Bill Ackman got into a fight 5 years ago and he’s taken quite a beating.


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All the way back in 2012, Bill Ackman, the manager of hedge fund Pershing Capital, published a research report claiming that Herbalife, a multi-level marketing company that sells nutritional supplements, weight-loss products and protein shakes, was a pyramid scheme and that in time it’s worth would go to zero.

We all know talk is cheap…..

SO…….

Ackman did more than just talk about it, he put his money where his mouth was and made a billion dollar bet that Herbalife shares would tank.

Activist Investor

You might be wondering why someone would publically declare their intent to short or bet against, a company’s stock; you want to keep your best stock tips to yourself right?

WRONG!!!

In this case it’s because Bill Ackman is what is known as an activist investor.

Activist investors are different from the weekend warrior investor buying up shares of Tesla and Snapchat in his or her den. Activist investors seek to actively effect change in the companies they invest in. One way they do this is by buying up enough stock to grant them a seat on the company’s board.

Carl Icahn, another activist investor, is famous for this. Known for being a corporate raider, Icahn would use a board seat to cajole, bully or coerce the company into pulling off wholesale changes. He also typically was only in it for the short haul. For example, Icahn might use his board seat at Bombardier to get the leadership to fire 25% of the workforce, temporarily boosting profits and driving the stock price up; he would then sell his stake and pocket a quick score.

The Rivalry

Carl Icahn and Bill Ackman have a history. They’ve gone to war before and so when Ackman announced his short it’s not entirely surprisingly that Icahn took the opposite position – even going on television to beat the war drum for Herbalife.

Back in 2004, when Ackman was closing down his hedge fund Gotham Capital. Ackman asked Icahn to buy his stake in a company called Hallwood Realty, the company was trading for $60 a share, and Ackman thought it was worth $140. They struck an agreement where Icahn would buy the shares for $80 and if he sold them for a profit within three years, they would have to split the profits.

1 year later….

Hallwood is part of a huge merger deal, valuing its shares at $137, almost the exact valuation Ackman predicted. Icahn however, refused to honour his end of the bargain because technically there was no sale – only a merger. The two went to court, eventually ending with Icahn having to pay $9 million to Ackman. The two of them have been rivals ever since.

The Scorecard

This fight has taken its toll on Bill Ackman. At times his losses on Herbalife have amounted to a staggering $700 million. Even then he’s refused to sell.

When Ackman announced his position, Herbalife was at $50 a share. Ackman had cause for joy early on as the shares tumbled to around $30 but then Icahn got involved.

Icahn quickly amassed a 13% stake in the nutrition company and told anyone who would listen how great Herbalife was. Over the next 12 months, Herbalife’s share price would rise to $78.

At this point it would seem like Ackman was on the mat and the referee was closing in on the 10-count; but like most grudge matches Ackman got was not going down so easily. In March 2014, The US Federal Trade Commission announced that it was launching an investigation into Herbalife – this was a huge development, as the FTC hadn’t investigated a multi-level marketing firm for shady practices in over 35 years.

Multi-level Marketing

In theory, multi-level marketing companies work by having a network of freelance distributors sell their products. A distributor would buy $100 worth of product from Herbalife at cost and then be responsible for selling that inventory and recouping their investment. In practice, multi-level marketing schemes can come uncomfortably close to being a pyramid scheme. Here’s what we mean.

Pyramid schemes are scams, plain and simple.

In order to understand what a pyramid scheme is, think back to the Madoff scandal. Madoff would get wealthy investors to give him their money; they were more than willing, after all Madoff was returning 20% year after year for his clients. The catch was that the returns were fake; Madoff wasn’t investing any of the money – instead he would use money from new clients to fund the positive returns of older clients. Pyramid schemes like this thrive on recruiting new members, new clients whose “dues”, or investment money, forms the base of the pyramid.

The scam was alive as long as Madoff could bring in new clients.

In the settlement with the FTC, Herbalife was described as a company that willingly misled its distributors. Just like Madoff lured investor with the promise of incredible returns, Herbalife lured individuals, often from lower-income households, with the promise of easy wealth.

They also found that it made most of its money not from selling products, but from the recruiting of new distributors or “members”. There’s a signup fee of $60 to start but if you want better discounts on the products you have to resell, you must pay more. Some members have been known to pay as much as $4000 for “supervisor” status.

These members were supposed to recruit new distributors, incentivized with bigger commissions, and the cycle would continue. The FTC also found that the “overwhelming majority” of Herbalife members made little to no money, with many of them losing money. Those poor souls are at the bottom of the “pyramid” with the supervisors higher up, and Herbalife executives perched on the top.

If that isn’t a pyramid scheme, then it’s extremely predatory at best.

The Final Score

It’s hard to see Ackman coming out of this with a big win.

Even after a fairly damning assessment from the FTC and the big settlement, Herbalife shares remain relatively strong. Ackman has a lost a lot of money, and he has investors that are no doubt feeling panicky.

Icahn, on the other hand, seems to have the clear advantage. He is an independent investor, so he doesn’t have to worry about his investors and appears committed to making Ackman suffer. He is long 17 million shares to Ackman’s 20 million shares and also has fellow billionaire George Soros in his corner.  William Stiritz, the CEO of Post Holdings, also picked up a similar stake as Soros and together the three tycoons own 30% of the company. All Icahn needs to do is help Herbalife clean up its act just enough to avoid the scarlet letter of a pyramid scheme and Ackman is done.

For now, Ackman is still standing but he better watch out for that next big punch.

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