One aspect of Ackman's activist approach that I believe is widely overlooked is his creation of a system to align CEOs he hires into companies. I have discussed this method of Ackman's in an earlier post, so this may sound a little repetitive to those who previously read it. The reason why I think his true genius is on display through the technique of having the incoming CEOs invest in warrants is that, when the writing is on the wall in a few years, I believe we will see the benefits in the stock prices of Howard Hughes Corp. and JCPenney. So how, you may ask, does this intangible factor guarantee success? The answer is that it doesn't. But given the importance I place on having a good management team in place, if you give me a great CEO and further have incentives in place that amplify his long-term up- and down-side, you have my close attention for at least a few hours!
Howard Hughes Corp. Warrants - Purchase Terms
- Weinreb and Herlitz ("W&H") bought 2.7m warrants for $17m, or ~$6.30 per warrant on Nov. 19, 2010
- Strike price is $42.23 (closing price on 11/19/2010)
- Breakeven price is therefore $48.53 ($6.30 + $42.23)
- 7-year life; if share price is not at least $48.53 by Nov. 19, 2017, Weinreb and Herlitz stand to lose 100% of their $17m investment
I believe W&H will continue to do their best to surface value by Nov. 2017 because of the leveraged upside both still have from this vantage point. If they are able to build the value of the company to $100 (my intrinsic value estimate for HHC), this would mean a $139m profit [(100-48.53) x 2.7] or a 817% gross return.
Thus far, management has been quietly working away on advancing developments at the South Street Seaport, Riverwalk Marketplace, Columbia MPC, Bridgeland MPC, Woodlands MPC, and the Ward Centers in Honolulu. My bet is that W&H will really pick up the steam in 2015, and by 2017 we will have seen various value realization moves (e.g. spin off a segment, sell partial interests for more than people expect). Don't forget that you also have Bill Ackman, the financial engineer of all financial engineers, to ensure than as much value by then is surfaced.
J.C. Penney Warrants - Purchase Terms
- Ron Johnson bought 7.257m warrants for $50m, or ~$6.89 per warrant in June 2011
- Strike price is $29.92 and breakeven price is therefore $36.81 ($6.89 + $29.92)
- 7.5-year life; if share price is not at least $36.81 by December 2018, Johnson will lose 100% of his $50m investment
- The warrants cannot be sold or hedged for the first six years of their term
- Executive Subscribed Warrants are a great tool to align the long-term interests of management
- Under this incentive, the CEO must build value over the next six years or risk losing his entire investment
- Implications: He is much less likely to make decisions for the short term
- Evidence: JCP going against grain of giving back in to couponing to meet quarterly expectations
- Okay, so what if this system is a success? What happens after the 6th-7th year? How is the CEO aligned after this point when the stock is up several hundred percent?
- Answer: I don't, but for the next several years you can bet the CEO will do everything he can to surface value.
- I don't expect this system can be done for every company, so therefore it is not the answer to alignment problems at most companies
- Answer: That is very true. For this warrant system to work, (1) a competent CEO with the financial means to invest a convincing sum must be available, (2) the company must be undervalued and thus be perceived as a great investment by the incoming CEO. So we should not expect to see this implemented well too often. However, if other activist investors do copy Ackman's approach, close attention should be paid to the opportunity.