It’s Dangerous Out There—–When Hedge Fund Herding Gets It Wrong

By Alexandra Stevenson & Matthew Goldstein at The New York Times

The billionaire investor William A. Ackman has become the unofficial leader of a thundering herd that has lost billions of dollars betting onValeant Pharmaceuticals over the past year.

The 49-year-old founder of Pershing Square Capital Management, the $12.5 billion hedge fund, found himself going to bat again for Valeant on Wednesday when he testified before Congress about Valeant’s controversial drug pricing policies, which have included inflating the prices of vital heart medicines right before learning that generic equivalents were coming to the market.

Mr. Ackman’s firm has lost billions of dollars on Valeant. Shares of the Canadian drug maker have plummeted 85 percent since he first pitched the company as one of his best investment ideas at a hedge fund charity event last year.

Not coincidentally, big names like Paulson & Company, Viking Global Investors and Brahman Capital have also lost billions, collectively, by betting on Valeant — underscoring a growing phenomenon of hedge fund groupthink. It is a reflection of big-dollar investors chasing too few ideas and getting tripped up when things turn poorly for a company they have set big markers on.

“The bottom line is, hedge fund herding is not going away anytime soon,” said Andrew Karolyi, a professor of finance at Cornell University. “If anything, we are now seeing the early signs that this type of hedge fund herding is spilling over into herding of large institutional investors. To the extent that that spillover grows and expands, then we will be concerned.”

Hedge funds piled into Valeant as the stock soared more than $200 a share last year, even as warning signs about the company’s leadership and business practices began to appear. The stock is now trading around $36 a share, as Valeant prepares to install a new chief executive and races to meet a deadline to file a delayed financial report.

Big hedge funds employ teams of analysts to conduct research on companies, and they also spend tens of millions of dollars on outside research. But managers are also influenced by the big bets of their counterparts: So-called best ideas get exchanged at charitable events and exclusive industry dinners attended by traders and managers.

“Why do people believe it?” asked David Maris, an analyst at Wells Fargo. “They follow Valeant because they want to follow it. They want to believe they have found a new way to make money in pharmaceuticals without investing in new drugs — it sounds like a magic money box.”

The crowding of hedge funds into Valeant was not an isolated event.

SunEdison, a renewable energy company, was once a hedge fund darling. Big investors included Omega Advisors, Glenview Capital Management and Greenlight Capital Management. David Einhorn, the founder of Greenlight and one of the industry’s most closely followed investors, emerged as SunEdison’s head cheerleader when he gave a presentation promoting it in October 2014 at a Manhattan charity event. He called his presentation: “Here Comes the Sun-E,” playing of SunEdison’s stock ticker name.

Mr. Einhorn, 47, whose fund at its peak owned 6.8 percent of the company’s shares, remained bullish on SunEdison’s prospects even as the stock, which was trading at about $31 a share last summer plunged during the remainder of the year. In early January, as SunEdison shares were trading at $3, Mr. Einhorn got a representative appointed to the company’s board.

Then on April 21, the company filed for bankruptcy. Shares now trade for around 24 cents.

Calculating specific losses for a hedge fund is difficult without knowing the prices which a firm purchased its shares. But Valeant’s and SunEdison’s plunging share prices have caused considerable carnage.

It is a time of turbulence for the hedge fund industry, where some of the biggest names have reported double-digit losses. Last year, firms fell deeply into the red after wide swings in certain so-called hedge fund hotel stocks, leading what Daniel S. Loeb of Third Point Management called a “hedge fund killing field” in a recent investor letter.

The total value of hedge fund positions in SunEdison, which once accounted for 66 percent of the company’s shares, is now worth just $15 million after its bankruptcy filing, according to FactSet, the financial research firm. Before hedge funds began selling their SunEdison shares last year, the value of all of those firms’ holdings was $3.5 billion.

The losses are worse with Valeant. At the beginning of 2015, hedge funds owned about 23 percent of the company’s shares. Today, the market value of the industry’s holdings in Valeant have fallen by $7.3 billion even as hedge funds bought more, according to FactSet.

Firms have until mid-May to disclose whether they sold or bought shares in the fourth quarter.

That so many hedge funds remained bullish on Valeant despite months of turmoil — as questions were raised repeatedly about its accounting practices — reflects the difficulty managers sometimes have with changing course.

“We all get lazy and when an idea seems to be working — inertia tends to take over and you stop paying attention,” said James Chanos, the founder of Kynikos Associates and one of Wall Street’s best-known bearish investors. “That’s on full evidence with Valeant and SunEdison too,” he added.

Mr. Chanos’s firm began researching Valeant in late 2013. The company was a classic corporate roll-up that was growing because of serial acquisitions, piling on the debt at the same time. His short thesis focused on the fact that Wall Street was giving the company too much credit for future growth that would continue only as long as Valeant could keep acquiring bigger companies.

In February 2014, Mr. Chanos presented Valeant as a stock to short at his annual “Bears in Hibernation” retreat in Miami, which some three dozen of his friends and like-minded bearish investors in the hedge fund industry routinely attend.

Mr. Ackman reached out to Mr. Chanos a month later to learn about his short bet and Mr. Chanos offered to share his research. Mr. Ackman appeared not to be persuaded and by February of the next year, he began to build what is today a 9 percent stake in Valeant.

Now, as a recently appointed member of Valeant’s board, Mr. Ackman is not only one of the biggest investors in the company, but has also positioned himself as an architect of its potential comeback as well. His most recent investor letter on April 26, emphasizes his role in stepping in to stabilize the company earlier this year, gaining two seats on the board.

But much work remains. Valeant still has a debt pile of $31 billion to manage. It continues to wrestle with the fallout from a now shuttered mail-order drug distribution company, Philidor Rx Services, which led to an internal review of its accounting for revenue from that channel. It may have to restate earlier earnings.

Mr. Ackman, in his opening statement on Wednesday to the Senate Special Committee on Aging, tried to strike a conciliatory tone when it came to the uproar over Valeant’s history of increasing prices on drugs it acquired through acquisitions. He said Valeant will institute a process to ensure it considers “all appropriate factors and patient access in particular, when setting prices for its drugs.”

Scolded by one senator for not looking closely enough into Valeant’s drug pricing, a somewhat flustered Mr. Ackman said, “I regret that we didn’t do more due diligence.”

For Mr. Einhorn and SunEdison, the path forward is more uncertain. Normally, equity holders get little to nothing in a bankruptcy reorganization. Mr. Einhorn’s Greenlight firm cut its stake in the company nearly in half a few days before the bankruptcy filing, but by then, the damage was done.

Mr. Einhorn has not said anything since the bankruptcy filing and has said little to his investors this year about his bet on SunEdison.

But in a letter to investors in January, Mr. Einhorn quoted David Bowie, in what now seems like a prescient statement, “I don’t know where I’m going from here, but I promise it won’t be boring.”

Source: As Valeant Tumbles, So Does Bill Ackman’s Hedge Fund Herd – The New York Times