Dear Pershing Square Investor,
A number of press reports have raised questions about my appearance on CNBC last Wednesday, and some have even questioned whether my appearance was intended to drive down the market so that we could profit on hedges we had previously entered into. I thought you would find greater transparency into our investment positioning over the last few weeks helpful in responding to those who have expressed concerns.
As you know, we have been extremely alarmed about both the health risks of the coronavirus and its economic impact since earlier this year. While we are a long-term investor, we view our principal responsibility as preserving capital and protecting our investors from losses. In light of our concerns, we had two choices: we could either sell all of our investments or hedge our portfolio. We chose to hedge coronavirus risk rather than sell because we are long-term investor, and we believe that all of our companies would eventually recover, and create substantial value over the long term.
As a result, in February, the Pershing Square funds purchased credit default swaps (CDS) on various investment grade and high yield credit default swap indices, namely the CDX IG, CDX HY, and ITRX EUR. At the time of purchase, the IG or investment grade indices were trading near all-time tight levels of about 50 basis points per annum. The high yield index, the CDX HY, was also trading near its lowest spread ever. When one adjusts for the fact that a number of companies in the high yield index were on the brink of default (and these near-default companies’ spreads were in the thousands of basis points), the spreads on the rest of the companies in the index were actually well below the 2006-2007 all-time lows.i
Because we believed that the coronavirus could only be stopped in Europe and the U.S. with an unprecedented economic shutdown, based on what we learned from China, we were confident that U.S. and European credit spreads would likely widen substantially from their near-all-time lows. We believed that global shutdowns would also affect all of our portfolio companies negatively to varying degrees, causing their stock prices to decline substantially. We believed, however, that our hedging program would likely be an effective one because as the spreads on the indexes widened, our CDS would become much more valuable.
Based on this analysis and to protect our investors from these potential losses, we purchased a very large notional amount of CDS. We disclosed that we had done so in a press release issued by Pershing Square Holdings, Ltd. on March 3rd, 2020:
“Dear PSH Shareholder,
During the past ten days, we have taken steps to protect the portfolio from downward market volatility. We have done so because we believe that efforts to contain the coronavirus are likely to have a substantial negative impact on the U.S. and global economies, and on equity and credit markets. Our approach to address this concern has been to acquire large notional hedges which have asymmetric payoff characteristics; that is, the risk of loss from these hedges is limited, while their potential upside is many multiples of our capital at risk. These hedges will likely mitigate portfolio losses in severe market declines, while also somewhat reduce the portfolio’s upside potential if there is minimal economic or market impact from the virus.”
On March 9th, we issued another press release which disclosed the following:
“Dear PSH Shareholder,
We are reporting our NAV today so that shareholders are informed of the materially positive impact on NAV of various hedges that we previously acquired to protect the portfolio from downward market volatility. As we explained in our March 3, 2020 communication, we have acquired large notional hedges with asymmetric payoff characteristics which will help to mitigate portfolio losses in severe market declines, while reducing the portfolio’s upside potential if markets recover. While recent market declines have caused the market values of our portfolio companies to decline substantially, the increased value of our hedges has more than compensated for these losses as you will note from today’s reported results.”
At the time of the March 9th press release, our CDS contracts had increased in market value from zero to approximately $1.8 billion because of spread widening.
By March 12 th, our CDS contracts had increased in value to $2.75 billion, and we began selling. We sold because the risk-reward ratio of holding the contracts at 140 basis points was not nearly as compelling as when spreads were at 50 basis points. Also, our CDS position had become a very large percentage of our portfolio, approaching 40% of our capital as our companies’ stock prices declined.
Furthermore, the deterioration in markets greatly increased the opportunity cost of our owning CDS. In order to make a meaningfully greater profit on CDS, spreads would have to widen further to approximately the levels they briefly achieved during the financial crisis. Had we had been able to sell our entire CDS position on March 12th, we would likely have done so, but because of the very large size of the position, it would take us more time to exit.
At the time, the administration and various city and state governments were beginning to take the risk of the virus more seriously. The President began holding daily press conferences with his coronavirus team, various cities were going into lockdown, and a number of state governors, most notably Governors Cuomo and Newsom, were showing strong leadership in addressing the growing crisis. Meanwhile stocks continued to decline, which made the opportunity cost of owning CDS at their then-trading levels of 130 -150 basis points even less attractive. Beginning on March 12th, we began unwinding our hedge, and continued to do so every day thereafter until we completed our exit on the morning of March 23rd.
On the morning of Wednesday, March 18th I sent out four tweets:
Later that morning Scott Wapner asked me to come on his midday CNBC show, and I agreed. This was my first appearance on television in more than two years.
By Wednesday, March 18th at 12:30pm, when I appeared on CNBC, we had already sold slightly more than half of the notional amount of our CDS, realizing a gain of more than $1.3 billion, with the unrealized portion of our hedge having a market value at that time of $1.3 billion for a total of $2.6 billion. When my interview with Scott Wapner began, the S&P index was already down 6.5%.
I went on CNBC to further explicate my tweets, and to explain why I had gone from being very bearish to bullish, with a caveat. In sum, I explained to Scott that I believed that the best approach to killing off the virus was for the entire country to close the borders and shut down for 30 days, other than for essential businesses, government, and services. Then, carefully, the country could be reopened with testing of all Americans, social distancing, higher mask usage, and other mitigation practices. I also explained that
the alternative of an 18-month period of rolling shutdowns would likely bankrupt almost every business, even dominant, well-capitalized ones. Because the consequences of a rolling shut down of the country that occurred over 18 months were so dire, I explained that I was confident that the administration would choose instead to shut down the entire country at once for 30 days.
I also told Scott Wapner that I was sufficiently bullish that we were buying stocks in the market:
“And I’ve been super bearish, but I got bullish. Okay. And the reason why I got bullish, and I’ve been aggressively buying stocks, including Hilton, today, okay, and I’ve been buying all the way down: Hilton, Restaurant Brands, Starbucks, you know, walk your way through our – the only stocks I’m not buying are companies we’re on the board and are restricted. But the reason why, is the only answer for the world is to shut the world for 30 days.”
Shortly after the show, I heard that some had interpreted my remarks as being very bearish on the market. In fact, later that day, some commentators claimed that I was responsible for the market finishing the day down more than 10%, almost 4% lower from the time I started speaking on CNBC at 12:30pm that day.
Continue reading here.
