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Welcome back to the deep dive. Today we are really digging into one of the most uh volatile and frankly consequential years in recent activist investing history. Talking about 2016 for Persian Square Holdings or PSH. Yeah, 2016 wasn't just a tough year. I mean for them it was an absolute crucible. We're looking at their annual and quarterly reports from that time and they just they tell a story of crisis management, a forced portfolio overhaul and this really dramatic high stakes pivot just to stay afloat.
And that context is so important because the numbers themselves are just they're shocking. The baseline for the year, a gross return of 12.1% and a net return of negative 13.5%. Right. And meanwhile, the S&P 500 is delivering what almost 12% an 11.9% positive return. The fund even said, you know, this was their worst 12-month performance since the whole strategy launched back in 2004.
And that pain was so concentrated. I mean, it was acute. By the end of April, the year-to- date net return had already crashed to 18%. And the immediate problem, the the colossal anchor weighing the whole thing down was just one single investment, Valent. Unbelievable. That one position contributed a negative 16.2% drag on gross performance.
just that one stock early in the year. So our mission in this deep dive is really to trace that survival story. I mean they started from an absolute bottom, right? A shocking 26.4% decline in net asset value by the end of March. Yeah. So how did they do it? How did PSH stabilize these crisis holdings, monetize their, you know, their successful long-term plays to get cash and then turn around and deploy that capital into new opportunities?
And that's the twist, isn't it? Despite that disastrous start, they managed to pull off a recovery. They delivered a 16.3% increase in NAV just from the March 31st bottom through the end of the year. It's an incredible story of triage. It really is. And the first step was dealing with the patient that was flatlining.
We have to start with the valent crisis. Okay. So, when Valen stock just completely collapsed, the manager pivots from, you know, a passive owner to this active hands-on crisis intervention. What did that look like right away? It was immediate direct intervention. A desperate move really. Two representatives, including the investment manager himself.
They go right onto the board in March 2016. And the priorities were just survival. Survival. First, stop the financial bleeding, eliminate that risk of default, and second, find new credible leadership fast. And that urgency, you can't overstate it. The fear was that the company might not even be able to file its required financial statements, which would trigger a default on all that debt.
Exactly. I mean the company was just drowning in debt and it was facing this intense scrutiny over its financials. So the critical milestone, the absolute drop deadad date was filing that 10K annual report and that happened on April 29th. It did and the relief was immense. I mean after what had to be one of the most scrutinized audits in corporate history.
Only a tiny restatement for Q4 2014 was needed. They had cleared the default hurdle. So with the the immediate financial risk contained, they move on to leadership. They had to signal stability to the market, right? And that's when they announced they were hiring Joe Papa as the new CEO in May. Papa was a genuine industry veteran.
You know, he came from Pargo where he delivered a 24% compounded annual return. So, a real heavy hitter, a very heavy hitter. And they quickly followed that by bringing in a new CFO, Paul Harrenine from Zoatus, and a new general counsel, Christina Arian. This was a rapid systemic overhaul. They had to regain any shred of credibility.
Okay, so the patient is stable. You've got new doctors in the room, but the core business model was still, you know, under fire. What was the turnaround plan? The focus shifted entirely. It became all about debt reduction and transparency. The the strategy was basically twofold. One, increase the free cash flow from the core business, and two, aggressively sell off non-core assets.
They publicly said they were targeting assets worth about $8 billion for sale. And crucially, they changed how they reported the numbers. This goes right back to that transparency issue, right? It does. They rolled out this completely new financial reporting structure in Q4. The whole idea was to eliminate the complexity that had just plagued the stock's valuation.
They split the business into three logical verticals which were durable growth which is mostly Bow plus LOM and their international operations. then branded RX focused on domestic growth and finally US diversified products which are the stable cashg generating assets in splitting out boss plus lom that was a signal
a huge signal to the market by calling it durable growth they were essentially saying look this asset can stand on its own it could eventually be spun off or sold for a much higher multiple unlocking all this trapped value so despite all of this I mean a rapid and very serious restructuring new CEO financial stabilization clear strategy.
The fund still admits defeat and sells the whole position by the end of the year. That's the stunning conclusion. They sold it. And the irony is by the time they sold it was only what 3% of the funds NAV, but the manager said it consumed a disproportionate amount of human resources and substantial mind share.
And the admission was pretty stark. He just said it was a huge mistake. So, this isn't just about the financial loss, which was massive. A negative 19.2% hit overall. What's the strategic lesson here from this colossal failure? I think the lesson was twofold. First, just the enormous risk of relying on management's character in a highly acquisitive, you know, non-transparent business model.
Activism works best when you're fixing operational stuff, not when the whole structure has integrity issues. And the second part, the second part is just the cost, the reputational cost and the opportunity cost. They spent a whole year and massive resources on an investment that was fundamentally flawed.
It diverted their attention. At the end of the day, they had to cut bait to survive. That force pivot freed up their minds and resources. So, let's shift gears. Let's talk about the other huge public battle they were fighting at the same time. Yeah. The short position against Herbal Life, right? And this wasn't about saving a company.
This was about getting regulatory validation for their thesis. Exactly. And the start of 2016 was tense. It was all about the uncertainty around the FTC investigation. Yeah. Everyone knew there'd be a fine probably around $200 million, but the real question, the big one, was whether the FTC would mandate injunctive relief, you know, actual changes to how the business operated.
And the FTC wasn't being subtle about it. Yeah. They put out this on thereord statement on May 6th, which was very unusual. Basically telling the market, don't focus on the fine. Focus on the changes we're going to mandate. And this is where the fundamental battle was won. even if the stock market didn't see it right away.
The settlement comes on July 15th. Now, the FTC kind of danced around using the specific words pyramid scheme, but the language was devastating. Oh, it was devastating. It said the company had operated illegally, misled consumers, and had all the hallmarks of a pyramid scheme they had just successfully prosecuted.
So, what was the critical piece of that injunctive relief? What was the one thing that changed the game? The core mandate was a top-to-bottom restructuring of the US compensation model. Distributors couldn't be paid just for recruiting anymore or for loading up on inventory. Compensation had to be limited to verifiable, profitable retail sales.
That's the mechanical difference. That is the key. A pyramid scheme rewards recruitment. A legitimate business rewards selling to actual customers. The FTC essentially forced them to try and become a real retail sales business. But the stock initially it surged 20% on the news. So why the disconnect?
Market psychology. Investors just focused on the $200 million fine saw it as immaterial and figured the company would just absorb it and move on. But then as people actually started to digest how hard it would be to implement these new rules, reality set in. Exactly. The reality set in. The stock started to fall and it ended up dropping 33% from that settlement high by the fourth quarter.
And on top of that operational reality, you had major reputational and management shocks. Absolutely. The manager was explicit. Pyramid schemes are confidence games. And two massive things hit that confidence hard. First, the CEO, Michael Johnson, announced he was transitioning out, which signaled instability.
The media exposure, I mean, huge negative media. John Oliver's segment on Last Week Tonight got over 8 million views. Then you had the betting on zero documentary. It all just undermined the optimism that distributors need to keep recruiting. So by the end of the year, the fund is sticking with its thesis.
Intrinsic value is zero, and they're just waiting for these changes to take effect in 2017. Precisely. They believed the CEO's exit, the public humiliation, and the mandated changes would just lead to an accelerated decline. Okay, let's pivot hard now to section three, raising capital. You can't survive a valant level disaster and run a huge short unless you have cash.
And they got it by divesting two major long-term activist winners, Canadian Pacific Railway and Zoitis. Right. And these exits were less about just taking profits, though the profits were substantial. It was more about shrewd portfolio management. You monetize your low-risk stabilized companies to fund your next high-risk, high return plays.
Let's start with Canadian Pacific CP. That was the phenomenal turnaround story. It was the definition of activist success. They were fully out by August 2016, five years after they started. And the metrics, I mean, they speak for themselves. Operating margins went from 19% at the start to a guidance of 41% in 2016.
And the shareholder return, the share price nearly quadrupled. It generated a 318.9% total shareholder return. That company was fixed, it was stable, and they sold it at its peak. A huge win. And what about Zoetis, the animal health company? Zoetus was another great one, fully exited by November. Here, the win was all about operational efficiency.
The fund pushed management to get operating margins up from about 25% in 2014 to a goal of 34% by 2017. And they hit the goal. They beat the goal. Management actually outperformed. It generated a really healthy 57.9% return over two years. So again, a successful campaign, a stabilized company ready to be monetized.
But they weren't just fixing and exiting. They were also showing consistent success in their remaining longs. Air Products, APD, was the second biggest contributor in 2016. What was happening there? APD was the poster child for consistent successful management. Q4 2016 was their ninth straight quarter of double-digit EPS growth and the big strategic win was margins.
Operating margins were up 400 basis points to 23.1%. Which was a huge milestone for them, a huge milestone. It meant they'd finally achieved their goal of becoming the most profitable company in the industrial gas industry, even surpassing their rival Preair. And on top of that, they sold off non-core businesses like Versam, which gave them about $5 billion in capacity to focus on their core business.
So even in this terrible year, the largest gross contributor was actually restaurant Brands International QSR. Yeah, QSR added 3.3%. It really benefited from that capital light franchise model. You saw strong operational improvements, 16% organic EBITD growth, and cost cutting at Tim Hortons. It's that stable annuity that, you know, pays the bills while you sort out the messy stuff.
Which brings us to the final strategic moves of 2016, deploying all that hard one capital. Let's talk about the new activist long Chipotle CMG. This was the classic boow activist move. PSH buys a 9.9% stake in September at an average price of about $45 a share. And the thesis was pretty simple, very simple.
A world-class brand with great unit economics, but it was suffering from temporary trouble. And that trouble was of course the big food safety issues which had caused a peak decline of 36% in unit volumes. So they saw the temporary reputational damage as a chance to buy the permanent asset quality. What was the plan?
The path to recovery was twopronged operations and governance operationally you know greatly enhanced food safety protocols. That takes time, but it fixes the core consumer trust issue and at the same time push technology mobile ordering, catering, things that expand revenue. And they immediately went after the board.
Immediately governance changes were instantaneous. They got a board refresh in December 2016 that put Persing representatives right in the room. They weren't just buying the stock, they were buying the right to shepherd the recovery. And they saw a lot of growth potential, huge potential. Their core belief was that the US market could support 3,000 more restaurants for a total of 5,000 units.
So, this was a long-term growth story if they can just restore that trust. Finally, we have to talk about the legal and political bet that just delivered huge returns in the final quarter. The GSC litigation, Fanny May, and Freddy Mack. This added a massive 4.8% combined. Yeah, this was the highest stakes legal bet in the portfolio.
The whole issue revolved around the net worth sweep policy from 2012, right? The government mandated that the GSC's divert 100% of their profits to the treasury even though internal documents showed they were becoming profitable again. So the shareholders argued that the sweep was basically an illegal mechanism to prevent the GSC's from ever recapitalizing and getting out of government control.
And this position just exploded right after the election. It was a massive political tailwind. The total shareholder returns surged over 130% post election. And the reason was this new political confidence in a resolution, specifically the incoming Treasury Secretary nominee, Steven Minutuchin. He openly said he wanted to get them out of government control and restructure them,
which aligned perfectly with the fund's thesis perfectly. Their whole bet was that a political solution would eventually restore shareholder value. So looking back at the whole year, 2016 was a major inflection point. The fund takes this portfoliing hit from Valiant, but then demonstrates this really extraordinary ability to triage, successfully monetize wins like CP and Zoatus, and then decisively deploy capital into new high potential plays like Chipotle and the GSSE.
And the key takeaway for you, the learner, is really about crisis discipline. This year just encapsulates how hard it is to maintain conviction when you are under maximum duress. The valiant disaster taught a critical, very expensive lesson. Know the limits of your activist model, and if you fail, you cut the loss quickly, no matter the reputational cost.
The rally that followed shows the power of that disciplined capital allocation once the baggage is gone. But despite that massive rally from the catastrophic March bottom, the story wasn't completely solved by year end. By November, PSH's publicly traded share price was still at a substantial discount, over 20% to its actual net asset value.
The management team even called this unacceptable. And this raises a fascinating challenge for the fund as they head into 2017. They delivered this strong recovery. They cleaned up their balance sheet, but the market was still skeptical. So, it leaves you with a question to chew on. Given the intense reputational damage from Valiant, the concentration risks still in the portfolio, and the volatility of these highstakes legal plays, what single factor do you think would be the most effective, but also the hardest to solve in convincing the market to finally close that 20% discount to NAV? Something to think about where finance and perception really collide.
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