Kerrisdale Capital: A Case Study in Internet Activism

Sahm Adrangi, managing member of Kerrisdale Capital has written a great piece on internet activism below. Enjoy!

GGP: A Case Study in Internet Activism

In September, we will be giving a presentation at the 6th Global Forum on Investing in Distressed Debt on the topic of “Distressed Debt Activism In The Age Of Electronic Media”. We’ll focus on how activist investors in distressed situations are increasingly using internet communication to achieve faster and more meaningful impacts on their targets.

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, Hovde Capital, and T2 Partners 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 became involved from the beginning, providing a $375mm DIP loan. 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), Wendy’s (May 2008), etc. 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. They 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. The offer was rejected and shares continued to climb. 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.

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 reputation 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.