds (24 page)

After Ackman met with and questioned the CEO, he confirmed the insights that he had gleaned from his research, and began to build a short position in the stock and debt of the company through the purchase of CDSs.

The only problem with this short idea, Ackman believed, was that unless somebody was willing to say that the emperor had no clothes, the game could go on for years.

On the advice of his lawyers, Ackman decided to write and publish a white paper about the company’s weak financial condition and failed business model. The market reacted quickly to the publication of Ackman’s first report on the company, entitled “Buying the Farm,” in which Ackman disclosed his short position in a disclaimer written by his lawyer on page one. “Buying the Farm” Parts II and III followed shortly thereafter when Ackman responded to a series of company conference calls that attempted to rebut his published reports.

The experience earned Gotham around $70 million after the stock sold off and credit spreads widened. Later, a report issued by the Government Accountability Office (GAO), in response to a Senate Agricultural Committee investigation, validated many of Ackman’s concerns. Shorting Farmer Mac later seemed prescient as mortgage lenders Freddie Mac and Fannie Mae, companies with a similar business model to Farmer Mac that Ackman also shorted through the CDS market in 2002, turned worthless during the financial crisis in 2008.

Pleased with the profits from his Farmer Mac investment and interested in the potential returns from purchasing CDSs on companies with undeservedly high credit ratings, Ackman began researching other potential short candidates in mid-2002. Michael Neumann, a salesman on the Lehman Brothers credit desk, who had sold him CDS contracts on Farmer Mac, suggested that Ackman look at the bond insurers.

Ackman zeroed in on MBIA. It was the largest of the bond insurers, the largest guarantor of municipal bonds in the United States. While MBIA had its origins insuring low-risk municipal bonds, in more recent years it had begun to move into the more lucrative business of insuring exotic and highly risky collateralized debt obligations (CDOs) and other structured products. Ackman believed that the company was underreserved relative to the risk it was underwriting, was overleveraged, and was engaging in various accounting devices to shield losses and accelerate gains. He believed that it was poised for a dramatic fall. Ultimately, Ackman concluded that the business, despite its triple-A rating, was likely insolvent. Ackman shorted the stock and built a large position in CDSs on the company.

As with Farmer Mac, Ackman wrote a detailed white paper on the company’s flawed business model and accounting failures. Prior to releasing it to the public, he shared the details of the report with Alice Schroeder, then the number one
Institutional Investor
–ranked insurance analyst. Schroeder sent Ackman’s findings to the CEO of MBIA, Jay Brown. Brown then contacted Ackman requesting a one-on-one meeting. At the meeting, Brown discouraged Ackman from releasing his report and suggested that MBIA would use its powerful relationships as the largest guarantor of New York State and City bonds to cause Ackman trouble: “You are a young guy early in your career. You should think very hard before releasing that report,” Brown warned.

Ackman published it nonetheless, and almost immediately, Ackman says, “a whole bunch of bad things started to happen to me.” To that point, Ackman had lived a charmed life. He was happily married to his wife, Karen, whom he had met at Harvard. He was father to two young daughters, had a sizable net worth, and had an eight-room apartment on Central Park West in the landmark Majestic apartment building.

A month or so later, in December 2002, a New York State judge issued a preliminary injunction, halting the merger between Gotham Golf and First Union, putting Gotham in an untenable position. Ackman and his partner, Berkowitz, had negotiated a deal with the Ziff family to buy out the Ziffs’ interest in the firm, and were in the process of negotiating a deal for a new investor to invest $50 million in the fund and own 15 percent of the firm. With some investors asking for their capital back and with tremendous uncertainty about the outcome of the Gotham–First Union merger, it became difficult to value Gotham’s assets for the purpose of admitting and redeeming investors.

“We ultimately decided the only fair way to treat investors was to wind down the fund,” says Ackman.

Then things got more complicated. After MBIA complained to New York Attorney General Eliot Spitzer that Gotham was spreading false and misleading information about their company, in January 2003, Spitzer subpoenaed Gotham, and the SEC began an inquiry shortly thereafter. Between March and June of that year, Ackman faced six days of testimony with the attorney general’s staff. He had no idea the battle would ultimately last for six years. He just knew that, eventually, the bond insurer’s house of cards would crumble.

Besides his sale of Gotham Golf to First Union being stopped by a New York Supreme Court judge, Ackman had to endure embarrassing public scrutiny. At that time, “there was an article in the paper seemingly every day about Gotham or hedge funds being [Eliot Spitzer’s] next target,” Ackman says. “It was not fun to take my daughter to nursery school. Sometimes it seemed as though other parents would pull their children away from me when I walked into the school lobby. When you have an aggressive regulator trying to find you guilty of something, even though you know you’re innocent, it’s a scary time.”

“It’s a very interesting experience to be accused of something in a country where you’re supposed to be innocent until proven guilty. I think regulators have a tough job. I think it’s an important job; they’re the police force of the marketplace. I just think they have to remember that the goal should be: is this man innocent or guilty? I think they are under pressure to prove guilt and that leads to some wrongful convictions.”

David Berkowitz left Gotham a few months later, in May 2003. After a decade of working together assembling Gotham, Berkowitz didn’t enjoy the stress and had no interest in going forward in the business. “David decided he had had enough and didn’t enjoy coming to the office anymore,” says Ackman.

With the overhang of MBIA still on his shoulders and his reputation dragged through the mud, Ackman felt an obligation to the investors. He worked unpaid in 2003, dealing with the issues and winding down the fund. Over the next few years, Ackman ended up returning to investors all of the liquid investments at market value and nearly three times the carrying value of the Gotham private investments.

Rising from the Ashes

Starting over wasn’t the easiest thing for Ackman to do, but it wasn’t the hardest thing he was doing at that time either. “The biggest challenge was when Eliot Spitzer, the most famous aggressive regulator in the world, had me in his gun sights and I was sitting across the table from three or four regulators who clearly didn’t care, in my opinion, whether I was innocent or guilty. They just wanted to find me guilty,” says Ackman. He did not let it affect his resolve. Ultimately, the SEC and Spitzer found no wrongdoing at Gotham or with Ackman or Berkowitz.

Despite a distressing year and without even a letter of acknowledgment from Spitzer’s office clearing his or his firm’s name, Ackman still wanted to stay in the game. Coincidentally, Ian Cumming, chairman of Leucadia National, happened to be vacationing at the same resort in Cabo San Lucas as Ackman and his wife in February 2003, and told the young manager that whenever he was ready to do something new, Leucadia wanted to be his partner. He had one stipulation: Leucadia had to be his sole partner, which meant he couldn’t accept money from any of his former investors.

In the fall of 2003, he did just that and ended up negotiating a deal with Leucadia to invest $50 million and launch his new firm, Pershing Square, with their backing. “So the only good thing I had going for me was that a very reputable investment firm with a track record better than Buffett’s from 1979 to the present agreed to put in $50 million,” says Ackman.

And so Pershing Square was born in January 2004, with Ackman vowing not to make the same mistakes twice: this time around, he would invest only in publicly traded securities.

After he made the deal with Leucadia, Ackman wrote a letter to all of his investors announcing that he was launching a new firm, but that the fund was not open to investors other than Leucadia. While Ackman always kept his investors informed even through the tough year winding down Gotham, he was surprised that the only angry calls he received during that time were from people who were disappointed that they were not permitted to invest in his new fund.

Ackman named the firm Pershing Square after the square in front of Grand Central Terminal, where his offices were located. The well-known café of the same name caused some humorous confusion for Ackman in the early days. He was having lunch at the Pershing Square Café one afternoon when the maître d’ told him he had a call from a very prominent businessman on the phone. When Ackman picked up and asked the man why he had called him at this number, he replied, “Well, I asked my secretary to find you and she just looked up Pershing Square in the directory and called.”

In June 2004, Pershing Square initiated a stake in Sears Roebuck & Company. “Sears was one of the first big investments we made,” says Ackman. “What attracted us to the company was that after they sold their $30 billion credit card business, the enterprise value declined massively. They used the money from the sale of the credit business to pay off their debt and to buy back a bunch of their own stock, yet the stock just continued to go down.”

“So we bought a stake in the company, but we were a tiny little fund without a lot of firepower. We believed the business had reached the end of its strategic life, and the pieces—the real estate, the brands Craftsman and Kenmore, Sears Home Services, the inventory, etc.—were worth a lot more than what the stock was trading. And we believed we could help unlock value by catalyzing a sale of the company to a strategic buyer—either a real estate investor or another retail company,” says Ackman. Remembering Steve Roth’s request to “come see me” with his next great idea, Ackman called him up. He pitched him and got him on board, and Vornado ended up investing about $400 million, giving Pershing and Vornado 4.9 percent of the company. Ultimately, they were a catalyst for the business being sold to Kmart in November of 2004.

Pershing also had a large position in Kmart when the deal was announced, and they made a lot of money when the two companies merged. “It was the best month in the fund’s history,” Ackman explained. That’s not the only reward Pershing received for their stellar investment; they also got a serious upgrade in office space.

Steve Roth’s Vornado owned a lot of premier office space across Manhattan, including the 888 Seventh Avenue skyscraper, which was the home to some of the world’s wealthiest hedge funds and private equity firms including George Soros’s Soros Fund Management and Dinaker Singh’s TPG Axon. The building, right across the street from Carnegie Hall, is now fully renovated with marble floors and sweeping views of Central Park. Roth gave Ackman a good deal for 10,000 square feet of space on the twenty-ninth floor. Ackman was happy. It was a big improvement from his first windowless office back in 1993.

In January 2005, Pershing was opened up to additional investors besides Leucadia. Rick Sopher, chairman of LCH Investments NV, who had been so impressed with Ackman’s dogged work on Rockefeller Center in the mid-1990s, jumped in immediately. “When Bill launched Pershing Square,” he says, “I was by then running Leveraged Capital Holdings, the world’s oldest multimanager fund. It was a rare case of it being totally obvious at the first meeting that we had to invest, and we received and subsequently subscribed on copy number one of the Pershing Square prospectus.”

Fast Food, Building Record Results

In mid-April of 2005, Ackman invested in Wendy’s, building an equity position through options, at which time he pushed Wendy’s to spin off the company’s Canadian Tim Horton’s subsidiary. “Wendy’s was the first high-profile activist investment we made at Pershing Square on our own,” says Ackman. “This was a company with a $5 billion market cap. We raised a coinvestment fund from a group of our investors, and we bought just shy of 10 percent of the company. We had started buying the stock right during the time someone supposedly found a finger in the chili at Wendy’s,” he recalls.

“That’s what helped create the liquidity for us to buy the stock,” he continued. “We were literally in the middle of our buying program when that happened. We were attracted to Wendy’s because they owned 100 percent of Tim Horton’s, a Canadian coffee and donut chain. At the time, Tim Horton’s was generating $400 million in operating income and we valued it at over $5 billion. Meanwhile, you could buy all of Wendy’s for less than $5 billion. So we figured that if you could buy Wendy’s and spin off Tim Horton’s, we would get Wendy’s for free, a company we believed was worth a few billion dollars,” says Ackman.

“The way the numbers worked is that we paid $38 a share and believed if you spun off Tim Horton’s, the stock would eventually double to $76 a share,” says Ackman.