Since Pershing Square Holdings went public last year, Bill Ackman used a portion of this year’s annual letter to investors to explain the large cap activist investment strategy followed by Pershing Square Capital Management (which manages PSH) and the transition from what Ackman calls Pershing Square 1.0 and Pershing Square 2.0.
“In Pershing Square 1.0, we took substantial stakes and pushed for corporate changes which we believed would create shareholder value. Our holding periods were shorter. We achieved high rates of return, but required constant recycling of capital into new ideas. The changes we advocated were more structural and corporate than managerial and operating,” Ackman writes. “In retrospect, the development of our investment in General Growth Properties Inc (NYSE:GGP) represents the inception of Pershing Square 2.0.”
Bill Ackman: Pershing Square is value investing writ large
The approach that Ackman describes, especially for Pershing Square 1.0, will sound familiar to value investors. He looks for ‘simple, predictable free-cash-flow generative’ businesses with some sort of competitive moat and modest leverage if not extra cash on hand. He also looks for businesses without too much exposure to commodity prices, interest rates, or other macro conditions that are completely outside the company’s control. Short positions are just the opposite: high leverage, bad business models, and the need for access to capital are sure to draw a look from Pershing Square analysts.
Ackman determines valuations by estimating the present value of future cash flows to owners (eg dividends) only buys when the current price is a deep discount to what he considers to be fair value. For short positions he looks for a ‘ceiling on valuation’ that plays the same role as the margin of safety on long positions in keeping risk under control. And again in the vein of value investing, risk is defined as the chance of losing principle, not price volatility.
Investment in GGP fundamentally changed Pershing Square
Not of that has changed, but the transformation to Pershing Square 2.0 happened when Ackman took a position in General Growth Properties in 2008 and then took a seat at the GGP board. The creation and spinoff of The Howard Hughes Corp (NYSE:HHC) Corporation two years later was meant to collect unrelated, non-core assets in a new company that would better unlock their value. Pershing Square got to appoint a third of the HHC board and Ackman became chairman, building the rest of the management team from scratch. Successful deep engagements at Canadian Pacific, Air Products, Platform Specialty Products, and Zoetis followed, as well as the investment in J C Penney that ended in deep losses.
Pershing Square exited its investment in GGP last year, but it is still invested in HHC and doesn’t appear to have any plans to exit soon. In fact, Pershing Square 2.0 won’t necessarily move on just because the initial gains from restructuring have been realized.
“Once we are in a position of influence and own a high quality business run by able management who manages the business well and allocates free cash flow intelligently, absent excessive overvaluation or a substantially better use of capital, there are few good reasons to sell,” writes Ackman, in what sounds a lot like Buffett’s statement that his “favorite holding period is forever.”
This change means that Pershing Square can focus on delivering with its core positions instead of always looking for new investment ideas and avoid all of the costs that come from building up a new position and developing (or fighting for) influence in a new company. It also builds Pershing Squares reputational equity – since other institutional investors know that Pershing Square intends to stick around for the long-term it’s easier to get them on board with proposed changes.
Pershing Square’s changing capital structure
But this approach only really works if Pershing Square has stable capital that it can invest for very long periods of time, a major factor behind last year’s IPO. Replacing redeeming investors with equity (the letter mentions the possibility of issuing low-cost, long-term, unsecured, covenant lite debt as well) allows Pershing Square to fully invest instead of always needing some liquid investments to satisfy redemptions.
If you count equity and employee capital, than permanent capital is nearly half of the total that Pershing Square is working with, and if you throw in ‘loyal investors’ and long-term contractual commitments in the funds, Ackman says that Pershing Square is approaching the ‘ideal of permanency’.
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