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Forbes

Ackman’s Assault On Herbalife Risks More Hedge Fund Regulation

Christopher Versace – September 14, 2015 – Forbes

Bill Ackman Pyramid SchemeThere has been a push by many politicians of both parties in Washington to beat up on Wall Street generally and hedge funds in particular. One need to look no further than Republican presidential candidate Donald Trump who claims hedge fund managers are not paying enough taxes. In a tirade that received accolades from liberals Warren Buffet and Sen. Elizabeth Warren, Trump claimed that the hedge fund operators “are getting away with murder” by alleging “they’re paying nothing.”

This is nothing new as hedge funds have been a popular target for populist rhetoric. President Obama was quoted in a Bloomberg story titled “Obama Says Hedge Fund Managers Are ‘Society’s Lottery Winners” as saying “if we can’t ask from society’s lottery winners to make that modest investment, then really this conversation is for show.” President Obama wants to increase taxes on hedge fund managers and investors to pay for more federal education funding.

Our system of free market economics relies on government not picking winners and losers. Hedge funds play an important role in a free market economy by helping assess the long-term viability or fatal flaws in a corporate business model and structure.

A hedge fund is commonly known as an alternative way to invest money for large institutions or people with large assets. A hedge fund is basically a fancy name for an investment partnership. There is a fund manager and investors. The idea is to maximize returns and minimize risk by offsetting possible losses with an investment strategy. These funds can go “long” on a stock, betting that the shares will increase in value, or they can go “short” on a stock, betting the shares will decrease in value or maybe even go out of business.

Hedge fund’s take great risks and, with that, come great rewards. According to Forbes in 2013, “in total, the 25 highest-earning hedge fund managers and traders made $24.3 billion in 2013. The lowest earning hedge fund managers on our list made $280 million last year.” Even hedge fund managers can have a rough year and we saw that in 2014 when the 25 top hedge funders according to Institutional Investor made an average of $467 million in 2014. The aggregated $11.6 billion haul for those 25 was half of what hedge funders made in 2013.

As you can imagine big dollars are at stake for top tier hedge fund managers as well as smaller and medium sized ones. As we heard in the film Wall Street from the hedge fund poster child character that is Gordon Gekko, “Greed is good,” but as we watched the film we learned that Gekko would cross moral lines to get what he needed.

Unlike in the marketplace where the best products at the best prices thrive, under crony capitalism it’s those with the best relationships with government and politicians that win. Using the government to investigate and destroy a company for the purposes of making money – even shorting a stock — is not an ethical way to profit. Engaging in that type of activity brings more oversight to other hedge funds that are acting fully within the bounds of a free market.

There is nothing wrong with shorting a stock and betting against a company in a free market. There is, however, something wrong with an investor using the government to destroy a company while shorting a stock.

The classic case study in this is Bill Ackman, founder and CEO of hedge fund Pershing Square Capital Management. As website Insider Monkey notes, “Bill Ackman is a long term value investor, taking advantage of short term downward moves in prices. He is particularly successful at special situations investments.” Per the service, top holdings included Valeant Pharmaceuticals, Air Products & Chemicals, Canadian Pacific Railway, and Zoetis at the end of 2Q 2015.

Odds are, however, you’ve not heard of Bill Ackman or Pershing Square Capital because of those holdings, but rather because of Herbalife shares. For several years, Ackman has been crusading against Herbalife, which he contends was operating a “pyramid scheme” that targets poor people. In December 2012, Ackman issued a research report that was critical of Herbalife’s multi-level marketing business model, calling it a pyramid scheme.

Last year, Ackman was exposed in a news story about manipulating the levers of power in the federal government to attack Herbalife. In a March 9, 2014 story in the New York Times:

“at a Midtown Manhattan steakhouse last June, William A. Ackman, the activist hedge fund manager who had bet a billion dollars on the collapse of the nutritional supplement company Herbalife, offered his latest evidence to a handful of other hedge fund managers about why the company’s stock could soon plummet. Mr. Ackman told his dinner companions that Representative Linda T. Sánchez, Democrat of California, had sent a letter to the Federal Trade Commission the previous day calling for an investigation of the company. The commission had not yet stamped the letter as received, nor had it been made public. But Mr. Ackman, who had personally lobbied Ms. Sánchez and stood to profit if the company’s stock dropped as a result of the call for an inquiry, already knew what it said, and read from a copy of it that he had on his cellphone. When Ms. Sánchez’s office ultimately issued a news release a month later, it was backdated as though it had been made public the day before Mr. Ackman’s dinner talk.”

The same New York Times article reported groups such as the Hispanic Federation and the National Consumers League sent numerous letters to federal regulators. “Each person contacted by The Times acknowledged in interviews that they wrote the letters after being lobbied by representatives from Pershing Square, or said they did not remember writing the letters at all. Mr. Ackman’s team also then started to make payments totaling about $130,000 to some of these groups, including the Hispanic Federation — money he said was being used to help find victims of Herbalife.”

This was followed up by The Wall Street Journal, which reported on March 12, 2015 that Ackman might be the subject of a criminal probe. “Federal prosecutors and the Federal Bureau of Investigation are probing potential manipulation of Herbalife Ltd. stock and have interviewed people hired by hedge-fund billionaire William Ackman, who has led a long-running campaign against the nutritional-products company, people familiar with the matter said.”

If this story proves to be true, it is an indictment of the practices of Mr. Ackman — not of Herbalife. There is little doubt that Mr. Ackman’s efforts to get government to destroy a company so he can profit on his shorts will cause blow back on all hedge fund managers and there will be repercussions for the whole industry that is already facing greater regulation.

In the 2015 KPMG/AIMA/MFA Global Hedge Fund Survey titled “Growing Up: A New Environment for Hedge Funds” more than three-quarters (77 percent) of more than 100 hedge funds “cited increased regulation as the biggest threat to the industry overall; 84 percent said that their operating costs had increased as a result of compliance obligations.”

Hedge fund managers throughout America can’t be happy that Ackman is bringing scrutiny to the hedge fund industry and its business model. Destroying a profitable company for private gain is inconsistent with a healthy free market system. Perhaps it would be wise for Ackman to give up what increasingly looks like a his personal fight with Herbalife and utilize his unique skills and his knowledge of the markets in search of profit generating investments for his investors. Rep. Sean Duffy (R-Wisconsin), Chairman of the House Financial Services Subcommittee on Oversight & Investigations, should use his committee as a standing committee to conduct oversight on crony capitalism. Bill Ackman would be an excellent first witness.

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