In Herbalife ‘Short War,’ Hedge Funds Miss the Target

Bill Ackman and Carl Icahn
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Bill Ackman and Carl Icahn

A star-studded battle among hedge fund titans over the nutritional supplements company Herbalife became the talk of Wall Street when it erupted. But when the barbs eventually fall silent and the klieg lights dim, how will the Herbalife war end? And what truth will emerge?

The arrival of the hedge fund billionaires — William A. Ackman, Daniel S. Loeb and Carl C. Icahn — spawned a media circus. And at times, some investors acted as if they were the stars of a reality-TV show. Yet blustering and bluffing are what traders do, after all.

In the beginning, the dispute was over how Herbalife sold its products and to whom. In December, Mr. Ackman made a presentation at an investor conference, saying that Herbalife was a pyramid scheme. Herbalife vehemently denied those claims, and put on its own investor day in January to rebut them.

The focus, however, soon turned to the hedge fund celebrities. A day before Herbalife's presentation, Mr. Loeb's hedge fund, Third Point, disclosed that it had acquired 8.24 percent of the company's shares, giving Herbalife a huge show of support.

After Mr. Loeb, Mr. Icahn — who is worth some $15 billion, according to Forbes — entered the fray. Yet the fight first appeared to be about something other than Herbalife last month, when Mr. Icahn and Mr. Ackman duked it out on CNBC over real and imagined insults dating back a decade. At the time, Mr. Icahn did not disclose a position but noted that if someone tried to acquire Herbalife, it would spell trouble for Mr. Ackman because "if that happens, that stock could rush to $100."

It was perhaps no surprise when Mr. Icahn announced later that week that he had acquired an almost 13 percent interest in Herbalife. Mr. Icahn topped that off with an announcement last week that he had cut a deal to put two of his people on the Herbalife board and acquire as much as 25 percent of the company.

As a result, the debate over Herbalife has been reduced to the level of a junior high school feud as it becomes about traders trash-talking each other. Hedge fund billionaires may have huge egos and not like each other? Really? As Gordon Gekko says in the 1987 film "Wall Street," "If you need a friend, get a dog."

To employ another movie reference, what's happening with the hedge fund battle is the reverse of a famous "Godfather" quotation: It's not business, it's personal.

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A recent exchange on CNBC's "Fast Money" program says it all. Under the heading "The Ackman Pain Trade," one of the hosts talked about why Mr. Ackman's claims were wrong. He stated, "The reason I think Herbalife is not a fraud is, No. 1, I have a very close personal relationship with Dan Loeb, who doesn't believe this is a fraud." Right.

So no one appears to be doing an actual investigation or asking the right questions. The central issue, in case you need reminding, is whether Herbalife is a pyramid scheme, in light of some of the questions that Mr. Ackman has raised. This is important, as not just billions are at stake, but an entire company and the tens of thousands of people who are affiliated with it.

And for all the talk of a "short war," the finance people are not likely to dictate the ending here. David Einhorn was reportedly short on Herbalife but has already closed his position. Mr. Loeb is said to have sold at least part of his stake at least, and may have sold it all. Mr. Loeb is required only to disclose the position in his quarterly reports to the Securities and Exchange Commission in May. (Mr. Loeb declined to comment, and Mr. Einhorn did not respond to requests for comment made to his representative)

Hedge fund traders are in it for the short-term profit. And that's yet another reason the focus should be on the actual claims here instead of finance.

With the hedge fund titans exiting for a quick profit, the talk of a "short war" will die down. But this still leaves Mr. Icahn and Mr. Ackman. It also leaves the specter of another financial trick, a short squeeze.

If a short squeeze occurs, Mr. Icahn's purchase of Herbalife shares, along with other purchases, will force Mr. Ackman to return the shares he had borrowed at a much higher price. This would be deadly — the 2008 short squeeze around Porsche's acquisition of Volkswagen sent VW's shares skyrocketing, briefly making it the most valuable company in the world. Mr. Ackman could lose more than a billion dollars if a similar situation were to happen at Herbalife.

But this is not likely to happen. Mr. Ackman probably didn't borrow his shares to short from hedge funds, but rather through Goldman Sachs, his prime broker, using Herbalife shares held by index and other "safe" institutional investor funds like Fidelity. It is unlikely that these institutions will sell their shares or call them back. And shares available to short are likely to remain plentiful even after Mr. Icahn takes his full position.

Herbalife is not even among the 50 most-shorted companies, and about half of Mr. Ackman's position is traded every day on average, meaning that there is still a lot of stock out there.

So, it's unlikely that Mr. Ackman will be forced into a short squeeze without someone buying the entire company. Except for Mr. Icahn, it is hard to see anyone making a bid, given the uncertainty and the unwillingness of a bank to finance an offer. Certainly, a private equity firm would not want to take the risk.

As for Mr. Icahn, he is taking two board seats and apparently entering into an agreement that he won't sell his shares for a year unless the price is above $73 a share. And Mr. Icahn has signed a standstill, agreeing not to make a bid unless someone else goes first.

So how will this end? It's not likely to end soon. Neither Mr. Ackman nor Mr. Icahn is going anywhere, and the rest of the hedge funds are just trading in and out, riding the waves. And while Mr. Ackman is hoping that regulators will step in and end it all, it is hard to see them acting without a very thorough and lengthy investigation.

And while Wall Street's focus, and everyone else's for that matter, has turned to the drama of two financiers who don't like each other (what's new?), it ignores what actually matters. In the absence of anyone looking at the facts, Herbalife will be under great pressure to keep its earnings up while Mr. Ackman continues to push the company to change how it reports those earnings.

Without someone buying the company, it is essentially a stalemate. The only way out appears to be over time as each quarter unfolds and Herbalife's model holds up under Mr. Ackman's scrutiny — or doesn't. Let's face it, without something to stop the attacks, the company is going to undergo strain as time goes on and the questions and suspicions persist. But this could take years.

In other words, take a seat, folks, as this "short war" may take something that Wall Street hates almost as much as it likes a good cat fight: patience.