(Bloomberg View) -- One of the classics of investment literature was written in 1955 by a man named Fred Schwed Jr., a disillusioned former Wall Street trader turned children's book author. Drawing on his Wall Street experience, Schwed wrote a scathing indictment of all the ways investment advisors separated clients from their money. It was titled, "Where Are the Customers' Yachts?"
Bill Ackman's revelation on Monday that he had dumped his stake in Valeant Pharmaceuticals International Inc. after it had dropped from $260 to $11 in the space of a year and a half -- and, according to Bloomberg, cost Ackman's hedge fund more than $4 billion -- has already provoked a good deal of excellent commentary. My Bloomberg View colleague Barry Ritholtz pointed out that it exemplified Ackman's lack of consistency as an investor, while Matt Levine noted that Valeant, with its postmodern approach to drug pricing and earnings growth, was the perfect sucker's bet for a postmodern fund manager like Ackman.
But there's at least one more question hanging over the Valeant debacle: "Where are Ackman's customers' yachts?"
The typical hedge fund has two different income streams: a management fee and a performance fee. This fee structure is encapsulated in the phrase "2 and 20," meaning that the fund takes 2 percent of its assets each year for managing the fund, plus 20 percent of any profits (the performance fee).
The fees charged by Ackman's fund, Pershing Square Capital Management, have been slightly lower than the norm: a 1.5 percent annual management fee and performance fees that have ranged up to 16 percent, depending on the fund. (Pershing Square manages four different hedge funds.)
Although Pershing Square's overall performance has been quite good since its inception in 2004, Ackman's track record is littered with huge bets that went bad. In 2007, he set up a $2 billion fund specifically to target, er, Target. It crashed spectacularly. In 2010, Ackman bought 39 million shares of J.C. Penney Company Inc., got a seat on the board, brought in a new chief executive, got rid of that CEO a few years later, got off the board, and sold his shares for a loss of over $600 million.
The J.C. Penney fiasco badly hurt Ackman's performance in 2013. Though the S&P 500 was up 32.9 percent, Pershing Square only rose 9.6 percent. Even so, the fund by then had $11.2 billion of investors' money, which, if you do the math, would suggest $168 million in management fees. (Pershing Square says that the amount is lower because it does not take management fees for the approximately 8 percent of the fund that consists of its employees' money.) In addition, even though Ackman woefully underperformed the market, his firm still claimed a performance fee since it generated a positive return; I estimate that to be in the $140 million range. Thus Pershing Square and Ackman reaped, conservatively, nearly $300 million for a pretty dismal result.
In 2014, however, Ackman did something brilliant. No, I'm not talking about his investment in Valeant, which went up that year. Nor am I talking about his investment in Allergan Plc, which he loaded up on early in the year, and then acted as a "co-bidder" with Valeant in a takeover attempt -- an effort that ended when Activis rode in as Allergan's white knight. Ackman wound up with a $2.6 billion gain when he sold his Allergan stock.
What I'm talking about is his decision, that October, to take public a closed-end fund that was designed to track Pershing Square's performance. It was called Pershing Square Holdings Ltd, and the IPO raised $2.8 billion. By the end of the year -- a year in which Pershing Square Holdings was up over 40 percent, thanks largely to that Allergan takeover play -- investors had nearly $18.3 billion with Bill Ackman's funds. Go ahead, do the math: 1.5 percent of $18.3 billion is $274.5 million. Deduct some of that because of the employees' assets, and it was still in the $250 million range. And the performance fee was around $700 million. CNBC reported that December that "Ackman was poised to pull in at least $1 billion" in compensation.
The disadvantage of having a publicly traded closed-end fund is that, whether you have a good year or a bad one, you have to report your performance to the public. The advantage, however, is that the money residing in that fund is permanent capital -- it can't be withdrawn by investors who want out because, say, they are upset with poor performance. Ackman buttressed that permanent capital with a $1 billion bond offering.
So what's happened since then? You know the story. Valeant started cratering in August of 2015, and by the end of the year, it had fallen from the low $260s to the low $100s. Pershing Square fell 20 percent and its assets shrank by $3.5 billion. Although there were obviously no performance fees, the management fee was still pretty hefty, in the $200 million range. According to the annual report Pershing Square Holdings issued that year, Ackman and his team took down over $550 million in total compensation, though much of that was related to the firm's 2014 results.
Last year was more of the same: fund down 13.5 percent (while the S&P was up 11.9 percent), with assets shrinking to less than $11 billion thanks to Valeant's continued decline. Pershing Square's management fee? Probably in the range of $150 million.
To sum up, Ackman and his team have paid themselves some $700 million in fees in the last two years, while his investors have lost billions. Nice work if you can get it.
Many fund managers, faced with back-to-back negative returns, would close their fund, distribute whatever money was left to their unhappy investors, and head for the Caribbean with the millions "earned" in management fees. Most funds can't earn incentive fees after generating negative returns until their investors are made whole. And that is often just too hard a mountain to scale -- or the fund manager has become so rich he can't be bothered. Ackman vows, however, that that won't be the case with Pershing Square.
"I'm committed to making investors whole," he told me on Wednesday. "More than whole." Although he acknowledged that Valeant was an awful mistake, he insisted that he was proud of his record as an investor. Even after the debacle, Pershing Square's annualized returns are around 15 percent, which indeed is something to shout about, though it is worth noting that as Ackman's fund has gotten bigger in recent years, its performance has lagged. It's the old story: Investors throw money at a hot fund, and it stops being hot -- in part because investors are throwing money at it.
Pershing Square also insists that its executives, who have much of their own money in the fund, have suffered right along with investors. Ackman has lost $500 million on Valeant. As for the hundreds of millions in management fees, hedge funds claim that money is necessary to keep the lights on and pay the employees enough that they will stay despite not getting a performance fee. Ackman has changed his fee structure to make it more palatable to investors who have stuck by him.
Mostly, I think, Ackman wants people to believe that he's still a great investor. In the past year, the fund has gained 18 percent, so maybe it won't be too long before it can take performance fees again. We'll see.
In the meantime, he's got one ace in the hole -- that closed-end fund he started in 2014. According to Pershing Square's documents, it now holds $4.5 billion, the most of any of Ackman's four funds. The fund, which is incorporated in Guernsey and trades on the Amsterdam exchange, has performed horribly, as the chart above shows. But it works just like a stock: Though investors can trade in and out of it, Ackman gets to keep that $4.5 billion and use it to (he hopes) regain his reputation as a fund manager. And if he fails -- if he uses that money to makes another Valeant mistake -- there is really nothing any of those investors can do.
Is Bill Ackman the worst offender in his industry? No. Nonetheless, his travails with Valeant illustrate one of Wall Street's basic laws: If a hedge fund is big enough, the manager will earn millions -- nay, hundreds of millions -- no matter how poorly his investments do. That hasn't changed since Fred Schwed's days.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Joe Nocera is a Bloomberg View columnist. He has written business columns for Esquire, GQ and the New York Times, and is the former editorial director of Fortune. He is the co-author of "Indentured: The Inside Story of the Rebellion Against the NCAA."
To contact the author of this story: Joe Nocera at jnocera3@bloomberg.net.
To contact the editor responsible for this story: Jonathan Landman at jlandman4@bloomberg.net.
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