Thoughts on Pershing Square's Q1 Letter to Investors

On June 8th, Pershing Square (PS) issued its Q1 letter to clients (below).

http://www.scribd.com/doc/16261914/Pershing-Squares-Q1-Letter-to-Investors

After a thorough read, I felt it necessary to expand on some thoughts I had that underlie the essence of what it means it to be a value investor, and how PS seems to combine value investing, shareholder activism, and corporate governance.

First off, paradoxically, where PS failed in its proxy contest with the Target (TGT) Board of Directors, they actually succeeded in producing what matters - an increase in shareholder value. An increase in the stock price of TGT is not a long-term increase in the value of the company, however, the end result is desirable, as it shows that capitalism and the corporate governance process seem to work, albeit with their own set of issues. Specifically, the existence of a universal proxy card and non-anonymous voting in one of the largest corporations in America shows that corporate governance is still a major issue throughout the developed markets, however, this is getting better over time. It also represents opportunities for further value creation. Note that PS' methodology of "governing the corporation" is a massive change from the "wild west" days of the 80's and 90's where shareholder activism denoted hostile takeovers, 13-D's forcing the sale of the company, etc. In this day and age, shareholder activism has been transformed and refined. In form, PS is a hedge fund, however, its actions with McDonald's (MCD), TGT, and Border's Group (BGP), resemble tactics similar to those of a VC or private equity investor. Proxy contests, board / management changes, strategic planning proposals, capital allocation changes - these are but a handful of the methods that modern day shareholder activists now use to produce long-term increases in the value of a company. In the future, the TGT Board may or may not produce the desired economic results. However, the threat of loud, powerful, and credible investors with reasonable complaints and viable plans are enough to cause boards the grief necessary to make positive changes. This is the way forward, and I believe that with the recession still in full force, shareholder activism will come back with a vengeance once money managers recuperate and get over the market and business dislocations of the past year. These corporate governance issues existed before the credit crisis, and they represented an opportunity for an increase in shareholder value then. Now there are price-to-value gaps across countries, asset classes, and sectors, and this is just gravy for value investors that can spot opportunities, have the resources available to stake claims in companies, and eventually push for changes to close these gaps while increasing economic value - the holy grail of investing.

While the media has been focused on PS' proxy dance with TGT, the most interesting portion of the letter is actually in regards to PS' investment in General Growth Properties (GGP). It exhibits two interesting points about value investors. First off, true value investors do not define themselves by asset classes or sectors. They are agnostic in terms of the investment form, and only search for investments that exhibit two basic qualities 1) excellent probability of limited downside in a worst-case scenario, 2) excellent probability of material upside in the worst-case scenario. This is evident by PS' purchase of GGP unsecured debt and equity, while already expecting it to file for Chapter 11. Value investors are often viewed by the public to be invested solely in stocks, however, at the right price, anything can be a value play, and true value investors will ALWAYS seek legal and contractual protection (read: limitation of downside) by moving up the capital structure, provided risk-reward is to their liking. PS's purchase of unsecured debt exhibits this, however, it's investment in equity exhibits a search for what is essentially free (or low cost) optionality - another hallmark of value investors. Secondly, value investors routinely play in spaces where they have an edge and where there is limited competition. PS' edge is in real estate, as it had extensive real-estate experience from its dealings with MCD, TGT, and other portfolio companies. In reviewing PS's attempt to provide GGP with DIP financing at ludicrously attractive terms (to PS) when nobody else wanted to, it is apparent that a lack of competition confers the ability to earn above average returns. While PS' DIP financing proposal ultimately failed, GGP's board did what it was supposed to do and solicited more attractive DIP financing. In this scenario, PS earned $15mm without even putting up a dime of its proposed $375mm commitment. Should PS's proposal actually have gone through, it stood to make ~$110mm (assuming static LIBOR) on a $375mm investment (~29%) over an 18 month time frame, all while maintaining the most senior portion of the capital structure, which was backed by first-lien AND second-lien collateral. This does not even include the zero strike warrants for 4.9% of the post-bankruptcy entity (IE - free optionality), which could have been worth tens of millions upon exit. Although their proposal failed, this still benefitted PS, as the auction process for the financing increased the probability of GGP exiting chapter 11 in good financial shape, and thus allowing PS to make multiples on its unsecured debt and equity investments. A bitter-sweet end to the DIP financing process, but still much more sweet than bitter. This example demonstrates how value investors focus on limited downside and material upside in all investments.

A quick look at the statement by PS regarding the sale of stocks in its portfolio illuminates another principle. While value investors search for absolute value, at the end of the day, everything is relative. This is why value investors are agnostic, as Wendy's common at a 30% discount to intrinsic value is actually rich when compared to General Growth Properties senior unsecured debt at 50% to face value / post-bankruptcy value. Similarly, GGP senior unsecured debt at 50% to face value is rich relative to DIP financing at a 4% commitment fee, 3% exit fee, LIBOR + 12%, and free zero strike warrants for 4.9% of the post-bankruptcy common. It is all relative, and selling cheap investments to buy cheaper investments, while psychologically frightening, is actually the most rational thing one can do.

In PS' brief paragraph on "Equity Shorts", it is interesting to note that this hedge fund is actually doing what it promises it will do - hedge. Hedging is a rational action, as it theoretically allows for the "locking in" of a spread or profit. Although, I believe PS' walks a fine line with this as long / shorts are not perfect hedges and it risks being caught offside on its short position (see Greenlight Capital and the drubbing it took on its Volkswagen trade in October 2008). The only modicum of comfort comes from GGP and TGT having multiple differentials that allow for higher upside than their corresponding shorts, yet similar downside potential. In order for these hedges to work, correlation must initially be high, and must stay relatively static, if not improve. With no event (IE - closing of a deal as in risk arbitrage) forcing convergence of the multiple differential to zero, these are not true hedges, but simply fit the bill in eliminating some uncertainty. It should be noted that economic / sector risk is (almost) eliminated, while business-specific / event risk is added to the picture. This is why long / short investing does not represent true hedging, and is closer to the "art" side than the "science" side on the arbitrage scale.