When people talk about the historic collapse of Valeant's stock price (down 65% this year), the first name that usually comes to mind is that of Bill Ackman whose Pershing Square has been one of the biggest investors in VRX stock and also one of the biggest losers, wiping out billions in assets under management as a result of Valeant's unprecedented unwind late last summer.
But while the flamboyant Ackman, who enjoys basking the spotlight when his 100+ page slideshows lead to en immediate eruption (or collapse) in a given company's stock price but certainly not when the winds blow against him, is the most popular holder of Valeant stock, another name, with over 35 million shares, is a far greater bagholder.
We are of course talking about the highly concentrated and far lower profile, Sequoia Fund, which at one point last year had more than 30% of its portfolio invested in Valeant, and whose most recent publicly disclosed AUM was roughly $5.5 billion. That, to be sure is not the latest assets under management because as Morningstar has hinted in the past few weeks there has been a run on the suddenly disappointing fund, which according to the WSJ has seen more than $500 million in redemption requests.
Indeed, while Ackman has allegedly so far avoided an influx of withdrawals from Pershing Square despite being down over 20% in 2016 following a comparable return in 2015, Sequoia's LPs have been far less merciful and have been scrambling to get their cash out. The problem is that, as the curious case of Tom Bentley shows, Sequoia has been unable to satisfy their cash out demands, and instead has been meeting redemption demands "in kind" by shooting over stock equivalents.
As the WSJ reports, when Tom Bentley tried to pull his money from a mutual fund troubled by its large stake in Valeant Pharmaceuticals International Inc., he instead received shares in a Springfield, Mo. auto-parts retailer.
Sequoia Fund Inc. sent the retired computer hardware engineer about 5% of his money in cash and the rest was stock in one company–O’Reilly Automotive Inc. Mr. Bentley said he sold the shares as soon as they appeared in his account on April 7, but they had already dropped in value.
Typically, mutual fund investors expect cash instead of stock when they ask for their money back. But investors seeking to pull large sums from Sequoia are getting a combination, according to people familiar with the matter.
"It has been pretty horrendous," Mr. Bentley said.
It is also a surprising approach to make, yet one which Sequoia is entirely in its right.
As the WSJ notes, Sequoia’s repayment approach, called a “redemption in kind,” is part of a longstanding fund policy that allows it to give shareholders mostly stock if they are pulling out $250,000 or more. A person close to the firm said it has done thousands of in-kind transactions over many years and that the majority are done for redemptions in excess of $1 million.
“It’s a perfectly legitimate strategy,” said Jeffrey Sion, a partner at Dechert LLP, who specializes in investment funds and tax.
But the move has come as a surprise to some investors and their advisers. While it is common for mutual funds to reserve the right to hand out a basket of securities to large, sophisticated institutional investors, it is rare for managers to use them to redeem individual investors, lawyers and analysts say.
The move is even more surprising because unlike illiquid junk bonds or bank loans (or increasingly investment grade corporate bonds), stocks remain quite liquid (mostly when one is selling in a rising market). As such for Seuqoia it is merely a matter of taking a few minutes to cash out existing holdings as a courtesy to its investors, not a case of prudently respecting your fiduciary duty.
Indeed, as the WSJ adds, "it is less common for managers of stock funds to redeem in-kind because equities, which trade on exchanges, are more easily bought and sold than less liquid fixed-income assets."
So why do it? "In-kind" redemptions have benefits for funds such as Sequoia that are experiencing redemptions. Unlike with sales for cash, the fund doesn’t have to recognize a capital gain on such transactions. As a result, remaining investors don’t bear the tax implications of sales associated with exiting shareholders, according to fund and tax lawyers.
For investors who expect an in cash liquidation, it can be not only a surprise but also a hassle: "If you’re a retail investor, who wants to get stocks? If you’re getting out of fund, presumably you’re selling because you want cash," said Michael Rosella, a partner at Paul Hastings LLP, who specializes in investment management. "Most funds have the right to do it, but you’re not going to do it if you don’t have to," he said.
Meeting redemptions with shares also keeps managers from having to sell stock to raise cash, which fund analysts say can weigh on performance.
More importantly, in an illiquid market in which traders become aware of the need to liquidate profitable positions, they can frontrun the selling of such positions as happened with Bill Ackman when all of his other holdings were slammed once fears swirled he would need to short up capital several weeks ago. In some extreme cases, one may be completely unable to liquidate as bid/ask spreads swell and selling even profitable positions results in a loss.
To be sure, one can't blame Sequoia: it has been vocal about warning shareholders that it is "highly likely" that they will receive all or part of their withdrawal in securities if they are pulling more than $250,000 from the fund, regardless of whether they have a bank or brokerage account to which stocks can be delivered. For many, ending up with stock that can not be sold is a very unpleasant option, especially if seeking prompt liquidity.
According to the WSJ, the fund has seven days to meet redemption requests and determines which stocks investors will receive. The firm typically pays out in stocks with high unrealized capital gains that trade often, and it advises redeeming shareholders to sell the securities they receive at market close on the day they exit the fund, said a person close to the firm.
It gets worse for the investors: such redemptions often shift risk and burdens from the fund to its selling investors, especially if they hold the fund in a taxable account. Those who receive all or most of their assets in stock may not have enough cash to pay taxes due on the redemption without selling the stock.
In addition, funds don’t necessarily give investors a pro-rata basket of stocks, which can expose the newly given holding to market risk from lack of diversification. The stock shares also may rise or fall in value after the investor receives them, producing capital gains and losses. In this case, the taxable gain or loss is measured from the value of the stock on the day of the redemption, according to Robert Willens, an independent tax expert based in New York.
Finally, selling those shares will also incur transaction costs that can be steeper for individual investors than large investors that benefit from longstanding relationships with banks and brokers and economies of scale.
The bottom line is that gimmicks such as the one attempts by Sequoia as it scrambles to meet its redemption obligations, will only make the bloodletting worse, and not only because the fund is down 11% year to date through Thursday. Having tipped its hands that when push comes to shove, Sequoia's troubled principals will trample their investors, will hardly inspire confidence in those other shareholders who have not yet submitted redemption requests.
In short, we expect many more stories of unhappy investors ending up with unsolicited stock instead of cash in the accounts, even as Sequoia's AUM dwindles and ultimately hits a low enough level where it has no choice but to get its remaining investors.
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But the worst news for Sequoia in the near future may have nothing to do with a surge in redemption requests, but the future value of its core investment, which may be even further impaired in the coming weeks following news out of Bloomberg that a Senate committee may start contempt proceedings against Valeant's soon to be former CEO, Michael Pearson, for failing to appear to give testimony related to an investigation on drug pricing.
“Michael Pearson was under subpoena to appear for a deposition today related to the Senate Special Committee on Aging’s drug pricing investigation, and he did not comply with that subpoena,” Senators Susan Collins and Claire McCaskill said in a statement late Friday. “It is our intent to initiate contempt proceedings against Mr. Pearson.” Collins, a Republican, is the chairwoman of the panel and McCaskill is the ranking Democrat.
Pearson was subpoenaed to testify at an April 27 hearing, the latest in a series of congressional probes into how drugmakers price medications. And while a Pearson lawyer said the executive will appear at the hearing in three weeks, the deposition subpoena was unfair in both timing and scope. The "committee hasn’t been clear about what topics and documents he’ll be questioned about," attorney Bruce E. Yannett of Debevoise & Plimpton LLP said. Without that, "the committee’s demand would expose him to an inherently unfair process for which we cannot adequately prepare him under the circumstances," according to the letter.
As a result, Pearson decided he would rather risk contempt than saying something which may be used against him soon in what is almost certain to be an avalanche of both civil and criminal cases in the coming months.
It is almost as if he suddenly has something to hide. Or maybe he had something to hide for a while. Recall that at the February hearing before the House Committee on Oversight and Government Reform, it was Valeant's former CFO, ex-Goldmanite Howard Schiller, who was then interim CEO while Pearson was on medical leave, testified for the company.
Since then Valeant has had a dramatic falling out with Schiller, whom it implicitly accused of cooking the books and asking to resign from the Board which he refuses to comply with.
Perhaps he should testify again, now, some two months later. Considering the dramatic change in his relationship with his former employer, we have a feeling this new testimony would be far more interesting and exciting...