Recently, for instance, we profiled Urbana Corp, which has common shares and A shares. The public shareholders predominantly hold the more liquid but non-voting A shares whereas insiders own a majority of the voting common shares. In this dual share structure, insiders don’t own a majority of the company’s equity, but effectively control the company via owning a majority of the voting shares.

Sometimes, insider supermajority voting control can add value, if an insider can make decisions that may be unpopular to short-term-oriented public shareholders but beneficial for the long-term interests of the company. Other times, as in the case of MIM, supermajority voting shares by insiders can substantially destroy value for public shareholders.

In 2003, auto parts maker Magna Automotive spun off ownership of their real estate assets as MI Developments (NYSE:MIM). In short, MIM owned factories and office space and received steady rental income from Magna Automotive through long term triple net leases. The twist was that the founder and controlling shareholder, Frank Stronach, received 400,000 class B super voting shares in MIM, giving him effective voting control.  Also, MIM owned a controlling stake in a money losing horse racing venture dubbed Magna Entertainment (MECA), which was a pet project of Stronach’s.  Naturally, Stronach and the management of MIM made promises that MIM’s stable rental income would not be used to finance ongoing losses at the unpopular horse-racing venture.

The firm was spun off in November 2003 for about $23 a share, with firms including David Einhorn’s Greenlight capital taking a large stake in the common Class A Shares.

Below is a chart of MIM shares since the company’s spinoff.

Despite assurances to the contrary, MIM made an offer to buy out the remaining stake of the horse racing venture in July 2004.  The plan was to use the rental income on the Magna factories to renovate and build out slot machine gaming rooms at race tracks in states that would permit it.  Shareholders balked at the proposal. After the typical set of management resignations, Stronach quasi-backed downed and instead had MIM lend the money to MECA.   Unsurprisingly, horseracing popularity continued to decline and the expensive renovations failed to pay off.

Over the ensuing years, MIM continued to extend ever-larger loans with ever-lighter covenants.  Finally, in 2009, MECA filed for bankruptcy, leaving MIM high and dry for most of the loans.

To resolve the situation, MIM management proposed a reorganization that would pay a $15/share special cash dividend to shareholders by borrowing against MIM’s stable rental income.  MIM could then use its position as a creditor to the horse racing franchise to foreclose on the race tracks, which would then be 51% owned by Stronach.  Were it not for a concerted legal effort by the shareholders of MIM, the deal would have gone through.

To make matters worse, junior creditors of the bankrupt horse racing franchise sued MIM for the mismanagement.   MIM settled for about $100 mil, which was the proceeds from the sale of several of the racetracks auctioned by the court.  The remaining racetracks, now valued at only $350 mil, were transferred to MIM.  But the story didn’t end there, because Frank Stronach still owned the super voting shares in MIM and he still wanted the racetracks.

Eventually, Stronach got what he wanted. In exchange for his 400k super-voting shares, he received 480k regular shares plus full ownership of the horse racing assets, a deal valued at over $900/Super Voting Share.  And should anyone be surprised?  Trade democracy for monarchy and well, the king will behave like a king and help himself to the fattest pickings of the fiefdom.

Superior voting control leads to a superior equity claim on the assets of a company, and must be contemplated when evaluating an equity investment in a dual class structure where different share classes have different voting rights.  At the time of the spinoff, investors may have been correct in their valuation of MI Development’s assets.  But investors should have also asked the following question: just how much did Stronach’s majority voting control detract from the company’s valuation? In some cases, majority voting control can add value. But in the case of MIM, we saw a situation where a control investor’s disregard for passive shareholders was a company’s Achilles heel.

Why do such a disproportionate number of business entities choose Delaware? Among the many reasons, the most compelling include its non-existent income tax on out-of-state filers, flexible General Corporation Law, and, most importantly, its unique court structure. The Delaware Court of Chancery is a 219-year-old institution devoted solely to corporate law issues. The result of its long history and specialist judges (called chancellors) is that Delaware has the most well-developed body of corporate case law in the nation, which provides a predictability in interpretation and outcome that corporations seek. Former Chief Justice William Rehnquist said the following of the Delaware Court of Chancery:

“[S]ince the turn of the century, it has handed down thousands of opinions interpreting virtually every provision of Delaware’s corporate law statute. … Perhaps most importantly, practitioners recognize that ‘[o]utside the takeover process…most Delaware corporations do not find themselves in litigation. The process of decision in the litigated cases has so refined the law, that business planners may usually order their affairs to avoid law suits.’”

Given the depth and breadth of case law arising from Delaware, and the consequent predictability it affords in-state corporations, it is quite surprising that ANF seeks to reincorporate in Ohio partly so as to gain clarity on corporate governance issues. ANF provides the following as a rationale behind the move:

We believe that Ohio law affords directors a clearer balance of corporate governance rights and obligations than Delaware law and would thereby enhance our ability to attract and retain highly qualified individuals to serve as directors.

Seeing that numerous Delaware-based Fortune 500 companies have no problem attracting and retaining competent directors, this is a questionable claim. Beyond this, ANF also cites tax savings, but these savings are a meager 0.000062% of revenues and are certainly offset by the costs of creating and distributing a proxy, and the legal fees associated with effecting the reincorporation. The company’s final rationale is a vague “commitment” to the state of Ohio.

The reasons provided don’t appear to justify the effort, so what is the real reason for the move? A close inspection of ANF’s filing reveals a common thread – the threat of takeover and associated liability. ANF says it will gain “operational and statutory benefits” in Ohio that will allow it to remove its supermajority voting requirement and poison pill, both of which are designed to decrease the ability of potential acquirers to be successful. Further, it states that Ohio’s law provides “explicit guidelines regarding the matters that are appropriate for directors to consider … when deciding whether a proposed takeover is in the best interests of the corporation,” which provides clarity on potential director liability arising from a takeover. Additionally, as Chief Justice Rehnquist stated, the one area of litigation that arises for Delaware corporations is the takeover process, the consequence of being relatively less clear. As Dealbook points out,

Abercrombie will benefit from Ohio’s stricter anti-takeover rules. This includes Ohio’s business combination statute that, unlike Delaware’s business combination statute, is set off when a shareholder acquires 10 percent or more of Abercrombie instead of the 15 percent threshold in Delaware.

More important, Ohio also has a control share acquisition statute. According to Abercrombie, this statute “requires shareholder approval of any acquisition of shares of an Ohio public corporation that would entitle the acquiring person to exercise more than one-fifth, one-third or one-half of the total voting power of the corporation in the election of directors.” Abercrombie could have opted out of this statute but did not. …

The net result of this reincorporation will make it much easier for Abercrombie to steer an acquisition to its preferred acquirer and for shareholders to challenge the acquisition. In connection with the change, Abercrombie appears to be lowering the vote required to approve an acquisition via merger to 50 percent instead of the Ohio default of 66.66 percent. Ohio is also much laxer in regulating directors’ decisions to sell, rejecting Delaware’s Revlon doctrine.

Thus, the real drive for the reincorporation to Ohio appears to be greater control over potential acquisitions and clarity over potential liability arising from an acquisition. Does ANF have a legitimate reason for worrying about a takeover attempt? Although ANF has nearly doubled its share price over the past six months, it is still nearly 30% below its 2008 highs. Additionally, there have been several recent high profile buy-outs announced of clothing retailers in the past few months, including Gymboree (NASDAQ:GYMB) by Bain Capital, J. Crew (NYSE:JCG) by TPG and Jo-Ann Stores (NYSE:JAS) by Leonard Green & Partners LP, and buyout rumors have been swirling around Aeropostale (NYSE:ARO), American Eagle Outfitters (NYSE:AEO), and Chico’s (NYSE:CHS). Below we provide a comparison of ANF’s current valuation with those deals announced over the past few months:

Additionally, here is a comparison with other specialty retailers that have been the subject of takeover rumors:

Despite the industry-wide rumors of imminent takeovers, it would seem that ANF has less reason to fear a takeover given its premium valuation, though the market may simply be factoring in more margin upside for ANF in coming years when compared with some of its peers.

While we were unable to uncover other successful reincorporations away from Delaware and into Ohio, we should note that over the past several years there has been an increasing push from activist investors for target companies to reincorporate into North Dakota.

In 2008, North Dakota, prompted by Carl Icahn, passed a set of shareholder-friendly laws that require the annual election of directors (rather than staggered boards, long the bane of activist investors seeking quick change). Shortly after North Dakota’s enactment, activist investor John Chevedden sent shareholder proposals to Oshkosh Corp (NYSE:OSK), Hain Celestial Group Inc (NASDAQ:HAIN), Whole Foods Market Inc (NASDAQ:WFMI), and PG&E Corp (NYSE:PCG) to reincorporate to North Dakota. Several months later, in April 2009, seven more companies were targeted for reincorporation, including Exxon Mobil Corporation (NYSE:XOM), Lowe’s Companies Inc. (NYSE:LOW), Marsh & McLennan Companies Inc (NYSE:MMC), Amgen Inc. (NASDAQ:AMGN), Sempra Energy (NYSE:SRE) and Qwest Communications International Inc (NYSE:Q).

Carl Icahn has played a significant role, hiring the attorney that wrote North Dakota’s law and then subsequently promoting North Dakota in an Op-Ed in The Washington Post, in which he wrote:

North Dakota, for example, is recognized as having the most shareholder-friendly corporate laws in the nation, thanks to recent legislative action. By incorporating in the state and adopting its provisions, a public company would in one easy step improve rights for its shareholders and eliminate the often too-cozy relations between managements and boards.

Icahn then proposed that Amylin Pharmaceuticals, Inc. (NASDAQ:AMLN) and Biogen Idec Inc. (NASDAQ:BIIB) reincorporate in North Dakota.

Though these companies did not accept Chevedden’s or Icahn’s proposals, American Railcar Inc. (NASDAQ:ARII) filed a proxy asking shareholders to approve reincorporating to North Dakota (from Delaware).

The purpose of the Reincorporation is to enable the Company to reincorporate from Delaware to North Dakota and become subject to the North Dakota Publicly Traded Corporations Act. The North Dakota Publicly Traded Corporations Act provides a governance structure for publicly traded corporations that generally provides shareholders greater rights than they currently have under other state laws and, specifically, will afford shareholders of the Company greater statutory rights to involvement in the Company’s corporate governance process than they currently possess under the Delaware General Corporation Law (“Delaware Corporate Law”). … These rights are intended to decrease management entrenchment and increase management accountability to shareholders. Accordingly, the board of directors believes that the Reincorporation is in the best interests of the Company and its shareholders and will help maximize shareholder value.

Naturally, ARII is majority-controlled by Icahn. Shareholders approved the transaction and effective June 30, 2009, the company reincorporated from Delaware to North Dakota.

It will be interesting to see whether more companies leaving Delaware over the coming years choose shareholder-friendly states like North Dakota or management-friendly states like Ohio. Our pessimistic side wouldn’t be surprised if it’s the latter.

The debate over JOE has been ongoing since at least May 23, 2007, when Einhorn used The Ira Sohn Investment Research Conference (an annual forum where select hedge fund managers present their investment ideas to raise money for charity) as a platform to present his short thesis. At the time, JOE was trading at $55 and Einhorn valued it at $15. JOE dropped 10% after Einhorn’s presentation and nearly 50% in the subsequent six months (of course, this was during the general market meltdown in the second half of 2007). Notes from the presentation were passed around at the time and we have shown below in full certain notes compiled by BTIG and re-printed on ZeroHedge:

Short – JOE – The St. Joe Company
Company has primarily been in the business of development and sale of oceanfront properties in the Florida Panhandle.

• Sales to speculators led to record sales in 2005.
• Speculators have now turned into sellers. Most of St. Joes land holdings are timberland swamp.
• Poverty in the area does not help the company’s situation. The average income in the area is 30% below the national average.
• Great hope for new airport in 2010 but current airport underutilized. Comparable airports built (Jacksonville) have not had significant impacts upon that area.
• Lots of management turnover.
• Sell side models value stock at current price.
• peak ROE was 23% last year it was 9%.
• At current prices investors are paying over 8x book value for land.

Einhorn performed a discounted cash flow analysis as if they developed all properties in 10 years.
Discounted at 10% leaves the stock valued at $15

The company has two remaining businesses to service the $400 million in debt.

• Commercial real estate development.
• Sale of undeveloped acreage, this has been the principal source of revenue

More information about Einhorn’s 2007 thesis can be found here.

Entering 2009, JOE remained well below its 2007 trading levels. It was then, in May, that Bruce Berkowitz entered the debate. Berkowitz, whose Fairholme Funds is JOE’s largest shareholder with a 29% stake, began publicly touting his long thesis, while the stock traded at $25. Berkowitz became publicly more bullish after the Deepwater Horizon accident in the Gulf of Mexico which sent shares of JOE from $35 to $22 over the following two months, predominantly the result of fear that JOE’s coastal properties would be negatively impacted by the oil spill.

Berkowitz’s long thesis is based on three points. First, the company has an extremely low cost basis for its real estate holdings with little debt, a result of its long history and acquisitions stemming from the 1930’s. The market, according to Berkowitz, was failing to impound the true long-term economic value of this land, instead valuing it at “swampland” prices – just $3,500 per acre. Second, Berkowitz viewed the Deepwater Horizon accident as inconsequential with respect to JOE’s future, as the beaches remained open with no public health advisories. Third, Berkowitz saw a clear catalyst in the opening of the Northwest Florida Beaches International Airport in Panama City Beach, which is the first international airport built within the United States in fifteen years and is capable of turning the area into a major tourist destination and improving the commercial and industrial capacity of the region. Moreover, JOE strategically donated 4,000 acres toward the development of the airport, ensuring that it was built within JOE’s long-term master development plan.

This video interview with Berkowitz contains a synopsis of his long thesis from 2009. Berkowitz gave similar interviews throughout 2010.

In October, Einhorn announced he was short JOE and provided a comprehensive 139-slide presentation at the Value Investing Congress in New York to support his position. Einhorn believes that JOE’s assets are underperforming relative to the value the company is carrying them at, and that this will result in significant writedowns in the future. He showed that the company’s profits for the last decade were almost completely the result of land sales which subsidized its other operations, and that the sum of retained earnings and dividends, on a per acre basis over that period, amounted to just $1,102 – a third of Berkowitz’s “swampland” prices. Einhorn suggests that even at the high end of comparable sales, JOE’s land would be worth just $1,500 per acre. Einhorn argues that JOE has sold its best assets first and that it should take “substantial impairment” on the remaining assets. Additionally, Einhorn shows that further development will lead to negative returns, and that the company has ceased development because of these negative returns.

With the stock trading around $25 before the presentation, Einhorn revised his earlier estimate of JOE’s value to $7-$10 per share as a rural land company. The stock traded down 20% following his presentation.

Berkowitz has so far chosen not to respond publicly to the specific arguments Einhorn has made. Who will ultimately win this argument? Only time will tell, but in December it was announced that Berkowitz and his partner, Charlie Fernandez, would join JOE’s Board of Directors, seemingly indicating that Fairholme is willing to take an activist approach to unlocking value in its investment in JOE.

The first question we need to ask concerns the likelihood that BX will be able to dividend itself the proceeds from the NRG transaction.  While there’s nothing concrete preventing this, there are two factors we should consider.  The first consideration is that the Federal Energy Regulatory Commission (FERC) likely doesn’t want a grossly overleveraged DYN.  DYN provides a lot of power to a lot of people, and FERC regularly reviews M&A activity.  If the acquisition is approved, it will be implied that BX should manage the business responsibly.  If nothing else, BX should be concerned about protecting the value of its reputation with FERC.  Also, if DYN finds itself bankrupt within two years, BX could face fraudulent conveyance charges.  We can see on the chart above that bonds are already trading at a significant discount, so a sale of cash-flow generating assets to NRG might be seen as a somewhat deliberate impairment of an already distressed company — especially if the proceeds aren’t used to pay down debt.

The second issue we need to examine is what is preventing management from accepting the asset sale and refusing the buyout offer.  While the offer made was at a premium to the then-current share price, it was still well below the trading range in recent months.  The asset sale would allow management to take the company private (if they chose to do so), repay some bondholders, and potentially save the business.  The purchase and sale agreement with NRG is actually not with Dynegy, but with the wholly owned subsidiary of Blackstone that will be created to acquire Dynegy.  So this particular transaction is contingent on the acquisition taking place.  There was also an exclusivity agreement limiting Dynegy’s ability to shop for a better deal for 270 days or 90 days from the time the acquisitions are voted on.  (This is separate from the go-shop period.)  So there is a time constraint here, but nothing major.  The key takeaway is that management and shareholders still have options, reflected in the fact that shares are currently trading at a $0.38 (7%) premium to the buyout offer.

The lack of change of control provisions on the bulk of Dynegy’s debt allows us to dream up a number of results for how this can actually play out.  One interesting scenario could arise if the business continues to perform poorly and BX makes below par tender offers for longer duration bonds.  Investors will be aware that this could be their last chance to get out, and might be willing to accept a loss rather than roll the dice in a bankruptcy.  However, in this scenario, BX will face the difficult decision to “throw good money after bad”.  The real advantage of this strategy is that they can put off decision making to some point in the future when more information is available.

By most accounts, the buyout offer was made at a reasonable price, especially given recent market weakness and comparable transaction values.  It doesn’t look like BX found some magical loophole, or is taking advantage of some great market inefficiency.  For this investment idea to work, Dynegy assets will have to perform not only well, but better than investors have recently been expecting.

In our third and final case study, we’ll discuss our own work on Eagle Rock Energy Partners LP (EROC), a distressed master limited partnership that underwent a financial restructuring earlier this year to lighten its debt load and avoid looming covenant defaults. We believed that the restructuring plan supported by the company’s financial sponsor allowed the sponsor to unfairly steal value from public equity holders. We set up a website at www.fair-eroc.com advocating our views. In the end, our activism didn’t work – although forced to delay its first ballot due to a lack of support, the company mustered a majority of yes-votes on the second ballot to complete their transaction. Our egos were hurt, but our financial returns were not; the stock jumped ~15% on the announcement, and overall our investment in EROC generated a nice return. All’s well that ends well.

Below is an annotated stock chart of EROC. Note that this chart doesn’t fully capture the total return generated by EROC equity holders who held shares through the recapitalization; they also received value in the form of warrants and rights as part of the restructuring. Based on our calculations, unitholders received $1.25 to $2.00 of value from the rights / warrants package, which equates to a 20% to 33% contribution to a holder’s total return assuming a stock price of $6.

Below we’ll describe the situation and our activism, as well as relevant conclusions worth discussing. In addition to the foregoing and www.fair-eroc.com, we wrote about our investment in Eagle Rock Energy in this post in January.

The Situation

Eagle Rock Energy Partners, LP is a master limited partnership engaged in midstream natural gas gathering and processing and upstream oil and gas development. Prior to its recap, it also held a set of mineral rights, but sold these to Black Stone Minerals as part of the restructuring.

EROC went public in 2006 when Natural Gas Partners (NGP), a $7bn energy-focused private equity firm, essentially sponsored the partnership as a monetization vehicle. NGP and management owned the publicly traded partnership’s general partner, all subordinated units, and about 26% of the common units. It completed more than half a dozen acquisitions over the next few years, saddling the company with ~$800m of debt. When commodity prices crashed in 2008, the company’s forecasted leverage spiked and the company was forced to cut its unit holder distributions in April 2009. The company was forecasted to violate its leverage covenants in the second half of 2010.

In order to delever the company, Natural Gas Partners proposed a series of recapitalization plans to shareholders, beginning in September 2009. The plans were thinly veiled attempts by NGP to salvage value for their entirely underwater subordinated units on the backs of common equity holders. When MLPs like EROC halt distributions to common holders, the subordinated units begin accruing arrearages; for all intents and purposes, these accumulating arrearages render the subordinated units worthless. NGP offered to cancel the subordinated units in exchange for a hefty fee, a backstop for a rights offering at deeply discounted pricing, and various other bells and whistles that gave little value to common shareholders but unnecessarily complicated the proposed recapitalization.

Our Activism

Having seen other MLP recaps similarly mistreat common holders — many of which are dividend-seeking retail investors — in favor of the MLPs’ sponsors, we decided to set up a website to encourage holders to vote No to the proposed restructuring.

Our website was at www.fair-eroc.com. On the site, which cost us $10 and a few hours of HTML formatting, we uploaded our excel scenario analysis, comparing three scenarios: (i) no recapitalization, (ii) the NGP recapitalization, and (iii) an alternative and more fair recapitalization that didn’t compromise common holders’ rights in favor of subordinated holders’. We also wrote about our investment in EROC on our website here.

We think that our website found its way to most EROC equity holders, as well as the research analysts who covered the company. We received calls from holders large and small, and also had extensive conversations with one of the company’s two largest unitholders, which was working with the other large holder to negotiate revised terms for the proposal.

In the end, however, unitholders voted in favor of the plan. We’re not exactly sure why – the restructuring was clearly less than ideal, and we’re confident that NGP would have sweetened the offer if holders had rejected the initial proposal. But it’s ok – the stock traded up when the transaction was announced anyway. It appears that investors preferred cleaning up the capital structure and re-instating a distribution in the near-term than waiting a few more months for a better deal.

Conclusion

For our part, the activism was worth the effort. Our website allowed us to develop contacts within the EROC shareholder base and encourage other investors to support our stance with respect to the company’s proposed restructuring. We’re sure that our site helped increase the proportion of voters who voted against the plan, even though we weren’t able to break the 50% threshold. Given that our activism simply involved publishing some of our research, publicizing our position was time well spent.

While our EROC returns didn’t benefit much from our internet activism, we’re confident that publicizing our views will allow us to boost returns in the future, particularly in complex situations where we can simplify confusing transactions to the broader investment community.

Given that we publish an active blog, we’ll also write posts on the case studies that we’ll be profiling at the conference. We will discuss three examples where the internet has allowed distressed activists to share their analyses with a broader audience, recruit new investors and ultimately increase pressure on their intended targets. Our first case study, which we will profile in this post, is the battle between Pershing Square, T2 Partners and Hovde Capital over General Growth Properties.  In our second part, we’ll profile the bankruptcy of Energy Partners Limited, where Birch Run Capital successfully petitioned for an equity committee and forced bondholders to submit a revised Plan of Reorganization. In our third part, we’ll discuss our work on Eagle Rock Energy LP, an MLP that underwent a financial restructuring to avoid covenant violations, where we tried to use our website www.fair-eroc.com to rally shareholders to demand better terms.

General Growth Partners Case Study

GGP is a mall-based REIT which filed for bankruptcy in April 2009.  Pershing Square Capital Management was  involved from the beginning, even offering a DIP loan at the inception of the bankruptcy (which was later rejected in favor of another proposal).  In May, Bill Ackman, the manager of Pershing Square, presented the GGP Investment Case at the Ira Sohn Conference. Six months passed without much happening, and Pershing gave another presentation on mall REITs in early December.  Both presentations made their way through the hedge fund community, much like Ackman’s previous presentations on MBIA (May 2007) and Wendy’s (May 2008). Ackman’s work was likely helping frame the debate on General Growth’s valuation during the bankruptcy proceedings.

In December, things became a bit more interesting. Hovde Capital, which was short GGP, decided to respond to Ackman’s activism by going public with its own presentation. Entitled Fool’s Gold, Hovde claimed that weakness in the markets would lead to declining revenue at GGP, and that Ackman’s capitalization rate forecasts were too high.  We show in the timeline below how the Hovde presentation sparked an intense public debate.

The initial Pershing Square report was based upon two main claims. The first and most important argument was that GGP’s assets were not impaired.  Despite a troubled economy, its properties were performing well, and were not suffering sufficient deterioration to deem the equity underwater. The second important point was that General Growth’s distress was caused almost entirely by their inability to roll over coming debt maturities.  A number of scenarios were presented, but effectively the argument was that by extending maturities, debt holders would be repaid in full and shareholders would be left intact.  Ackman estimated the share value to be in the $9-$22 range compared to market prices in the $1-$2 range.

Months later, Hovde released a presentation claiming material deficiencies in the Pershing report.  The key complaint was that Pershing used old financial statements, and that there had been a significant deterioration in GGP’s earnings power.  On top of this, there were numerous reasons to be pessimistic about the economy in general, and mall retailers in particular, and this was hindering GGP’s ability to roll over expiring leases at reasonable rates.  Hovde also presented data suggesting that the cap rates being used weren’t consistent with what investors had been willing to pay over the last decade and were due for an upward correction (reducing enterprise value).  The result was an estimated value in the range of negative to positive $5 per share.

Shortly after the Hovde presentation was released, Whitney Tilson from T2 Partners released a short response describing the Hovde presentation as “a rare trifecta of poor analysis” in which a) economic weakness was overstated, b) accounting errors misstated operating income, and c) the wrong cap rate was used.  Until this point, there really hadn’t been much discussion of cap rates.  While Hovde gave a number of reasons why a higher cap rate should be used, they ended up using the same 7.5%-8.5% cap rate used by Pershing in their Fool’s Gold report.

One point that Tilson focused on, and the point that in hindsight mattered most to the investment idea, was the “strategic acquirer” factor.  Granted, it’s generally not a great idea to make an investment decision on the premise that some ‘greater fool’ will take you out at a higher price.  But the existence of interested buyers presented a risk to shorting a company that Hovde itself admitted could be worth $5 in its base case range. The stock was trading around $10 when Hovde released its report, and the levered nature of the equity didn’t make $10 theoretically too different from a $5 scenario.

Pershing responded to Hovde with a 55-slide presentation refuting the short thesis and increasing their fair value estimates to somewhere between $24 and $43 based on cap rates ranging from 7.21% to 6.21%.  Their most important claims demonstrated that recent performance hadn’t been as bad as suggested by Hovde; the economy was showing signs of improvement; and that lower cap rates were justified based on market comps and “control premiums”.

The debate continued through several more iterations of public presentations and commentary. Hovde used sellside estimates of NOI and future cap rates to bolster its arguments, and argued that strategic buyers were likelier to build positions lower in the capital structure than place bids that gave value to the equity.

Tilson, in turn, continued to email commentary supporting a higher GGP valuation to his broad-reaching email distribution list, and Hovde released a final presentation demonstrating some accounting errors and further justifying their numbers.

Ultimately, the argument became resolved when Simon made an offer to buy out GGP at $9, implying a market cap of $2.9b.  The offer was rejected and shares continued to climb well over $9.  Over the following months, numerous offers were made, none of which resulted in Simon acquiring GGP.  As of the time of this writing, the current plan of reorganization includes $8.55 billion of new capital coming from Brookfield Asset Management, Fairholme Capital Management, and Pershing Square.  Interestingly, GGP also plans to spin off its master planned communities and some other development projects.  This should separate out a piece of the business that some analysts believe holds no value.  Also, the Texas Public Pension Plan is investing $500mm to buy 4.9% of the equity at an implied price of $10.25/share, implying a market cap of $10.2B.  Shareholders are expected to vote on the reorganization on October 7, bondholders get no vote because there is no impairment.

Conclusion

What made the GGP debate unique wasn’t the valuation techniques or investment theses, but the communication methods used by the various funds involved. Both Ackman and Hovde attempted to use electronic distribution of their investment theses to influence public perception, as well as Chapter 11 participants. While GGP received acquisition bids well before it could tread down a more traditional plan of reorganization path, it’s likely that the presentations would have factored into the financial advisors’ valuation arguments, as well as the negotiations between the major creditors involved in the capital structure.

The public nature of the valuation arguments also created reputational risk for the parties involved. In this case, the views of Ackman and Tilson were vindicated, while Hovde’s dozens of pages of in-depth analysis left it with a fairly large loss on its short, as well as a black mark on its investing reputation.

It’s unclear whether the public debate over GGP’s valuation had a direct impact on the outcome of the case. The bidding war between Simon and the Brookfield consortium was ultimately about how much each interested party was willing to pay for the assets, as opposed to the perception of the company’s value by the market or other Chapter 11 participants. In our next part, we’ll see how Birch Run Capital’s presentation, which was as similarly in-depth and well-constructed as Pershing Square’s, actually played a central role in the Chapter 11 process, motivating the judge to extend disclosure hearings and ultimately issue a “substantial contribution” opinion from the judge for Birch Run’s valuable work. Of course, not to be lost on the hedge fund community, their presentation also led to a spike in the stock price immediately following its disclosure.

Mutual funds appear to have 83% of the market, compared to 5% for ETFs, about 1.5% for hedge funds and another 1.3% for funds of hedge funds.  Of course, the hedge fund market size (and its performance) is difficult to estimate, so these numbers should be taken with a grain of salt.  Other sources estimate it’s larger.  But our primary focus here is on ETFs and mutual funds anyway.

The chart below showing the growth of the mutual fund and ETF industry since 1993 might put it into better perspective:

For ETFs, the data doesn’t start in 1998, it starts in 1993 with $464 million invested.  The growth rate of ETFs has been higher, but it still has quite a way to go before it catches up with the big mutual funds.

One final chart that might be of interest to readers is the YoY growth of ETFs by type.  For investors like us, optimistic that the growth of ETFs will lead to more market inefficiency, this is the important chart to take note of:

In some cases, these enormous growth rates are less meaningful than they appear because if the international bond ETF market grows from $1 billion to $2, it will still likely be a tiny fraction of the total market.  But this should be a good roadmap for investors looking to see where ETFs are having an impact most (if they’re having any impact at all).

If investors are buying into (and out of) the S&P as a whole while ignoring the individual companies, the correlation between stocks should rise.  Even if ETF traders are looking at sectors, the effect will be the same.  Interestingly, a research director from Birinyi was quoted as saying “It is harder for individual investors and even for mutual fund managers to distinguish themselves by doing individual stock picks.  They might get the product right and the earnings right, but the market goes down and the stock is going to go down as well”.

While some investors or portfolio managers might consider this a risk, really it’s an opportunity.  The risk exists for those with very short time-horizons, like portfolio managers who are under pressure to outperform on a monthly basis.  If that’s the case, an investor can’t afford to make a good investment when the risk of being dragged down by the S&P is too great.  But if individual stocks are deviating from intrinsic value because they’re being pushed around by index buyers, there’s more opportunity available for legitimate analysts to dig into companies and find compelling values.

There are numerous reasons why the employment rate should be higher now than it was in the 1970’s, including the fact that women have entered the workforce in greater numbers and people are retiring at a later age (offset by the fact that people are living longer).  Still, data back to the 70’s is interesting because it shows how frequently these cycles occur and how they get resolved.  The last two times our economy shed jobs, it brought them back at a slow rate.  In the 70’s and 80’s our recoveries were a bit faster.  It seems like faster downturns lead to faster recoveries.

Readers might also take interest in the fact that employment rates have declined for the past few months, from 58.8% in April, to 58.7% in May and 58.5% in June.  This tells a different story than the unemployment numbers which show unemployment improving by 0.2% each month since April.  So clearly there’s some disconnect here between the employment numbers and the unemployment numbers.  It’s difficult to understand why the focus is on unemployment rather than employment, but when July numbers are out, we’ll be looking at the employed-population ratio before anything else.