Pershing Square Holdings (PSH) has published its annual results for the year ended 31 December 2022. During the period, PSH net asset value (NAV) total return per share decreased by 8.8%, ending the year at US$51.76 per share, while its share price total decreased 14.6% as a result of the widening of the discount to NAV at which PSH shares traded from 28.3% to 33.2%. In comparison, the S&P 500 declined 18.1% during the year ended December 31 2022, representing PSH NAV and share price outperformance of 930bps and 350bps, respectively. PSH’s compound annual return over the past five years to 31 December 2022 has been a NAV return of 25.1% (PSH share price 21.9%, S&P 500 9.4%) during that period (these returns are measured after the deduction of management fees and performance fees), which is commendable amid the recent volatile macroeconomic environment and markets.
Outperformance driven by interest rate hedges
PSH says that its outperformance of the S&P 500 during 2022 was driven by its interest rate hedges. Since the inception of this hedging programme in late 2020, these hedges have generated total proceeds of US$2.8bn for a total cost of US$419m for PSH and the other two Pershing Square funds as of 21 March 2023. Including the 2020 COVID-19 hedges, PSH’s manager has generated more than US$5.3bn in total hedging proceeds from a cost of US$446m. PSH says that, whilst the scale of the gains reflects the impact of particularly anomalous events disrupting financial markets, the board views these figures as truly extraordinary and appreciates the foresight and execution discipline exhibited by the manager.
Portfolio developments
PSH’s manager established a large position in Netflix in January 2022, and sold the investment in April. The decision to exit the position was taken after the company’s Q1 earnings report in which information came to light that caused the manager to lose confidence in its ability to predict the company’s future prospects with a sufficient degree of certainty. Although this led to a loss for PSH, PSH’s board says that it was pleased to see the manager act decisively when the facts changed.
SPAC versus SPARC
Also in 2022, PSH exited its position in Dominos and liquidated Pershing Square Tontine Holdings. PSH’s chairman, Anne Farlow, comments that “although our commitment to PSTH did not result in an investment for PSH, we did benefit from the process as it led to our investment in Universal Music Group. The Investment Manager has filed a public registration statement for Pershing Square SPARC Holdings, Ltd. (“SPARC” or “Special Purpose Acquisition Rights Company”), which has been designed to be a significantly more efficient and improved successor to the traditional Special Purpose Acquisition Company (“SPAC”). SPARC is subject to SEC review, and if approved, will allow the Investment Manager to work on a potential merger transaction without burdening investors with the opportunity cost of keeping their money in a trust account as is the case with traditional SPACs”.
Gearing
In May 2022, PSH redeemed the US$631m balance of its outstanding 5.500% senior notes due July 2022. PSH continues to believe that its ability to access low cost, long-term, investment grade debt is a competitive advantage, and its long-term debt management strategy is to manage leverage over time by increasing NAV through strong performance and laddering maturities through new issuances. At present, PSH’s debt profile is comprised of a laddered set of maturities, matching the manager’s long-term investment horizon, with a weighted average maturity of 9 years and a weighted average cost of capital of 3.1%. PSH’s total debt to total capital ratio as of March 21 2023 is 19.5%.
Dividend and buybacks
The board announced a 25% increase to PSH’s quarterly dividend and a new methodology for determining future dividends that ties future increases in dividend payments to NAV growth. In January 2023, the board increased the dividend again by 4.6% for 2023, based on that methodology.
Finally, the board also authorised a total of US $300m in share repurchase programmes in 2022 as it believed it to be a good use of capital in the current environment.
Manager’s review of 2022
“2022 was characterized by a high degree of stock market volatility driven by aggressive global central bank interest rate increases, the war in Ukraine, and broad-based declines in nearly every asset class. In that the value of financial assets is based upon the present value of their future cash flows discounted back at an appropriate interest rate, broad based increases in interest rates combined with greater global risk and uncertainty caused discount rates to increase substantially and asset values to decline. In other words, higher required investment returns from investors lowered the price that investors were prepared to pay for financial assets, causing stock prices to decline.
“Our equity holdings responded accordingly. Despite significant business progress in 2022 at each of our portfolio companies, the effect of higher discount rates for all but two of our companies overwhelmed their anticipated business progress, leading to stock price declines and mark-to-market losses for Pershing Square. Restaurant Brands and Canadian Pacific generated marginally positive total returns in 2022 as their business progress exceeded market expectations and overcame the downward impact on valuations from the rise in rates. Overall, our long-term equity portfolio generated a negative total return (including dividends) of 16.1% in 2022. In addition, PSH’s NAV declined by an additional 5.2% due to Netflix and losses in connection with the liquidation of Pershing Square Tontine Holdings, Ltd.
“Our losses on equities were offset somewhat by interest rate hedges, which contributed 14.3 percentage points of positive performance in 2022.18 These hedging gains, combined with our COVID-19 CDS hedges in February 2020, have been a highly material contributor over the last three years as they have generated approximately US$5.3bn in total hedging proceeds to date versus a cost of US$446m, the substantial majority of which have been redeployed in equities in a timely manner, which in turn have, in nearly all cases, increased substantially in value, further amplifying the benefits of our hedging gains.”
Manager’s view – Why Did We Not Sell Equities in Light of Our Views on Interest Rates?
“In light of our views on interest rates and their impact on equity values, why, you might ask, did we not sell or reduce our equity holdings in 2022? The answer is that our strategy is to maximize the growth in our long-term NAV per share which requires us to endure some amount of short-term, mark-to-market trading losses. We do not typically sell our core portfolio holdings even if we believe it is highly probable that they will decline in price in the short term, as long as our view of their long-term potential remains largely unchanged. We limit our short-term trading for this reason as doing otherwise will likely lead to lower long-term rates of return for Pershing Square due to several factors.
“We are often one of the largest shareholders of our companies. Over time, we have built important, longstanding relationships with their management teams and boards, which have enabled us to be an influential shareholder. We believe our influence increases the probability of value-maximizing decisions being made by our portfolio companies while reducing the risk of value-destroying errors. Were we to constantly trade around our positions, we would have a less credible voice with management and other shareholders when advocating for strategic initiatives and corporate changes which have long-term implications.
“Furthermore, large frictional costs are often incurred when acquiring and disposing of large holdings. To be successful as a short-term trader of large ownership stakes, we would have to successfully estimate how much a stock price will decline based on macro events, and then accurately predict what price we would have pay to repurchase the position. While our predictions about macro risks have been largely accurate, we cannot expect to always get it right. And even if we are correct in our macro assessments, it is far less knowable how and for how long the stock market and individual stocks might react to these events. A short-term trading program might enable us to avoid a small loss at the much larger cost of missing substantial stock price increases thereafter. As a result, we do not trade around our long-term holdings and generally only make adjustments in the size of positions to manage concentration risks in the portfolio.
“Some have suggested that we should launch a macro fund so that investors who desire exposure to just our macro strategy would be able to directly participate in what has been a very high-performing strategy. The problem, however, with this approach is that we have only found macro investments that fit our requirements – namely a high degree of asymmetry and a high confidence level in the predicted outcome – to be episodically available. While we made large profits hedging the financial crisis in 2008, we made no material macro-related investments after the crisis until February 2020. While we have continued to identify interesting asymmetric macro investments over the past three years, there is no certainty that similar opportunities will present themselves in the future.
“For the above reasons, we believe that our strategy of owning simple, predictable, free-cash-flow-generative, highlydurable and well-capitalized growth companies combined with occasional, opportunistic, asymmetric hedges will generate the highest, long-term rates of return for Pershing Square with the least amount of risk of a material permanent loss of capital. Our approach also has the benefit of being a better fit with our temperament, is less stress inducing, and much more time efficient. We therefore remain committed to this strategy that has served us well for nearly 20 years.”
Manager’s view – Market and Geopolitical Risks in 2023
“We are operating in one of the most uncertain and risky environments in decades. As of the present moment, we are in the midst of what may be the early stages of a US banking crisis with the potential for it to spread globally with Credit Suisse’s recent demise. Financial institutions are inextricably linked, and one large banking failure can ignite another and so on. This remains true even though some of the enormous derivative risks that almost took down the financial system during the crisis have been mitigated somewhat due to requirements for exchange trading of most derivatives. Banking is confidence sensitive. A run on deposits at one large bank, most recently Silicon Valley Bank (SVB), the 16th largest US bank by assets, has the potential to spread to other financial institutions.
“Until SVB failed, the vast majority of depositors did not concern themselves with the lack of deposit insurance for accounts above the FDIC-insured limits of $250,000. In reality, uninsured depositors are unsecured creditors of a bank which are at risk of loss in the event the bank were to fail. The events of the last few weeks made this manifestly clear as it was only a last-minute and apparently reluctant decision for the government to step in and guarantee uninsured deposits at SVB.
“Now that uninsured depositors understand that there remains a risk that they will lose access to and/or have their deposits impaired, many businesses are rethinking their working capital management and investment strategies. This concern is compounded by the large increase in short-term interest rates. Since the financial crisis, there was little if any return offered on short-term funds, and depositors were therefore not particularly concerned about the yields, if any, they earned on deposits. The recent large increase in short-term rates has caused CFOs and corporate treasurers at all companies to become more disciplined about maximizing the yield they can earn on short-term cash. This will increase the cost of deposits for most banks, as they will have to be more competitive with money market accounts, putting pressure on bank’s net interest margins.
“The US economy relies on its large network of community and regional banks to provide access to debt capital, particularly for small and medium-sized companies that do not have access to the public capital markets. These banks also are major providers of real estate and construction loans as the large so-called systemically important banks have for the most part exited these lending categories other than for large capitalization, usually investment grade, corporate borrowers.
“About 70% of commercial real estate bank loans are made by regional and smaller banks. There is a logic to this approach as real estate is inherently a local business, and a geographically proximate bank should be in a better position to assess the risks of local borrowers and the likelihood of their projects’ and business’ success. Increases in the cost of capital for regional banks will be passed along to their borrowers, and as a result fewer commercial real estate projects will be viable due to the higher cost of this capital. This will be a drag on the US economy and will make it more difficult for existing real estate owners to refinance their debts when they come due, which will negatively impact real estate values further impairing bank balance sheets.”