Hedge Fund Titans Go to War Over Whether Herbalife Is a Pyramid Scheme

Commentary about business and finance.
Jan. 14 2013 4:17 PM

The Great Herbalife War of 2013

Dueling hedge funds battle over whether the nutritional supplement company is a pyramid scheme.

Pershing Square Capital Management CEO Bill Ackman speaks at the New York Film Festival.
Bill Ackman

Photograph by Stephen Lovekin/Getty Images for Rubenstein Communications.

The first great financial war of 2013 has started, and it has nothing to do with Greek bonds or the debt ceiling or the Grand Bargain. Instead, it’s a hedge-fund-on-hedge-fund brawl about multilevel marketing of weight-loss supplements.

In one corner is Bill Ackman of Pershing Square Capital Management, in the other is Daniel Loeb of Third Point Capital. Both Jewish, both born in the 1960s, one from New York, one from Los Angeles, one educated at Harvard, one educated at Columbia, one long Herbalife and one short Herbalife. Herbalife describes itself as a “global nutrition company” that sells its products through its exclusive network of dealers. Ackman (short Herbalife) says it’s an illegal pyramid scheme that should be shut down by regulators, thus cratering its stock and making him a nice pile of money.

Loeb (long Herbalife) is best known for seeking out firms that he thinks have become undervalued because of mismanagement, and then shaking things up to increase the underlying value. He was a key architect of a campaign against Yahoo’s board early last year that led to a proxy battle, the ouster of a CEO, and ultimately the reorganization of Yahoo’s financial assets to create more money for its shareholders. In the case of Herbalife, Loeb’s making a simpler play. His claim is simply that Ackman is mistaken, and that his short-selling and propaganda campaign artificially depressed the price of Herbalife stock. In response, Loeb bought up 8.2 percent of the company after Ackman’s statements led the price to fall. All Loeb has to do to earn a return is ride out the storm.

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A pyramid scheme, in its most stripped-down form, is like a chain letter. You send a letter to five people with instructions to each of them to forward the letter to five more people. For a while it’s good clean fun, but after 15 iterations you’re up to 6 billion recipients and they’ve got nobody left to forward to. The same basic concept can be turned into a financial scam. I get an initial group of financiers to give me money to invest. Then instead of investing the funds, I pocket the cash and simply raise a new round of funding from a larger circle of investors. Some of their money goes to pay off the first round of investors, and some of it goes to line my pockets. Then you need yet another round of investments. Eventually the whole thing blows up, but the early investors can make a nice pile of change.

Of course, nobody would willingly invest in a company known to have that structure. So the Bernie Madoffs of the world cloak their pyramid schemes in fraud. Ackman’s allegation is that Herbalife is doing a version of this.

In principle, there’s nothing wrong with multilevel marketing. The way it works is that instead of advertising and marketing, you sell products directly, person-to-person. Some of your best customers can then be recruited to work as distributors themselves, and sell to their networks. This is not an illegal pyramid scheme, but it does have a pyramidal structure that makes it a possible vehicle for such schemes. And that, says Ackman, is exactly what’s happening at Herbalife, which he says “is in the business of selling dreams, not weight management products.”