Wall Street’s bru­tal arith­metic

The Washington Post Sunday - - BUSINESS - ALLAN SLOAN allan.sloan@wash­post.com

Wall Street math can be a won­der­ful thing. If you’re on the right side of it, that is.

Con­sider, if you will, the case of Bill Ack­man, one of Wall Street’s best­known hedge fund man­agers, who did one fab­u­lously prof­itable deal in­volv­ing the nowdis­graced and dis­tressed Valeant drug com­pany and one hor­ri­bly un­prof­itable Valeant-re­lated deal.

The prof­itable deal pro­duced a $350 mil­lion pay­day for Ack­man, whose man­age­ment com­pany gets 16 per­cent of the prof­its — in this case, $2.2 bil­lion — that in­vestors in his Per­sh­ing Square funds make. The un­prof­itable deal has gen­er­ated a $4.2 bil­lion loss, all of which is be­ing borne by Per­sh­ing’s in­vestors.

How can this be? Wall Street math. Be­cause the Valeant-re­lated profit was earned in 2014 and the Valeant-re­lated losses did not start un­til 2015, Ack­man got to keep the $350 mil­lion fee gen­er­ated by the 2014 profit.

Now, let’s back up a bit, and I’ll take you through this.

In 2014, a year in which Ack­man’s pri-

81 cents, 1.7%

vate hedge fund — he also runs a fund with pub­licly traded shares — earned a stun­ning 37 per­cent (after fees) for his in­vestors, Ack­man made a con­tro­ver­sial but wildly suc­cess­ful deal with Valeant. That was be­fore Valeant’s price-goug­ing strat­egy made it a na­tional pariah and its fi­nances turned into a sham­bles.

Valeant wanted to buy an­other drug com­pany, Al­ler­gan, but knew it would be dif­fi­cult.

So it made a deal with Ack­man for his funds to buy a large Al­ler­gan stake be­fore Valeant an­nounced its takeover in­ten­tions.

It was like shoot­ing fish in a bar­rel for Ack­man be­cause he knew that Al­ler­gan’s price would run up after Valeant made its of­fer. Which it did. A bat­tle en­sued, and Al­ler­gan sold out to a Valeant ri­val. But Ack­man’s Per­sh­ing Square funds emerged with that $2.2 bil­lion profit.

Then, in 2015, Ack­man de­cided that Valeant it­self was a great in­vest­ment. Which it wasn’t. Valeant’s price goug­ing and frag­ile fi­nances drove the stock down and down. So Ack­man, who had done ev­ery­thing he could to boost Valeant’s share price — in­clud­ing join­ing Valeant’s board and pick­ing fights with the likes of Char­lie Munger, War­ren Buf­fett’s part­ner and one of Wall Street’s most revered fig­ures — re­cently sold Per­sh­ing’s fi­nal Valeant stake.

Per­sh­ing ended up $4.2 bil­lion be­hind. Per­sh­ing’s in­vestors, that is.

Over­all, Per­sh­ing’s in­vestors lost a com­bined $2 bil­lion on Valeant deals. But be­cause the $2.2 bil­lion gain came in 2014 and the $4.2 bil­lion loss came in 2015, 2016 and 2017, Per­sh­ing’s two Valeant-re­lated deals are treated sep­a­rately for pur­poses of cal­cu­lat­ing “car­ried in­ter­est” fees for Ack­man’s man­age­ment com­pany.

Even though Ack­man, who has be­come one of Wall Street’s most mocked man­agers, wouldn’t talk to me, it’s only fair to point out that a good part of his piece of the $350 mil­lion fee was prob­a­bly rein­vested in Per­sh­ing Square. Ack­man prob­a­bly has a good part of his net worth tied up in Per­sh­ing’s funds and feels some of the fund in­vestors’ pain.

Even with his dis­as­trous 2015 and 2016 per­for­mances — his pri­vate fund lost 16 per­cent and 9.6 per­cent, re­spec­tively, ac­cord­ing to peo­ple who have seen the fig­ures — his in­vestors have still earned 14.8 per­cent an­nu­ally, com­pounded, from the fund’s launch in 2014 through the end of last year. (The fund is about even this year.) But that’s down from the 24 per­cent an­nual re­turn the fund had posted through 2014.

Ack­man is now strug­gling with a dif­fer­ent piece of Wall Street math — what’s called the high-wa­ter mark.

The big, big money that hed­gies make comes from their piece of their in­vestors’ prof­its. But in a case like Ack­man’s, prof­its don’t be­gin to get counted un­til Per­sh­ing Square tops its pre­vi­ous high, which was in 2014.

Ack­man’s pri­vate fund is about 24 per­cent be­low its high­wa­ter mark. That means it has to rise about 32 per­cent from its cur­rent level just to get back to where it was at year-end 2014 be­fore it can re­sume gen­er­at­ing “car­ried in­ter­est” fees for Ack­man. (The math: 100 di­vided by 76 is about 1.32.)

That’s a daunt­ing ob­sta­cle. An­other prob­lem is a civil suit, cur­rently pend­ing, that charges that the $2.2 bil­lion of profit Per­sh­ing made on Al­ler­gan was il­licit be­cause it stemmed from ma­te­rial non­pub­lic in­for­ma­tion that Ack­man got from Valeant.

Valeant has agreed to bear 60 per­cent of any loss that Per­sh­ing might in­cur as a re­sult of the suit. That leaves Per­sh­ing Square in­vestors at risk for 40 per­cent.

If Per­sh­ing hold­ers have to shell out money as the re­sult of the suit, will Ack­man’s man­age­ment com­pany kick in 16 per­cent of any out­lays, given that it took 16 per­cent of the prof­its?

Some day, we may find out. And we’ll all get an­other ex­am­ple of how Wall Street math works.



Bill Ack­man, chief ex­ec­u­tive of Per­sh­ing Square, earned $350 mil­lion in fees from in­vestors’ $2.2 bil­lion profit.


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