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In February of 2020, Bill Ackman and his hedge fund Pershing Square Capital Management were staring into the abyss. As Europe struggled in its containment efforts, and it seemed increasingly likely to those with a pulse on the international zeitgeist that a similar situation would also eventually play out in the US.
Earlier that month, and unlike Ray Dalio, who infamously proclaimed cash to be trash during an interview at Davos, and whose Pure Alpha 2 fund went on to lose 16% in the month of March alone, Bill Ackman was contemplating fully liquidating Pershing's equity positions in an unprecedented move to cash.
Such a move would surely be off-brand for an activist fund like Pershing Square. After all, the fund held concentrated positions in quality names like Hilton, Chipotle Mexican Grill, and Restaurant Brands International. And selling everything wouldn't be congruent with the fund's long-term ownership philosophy.
Plus, the sheer size of Pershing Square's assets would have made a speedy, orderly unwind rather tricky to pull off. So, instead of throwing the baby out with the bathwater, Ackman took steps to hedge his portfolio with a virtually guaranteed bet with an explosive asymmetric payout. Over the years, Pershing Square has become renowned for the depth of its due diligence, which usually culminates in highly information-dense, voluminous PowerPoint slide decks.
Its magnum opus arguably being Ackman's original 342-slide exposé of Herbalife back in December 2012. This was followed by a further 250-slide follow-up on the company in July 2014, and a 40-page slide deck defending Ackman's unfortunately misguided bullish view on Valeant Pharmaceuticals. Needless to say, the presentation, which ended with Warren Buffett's "Be fearful when others are greedy" adage, was less than prescient as Valeant turned out to be a massive money loser for Pershing Square to the tune of $2.8 billion.
But we all make mistakes, and the setbacks with Herbalife and Valeant did not dissuade Ackman from maintaining that same level of due diligence. His presentation on Starbucks, which the fund successfully exited for a nice profit earlier this year, was 43 pages long. Same story for the fund's 48-page distillation of months of due diligence on ADP.
After a lost campaign to install himself and two of his allies in the company's board of directors, Ackman and ADP CEO Carlos Rodriguez reconciled over dinner at Marea, the Michelin-starred restaurant on Central Park South. And yet, Ackman has stated on at least two occasions that some of his best bets are less the fruit of perspiration and PowerPoint wizardry, and more the result of a lightning strike of inspiration.
Here's a quotation from an interview with Bill Ackman from episode number 82 of The Knowledge Project podcast. "In some of our most successful investments, the amount of work that was done was in the hours, as opposed to even in the days or weeks or months. Just most recently, our hedge that we put on to protect the portfolio, the amount of time was minimal." Another great investment, this time on the long side and in the midst of the 2008 meltdown, was in Wachovia.
This position, too, was initiated in a matter of days after Ackman had gotten wind of an acquisition bid by Citigroup. Ultimately, Wells Fargo upped the ante and presented a more competitive bid, acquiring the distressed North Carolina-based lender. This trade helped bandage Pershing Square's record for 2008, during which its flagship fund declined 12% compared to the industry average for that year of returns of -19%.
But enough with the hedge fund trivia. It's time we got into the meat and potatoes of Pershing Square's trade of the century. Contained in Bill Ackman's letter to investors sent out on March 25th, 2020, is the following incredulity-inducing paragraph. "On March 23rd, we completed the exit of our hedges, generating proceeds of $2.6 billion for the Pershing Square funds, compared with premiums paid and commissions totaling $27 million, which which offset the mark-to-market losses in our equity portfolio." Taken at face value, turning 27 million into 2.6 billion is a 100-fold return.
And there are few instruments that can produce such spectacular returns. The most likely candidate being options. After all, dollar-yen options Nassim Taleb had purchased for $10,000 suddenly shot up to 17 million in the 1987 crash. And just last time, we discussed how an unrelenting volatility spike in S&P 500 put options from 60 cents to $16 in a matter of days led to the demise of Victor Niederhoffer's first set of hedge funds.
However, it turns out Ackman's instrument of choice was not options, but rather credit default swaps, the same instrument used by Dr. Michael Burry to bet on the collapse of the housing market. If you watch the movie The Big Short, then you're probably already familiar with CDSs. These are basically insurance contracts with maturities varying between 1 and 10 years, commonly 5 years.
In The Big Short, Dr. Burry had committed to paying yearly premiums corresponding to about 8% of his fund's portfolio for as long as the underlying loans didn't default or until he decided to sell the swaps to someone else. Also, the nature of these swap contracts allowed him to build up a very large notional position of 1.9 billion compared to just 555 million he was managing for the fund.
Bill Ackman did something similar, except in the much more liquid market for credit derivatives, both investment grade and high yield. According to Ackman, in February 2020, credit default swaps on the IG, or investment grade, index were trading at 50 basis points, that is, 50 * 1/100 of a percent, or 0.5%.
So, when Business Insider comes out with a headline that reads, "Bill Ackman turned a $27 million bet into 2.6 billion in a genius investment," well, they're engaging in mild clickbait because the 27 million refers to the monthly premium paid on a 5-year CDS contract, not to the total size of the bet.
At 50 basis points, you'd be creating 64.8 billion in exposure in return for a contractual promise to pay 81 million in quarterly premiums, or 27 million pro rata on a monthly basis. The point, though, was just to wait long enough for the spreads to widen so that Pershing Square could then turn around and sell the contracts to someone else on the open market.
After all, why shouldn't the spreads widen? That is, why shouldn't market participants start demanding larger premiums to insure against the bonds in these indices in the face of an already overstretched and frothy economy in the early stages of a worldwide recession/depression? Unsurprisingly, that's exactly what started happening, allowing Ackman to unload the contracts between the 13th and the 23rd of March at anywhere between two or three times his purchase price.
Matt Levine, in an article on Bloomberg written on the 28th of March, takes the middle point and assumes an average sale price of 130 basis points. 130 basis points divided by 50 basis points yields 2.6. So, the monthly premiums had now skyrocketed to around 70 million per month. 70 million over the remaining 59 months comes to around 4.13 billion compared to the 1.62 billion Ackman had agreed to pay, allowing him to pocket the difference, which corresponds to 2.51 billion, close to the 2.6 billion figure quoted in the Business Insider article.
His exact entry and exit prices are not known, so the exact amounts aren't known, either. Plus, the time value of money comes into play, so the discounted value would be slightly less than 2.51 billion. But, it's a decent approximation. Lastly, I would like to address Bill Ackman's appearance on CNBC on March 18th, during which he made such memorable pronouncements as saying Hilton would go to zero if the US didn't change course in the way it was handling the crisis.
Ackman has been criticized for using media exposure to talk his book and tank the market, allowing him to both offload his CDS position and at the same time redeploy the cash into stocks on the long side. Now, Ackman denies these claims and maintains that his positions in no way benefited from his appearance on CNBC.
So, we'll just have to take his word for it. Would I bet the farm on that statement being true? No, I must certainly would not. But, my interest in the story lies more in the trade itself than in the controversy surrounding that interview. After all, while it wasn't the 100-bagger touted in catchy headlines, an ROI of 160% over the course of a single month is nothing to scoff at.
Quite the contrary. Pershing Square's hedge was indeed a genius investment and a testament to Ackman's skill as an investor.
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