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QD view – Circling the Pershing Square

It’s that time of year where we see a flurry of annual and interim results hitting the market for companies whose reporting periods finish on 31 December. Even in a quiet year, it is quite possible for interesting stories to get lost in this first quarter deluge, but once you factor in the additional market noise that we have seen so far in 2022 (for example, from rising inflation and central banks’ moves to choke this off with interest rate rises; the war in Ukraine; rapidly rising power and energy costs, which are hitting everybody’s pockets), it’s easy for things to fall through the cracks, which brings me to Pershing Square Holdings (PSH).

PSH posted a respectable set of results earlier this week (click here to read our Jayna Rana’s coverage of these) and, the day before, announced an enhanced dividend policy (covered by our James Carthew in his morning briefing of 29 March – click here). There were some interesting comments hidden away in these announcements, which I think warrant some extra attention, particularly given the size of PSH’s surprisingly high discount.

Pershing Square – a lot of pent-up value

There is no getting away from the fact that PSH has suffered from a discount problem for quite some time, despite providing decent returns over the longer-term. To illustrate the point, during 2021, PSH provided an NAV total return of 26.9%, which was only marginally behind the S&P500’s 28.7%. However, PSH’s share price failed to keep pace with its NAV and the discount widened from 23.0% to 28.3%, meaning that the share price total return was just 18.6%.

The discount problem persists so, as at last night’s close, PSH was trading at a price of £30.20 per share, which is a discount of 31.2% to its most recent NAV of £43.89 per share. Put another way, there is a potential return of 45.3% if investors were able to close this gap and exit at NAV. The numbers are big – this pent-up value amounts to some £2.73bn.

Why is this hefty discount able to persist?

PSH has some large liquid holdings that should be marketable and so you would think that, with this sort of value to be extracted, arbitrageurs could have swept in by now and taken some action to close out the discount and make themselves a handsome profit. The main obstacle to this is the sizeable stake that the manager effectively controls (PSCM and its affiliates own 25% of PSH’s shares), which also gives some insight into why little effort has been put into marketing the fund and getting the discount down.

Why does PSH not bet on itself?

With a discount this high, you would think that it would make sense for PSH to be betting on itself and repurchasing its own shares – let’s not forget that, at a discount of 31.6% to NAV, share repurchases are highly accretive to remaining shareholders. Put another way, if you believe that the NAV is a fair estimate, logic dictates that you would need to earn a very high return on any alternative investment to justify not repurchasing stock. However, during 2021, not a single PSH share was repurchased, which I find very surprising.

A cynical observer might well say that, given its own significant level of influence, which is acting as a barrier to another hedge fund swooping in, there is little incentive for the manager to narrow the discount as this will likely mean shrinking the fund and this will mean lower fees for itself (and the performance fee is juicy – see below). It also suggests that the board is perhaps more aligned with the manager than external shareholders as it too is allowing this situation to persist.

Ditching shareholder meetings is nonsensical

In these situations, boards and managers typically put in a raft of measures aimed at tackling the discount. These will typically involve greater marketing spend and improvements aimed at making a trust more shareholder friendly. I was therefore surprised to read that the manager will no longer be meeting investors, which I think is precisely the opposite of what is required and therefore nonsensical.

Presumably PSH’s board has signed off on this, so questions have to be asked, once again, of the board’s alignment and whether it is serving external shareholders’ best interests. If I was being cynical, I would question whether the decision to go for radio silence reflects a desire by the manager and the board not to have to talk either about their inaction on PSH’s clear problems, or the mind-blowingly large performance fee that the managers accrued last year (clearly, I’m in the wrong job).

The new dividend policy – 1% of NAV, with the level maintained during downturns so that there are upward only revisions, does not feel sufficient to capture investors’ imaginations. If PSH’s board wants to use the dividend as a tool to attract investors, it needs to be more generous – 4% seems like a more realistic starting point.

Exceptionally nice work if you can get it!

In addition to a base management fee, payable in advance, of 0.375% of net assets (before any accrued performance fee), which is equivalent to 1.5% of net assets per annum (already exceptionally generous for a fund of this size, and please note the lack of a tiered fee structure), the manager is also entitled to a chunky performance fee. This is equal to 16% of the NAV appreciation above a high-water mark (note there is no hurdle rate to be achieved before the performance fee kicks in).

During 2021, PSH’s portfolio returned 32.0% but, after deducting a performance fee equivalent to 5.1 percentage points of the gain, returned 26.9%. This is a big drag on PSH’s NAV performance and, as noted above, is a major incentive for the manager to not shrink the fund. PSH paid a total performance fee of US$464m, of which US$443.3m was shared amongst 45 staff – an average of US$9.85m per head. These sorts of levels are like winning the lottery and must be creating perverse incentives for the manager. We have no issue with performance fees if they are well designed, but PSH’s clearly is not. However, perhaps the board would argue that this is the price you have to pay to get a manager such as Bill Ackman.

What about the other 75%?

A casual glance suggests that the remaining 75% of shareholders are paying a lot to the 25% that manage the fund, and a 31.6% discount suggests considerable dissatisfaction with PSH by the market (the failure of its SPAC, Pershing Square Tontine Holdings is unlikely to have helped in this regard). We think that this situation is not sustainable and that the board and manager will find themselves increasingly being pressed on these issues, despite trying to avoid the subject. It is difficult to see how this will play out. Measures could be put in place to make the PSH more attractive and the market would do the rest. However, given the efforts so far, this doesn’t seem likely. A more likely outcome, in our view, is that we could see a deal to take the fund private. While this might not be entirely satisfactory, it is perhaps the only way that shareholders could realistically get out at close to NAV.

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