Opinion

When Crony Capitalism Failed

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Posted: Nov 29, 2017 12:01 AM
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When Crony Capitalism Failed

Crony Capitalism means government action to favor a business over its competitors. It often involves regulation that the favored company can handle better or at lower cost than competitors. But it can also involve outright taxpayer funded subsidies to the favored company, or tax loopholes that the favorite can exploit better than competitors.

Crony Capitalism is itself a big business in Washington, which is swarming in lobbyists seeking such advantages for their clients. But not every business trying to play the Crony Capitalist game succeeds, and some are clearly better at it than others.

Pershing Square Capital Management is a hedge fund founded in 2004, run by billionaire investor Bill Ackman. Hedge Funds are like real estate investors looking for distressed properties to fix up and resell for profit. Except that Hedge Funds buy, fix up, and resell distressed companies for profit, much bigger profit than in real estate.

Ackman thought he saw an opportunity with a company named Herbalife, which makes and sells nutritional shakes and supplements. In December, 2012, Ackman invested $1 billion of his company’s funds going short on Herbalife’s stock, which means he sold $1 billion of borrowed Herbalife stock he didn’t own, on the hope he could buy and return the stock for less later, after he drove the price down.

Ackman proclaimed that the company was a pyramid scheme, based on his allegation that Herbalife’s sales were artificially inflated by sales to distributors rather than consumers, and that the company’s stock was going to zero. “The stock crashed, falling 10% in 6 seconds” Fortune reported in 2015.

Ackman admitted to Bloomberg TV in 2014 that he had spent $50 million for research and negative publicity about Herbalife. The New York Times reported that Ackman employed law firms and the Global Strategy Group, a public affairs firm that conducted opposition research on Herbalife and organized public rallies against the company.

ABC News reported Ackman paid $3.6 million to a “whistleblower” to help provide damaging information about Herbalife to the government, seeking an investigation that would result in the death of Herbalife, to the profit of Ackman and his investors. Ackman lobbyists broke through with Congressional Democrat Ed Markey of Massachusetts, who wrote to the SEC and FTC seeking investigations of Herbalife.

That bore fruit, as the SEC opened an investigation of Herbalife in 2013, and the FTC began investigating the company in 2014. By March 2015, Herbalife’s stock was down more than 50% from its peak.

But Herbalife presented its business case to legendary investor Carl Icahn, who bet his investments on survival of the company. And the federal investigations were resolved favorably for Herbalife. The New York Post reported that Herbalife stock shot up more than 10% on news of the settlement with the FTC, to $65 a share.

The company instituted new practices to better enable it to keep track of sales and the identity of buyers. The FTC confirmed earlier this year that 90% of Herbalife’s sales the previous month were to consumers, out of 3 million retail transactions, which exceeded the 80% required by the Herbalife settlement agreement.

Herbalife stock rocketed to $75 on this confirmation of compliance with the FTC requirements. That broke the back of Ackman’s Pershing Square Capital Management, which was left buying back its own shares for more than they were worth.

Tea Party Nation summarized,

“Wall Street investors frequently come to Washington requesting help….In the case of Pershing Square’s Bill Ackman, he came to Washington requesting his friends in Congress to get the Federal Trade Commission to put the nutrition company Herbalife out of business so he could profit on his Wall Street bet that the company’s value would go to zero. Like his many other recent investments, Ackman’s strategy was flawed, because he chose to attack a company that refused to be bullied into bankruptcy.”

Lesson learned: Crony Capitalist insiders don’t always win. Just look up the former company Solyndra.