12/2/2018 A Rescue Ploy Now Haunts a Hedge Fund That Had It All - The New York Times

A Rescue Ploy Now Haunts a Hedge

Fund That Had It All
By GRETCHEN MORGENSON and GERALDINE FABRIKANT JAN. 19, 2003

THEY had a glittering client list, dazzling reputations and smarts

galore, but as 2002 drew to a close, William A. Ackman and David P.
Berkowitz, hedge fund managers at Gotham Partners, were desperate.
They had received a mountain of requests from investors asking for
their money back and had suffered a devastating setback in one of their
biggest investments. The men, who just a few years earlier had been at
the top of the hedge fund world, were facing a run on the bank.

But Gotham had little in the way of liquid assets. What had begun in
1993 as a hedge fund specializing in undervalued stocks had morphed
into a portfolio of private companies and thinly traded public ones, all
exceedingly hard to sell. As 2003 dawned, Mr. Ackman and Mr.
Berkowitz delivered the bad news to investors: their portfolios were
being wound down and the assets would have to be sold at possibly
depressed prices.

It is all a startling comedown for Mr. Ackman and Mr. Berkowitz, both
hard-driving Harvard Business School graduates, who set up Gotham
Partners in 1993 with just $3 million in assets that, at their peak in
2000, ballooned to $568 million.

As last fall became winter, and their situation grew increasingly dire,
they turned to a strategy that had worked for them before but that one
investor surmises only compounded their problems this time: they
published research on their Web site in support of their large positions
in two companies, MBIA and Pre-Paid Legal Services.

That decision to publicly promote two of their biggest holdings --

known in Wall Street parlance as talking one's book -- is highly unusual

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among secretive hedge funds, which are lightly regulated and managed
for wealthy individuals. Even worse, Gotham's publication of upbeat
research about one company, even as the fund was quietly selling its
shares, looked very much like a classic pump-and-dump scheme.

While Gotham's moves may have been intended to help it meet

redemptions, they have instead brought unwelcome scrutiny. Eliot
Spitzer, the New York State attorney general, has begun investigating
Gotham, its principals and their activities -- a move signaling that Mr.
Spitzer, the force behind the nearly $1 billion settlement with top
brokerage firms over stock research, has zeroed in on the murky hedge-
fund world.

And in a letter sent to investors on Thursday night, Gotham said it had

received a letter from the Securities and Exchange Commission as part
of an informal inquiry, as well as subpoenas from Mr. Spitzer's office
requesting information about MBIA, Pre-Paid, its holding in Farmer
Mac (which it also promoted) and its proposed merger of First Union
Real Estate and Gotham Golf.

Although Mr. Spitzer's spokeswoman declined to comment on the

inquiry, a person briefed on it said investigators were assessing whether
Gotham's published research was an attempt to manipulate the market
for its own benefit. Farmer Mac, for example, on which the fund had
made a negative bet, fell significantly after Gotham's report on it was
made public last spring.

WHEN Gotham was publishing its two reports this fall, few outsiders
knew how strained its circumstances were. As Mr. Ackman and Mr.
Berkowitz scrambled to meet redemption notices from investors, they
had another worry. They were encountering resistance to their plan to
salvage their investment in Gotham Golf -- a money-losing golf course
company they had built that dominated the fund's portfolio. Their plan
was to merge it with First Union Real Estate Equity and Mortgage

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Investments, a profitable real estate investment trust that Mr. Ackman

took over in 1998. A lawsuit brought last April by a holder of the First
Union REIT's preferred stock threatened to block the deal, risking a loss
of $20.3 million that the hedge fund had loaned to Gotham Golf.

Mr. Ackman and Mr. Berkowitz were unaccustomed to failure. They had
attracted money from some of the wealthiest and most experienced
investors in New York, including the Ziff family, scions of the media
empire founded by William Ziff; Martin Peretz, owner of The New
Republic; and Michael E. Porter, a Harvard Business School professor.

''They were the money managers' money manager,'' said an investor in

New York who knows the Gotham principals well. ''They had a client
roster like you wouldn't believe.''

Neither Mr. Ackman, 36, nor Mr. Berkowitz, 40, would comment for
this article. Their lawyers also declined to comment.

The crisis began for real on Nov. 15, the last day that Gotham's investors
could notify the managers that they wanted to take their money out this
year. Five days later, on its Web site, Gotham published ''A
Recommendation for Pre-Paid Legal Services,'' a lengthy report on Pre-
Paid, a legal services provider in which the fund said it held one million
shares. In the report, Gotham estimated that Pre-Paid's business was
worth up to $67 a share. The stock closed that day at $24.75, down a
few cents.

This tactic had worked for Gotham before. Last May, it published its
first report on the Web: an extensive and negative piece on Farmer
Mac, a government-sponsored enterprise that makes farm loans. The
analysis was picked up by the news media, including The New York
Times, which printed several articles about Farmer Mac.

Initially, investors seemed to agree with the hedge fund's findings:

Farmer Mac's stock declined 49 percent from May to July. (It has since
rebounded, by 65 percent, to $33.15 a share.)

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With Pre-Paid, of course, Gotham wanted the stock to rise.

The day after Gotham put the Pre-Paid report on its Web site, Mr.
Berkowitz published a shorter version of it on TheStreet.com. That day,
Nov. 21, a New York state appellate court granted a preliminary
injunction preventing the Gotham Golf merger.

On Nov. 22, Gotham Partners publicized, for the third time, its bullish
view on Pre-Paid. This time, the report went out on the Business Wire, a
news service. Still, the stock barely budged. But by the end of the next
week, Pre-Paid had risen 16 percent, to $28.65 a share. And on Dec. 4,
Randy Harp, chief operating officer of Pre-Paid, sold 55,000 shares.

On Dec. 6, the court stopped the Gotham Golf merger until the
preferred shareholder suit was decided. The judge said First Union's
trustees who voted for the deal violated their fiduciary duty to preferred
holders.

Had the deal gone through, Gotham Partners would have received $77
million in cash and stock. Because it did not, Gotham Golf now teeters
on the brink of bankruptcy, making it unlikely that the hedge fund's
$20.3 million loan will be repaid. Gotham has appealed the court's
decision.

WITH the noose tightening, Gotham published a new report on Dec. 9.

This time, it was a scathing analysis questioning the sterling credit
rating of MBIA Inc., a guarantor of bonds and other financial
instruments. Using derivatives to amplify its return, Gotham had made
a huge bet that the company would falter. After the report hit the news
wires, the stock fell 3.7 percent. But the next day, and in the following
weeks, it rebounded, hurting Gotham's bearish bet.

Now, with Gotham's loan to the Gotham Golf being written off, and one
of its biggest bets, MBIA, going against it, Mr. Ackman and Mr.
Berkowitz had few investments left that they could sell. One was Pre-
Paid, whose stock had been rising.

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On Dec. 11, although the Gotham Web site still carried a

''recommendation'' for Pre-Paid and an estimated per-share value of
$67, Gotham Partners began selling, shedding 10 percent of its position
at around $30 a share, trading records show.

Asked then if that was a conflict, Mr. Berkowitz said it was not. In the
week ending Dec. 20, the fund sold Pre-Paid stock again, this time more
than 11 percent of its stake.

But on Dec. 23, the Gotham Web site -- and all the research on it --
vanished. The previous day, The Times had noted the fund's sales of
Pre-Paid shares at prices well below its target of $67.

Four days later, Mr. Ackman and Mr. Berkowitz advised investors that
Gotham's funds would be wound down and their assets sold.

IT is not unusual, of course, for a hedge fund to lose money. But how
did these two highflying managers get into such straits?

An examination of Gotham's activities in recent years shows a series of

ill-timed bets, a surprising lack of diversification and a dangerous
concentration in illiquid investments that could not easily be sold when
investors wanted their money back.

Mr. Ackman, the son of a commercial real estate investor in New York,
is an skilled salesman, according to people who know him. He is
intelligent, intense and intimidating, associates said. One person who
had extensive dealings with him said, ''He's charismatic; he's a nice
guy.''

Mr. Berkowitz is the partnership's grounding force, the analyst. He

received degrees in science and chemical engineering from M.I.T.

The men described themselves to investors as value-oriented and risk-

averse. They made bets on arcane but promising investments, like
stocks in troubled savings institutions that were suing the United States
government, and stood to gain many millions if they won.

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The fund did well out of the starting gate. It posted a return of 20.7
percent in 1993, dropped 3.4 percent in 1994 and rebounded 38.7
percent in 1995, a person briefed on the fund's performance said. Two
years of similar gains followed. But in 1998, Gotham lost 2.9 percent.
The managers recovered in 1999, their last good year, with a 16.3
percent return.

Although Mr. Ackman and Mr. Berkowitz were relative newcomers to

the hedge fund world, with those generally strong returns they could
make investors agree to lock up their money for three years, a relatively
long time in the hedge fund world.

But by 2000, they had strayed from their value focus, investing $2
million in Giftcertificates.com, a Web site that has been unable to go
public, and an unspecified investment in the Frontline Capital Group, a
technology company incubator. The fund had also moved heavily into
other private companies.

''They got very illiquid,'' recalled one investor who withdrew from the
fund. ''This was not their expertise, and I was not convinced they had
the capability to handle private equity.''

In 2000, according to an investor, the fund's liquid investments rose 20

percent, but its illiquid investments lost 15 percent. Some investors said
they started to worry then.

Looking back, it appears that Mr. Ackman and Mr. Berkowitz made a
classic investment mistake, throwing good money after bad. As Gotham
Golf, which accounted for 20 percent of the fund's assets, sank deeper
into trouble they began lending it money. From 2000 to 2002, the fund
lent Gotham Golf $15.4 million at 25.3 percent interest.

David Lesser, the president of Hudson Bay Partners, a private

investment firm and an owner of First Union REIT's preferred stock,
said the high interest rate showed how risky Gotham Golf was.

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According to S.E.C. filings, Gotham Partners also supported Gotham

Golf in 2000 by pledging $1.5 million in cash and about $2 million in
LandAmerica Financial Group stock as collateral for a loan from
Wachovia Bank. A year later, Gotham pledged $3 million as collateral
on another loan to the company.

Early last year, Gotham tried to salvage its money-losing investment in

Gotham Golf by proposing the merger with the First Union REIT. It
wasn't the first time Mr. Ackman had used money from the REIT's
shareholders to prop up an investment. In August 2000, the REIT
bought $10 million in preferred shares of HQ Global Workplace, a
provider of office services. HQ Global was the largest asset held by the
Frontline Capital Group, the incubator that accounted for 11 percent of
Gotham Partners' assets in 2000.

A person briefed on the REIT's purchase said it had been approved by

an independent committee of the trustees. But Mr. Ackman was very
close to most of the trustees since he had taken over the REIT.

Last March, HQ Global filed for bankruptcy, and Frontline did the same
a few months later. Gotham lost $4.2 million in Frontline in 2001. It is
not clear how much the funds lost in the investment over all.

As the troubles at Gotham Golf mounted, redemptions at the hedge

fund were escalating. According to a letter to investors in 2000,
Gotham Partners had received $108 million in redemption requests,
almost a quarter of its capital. The next year, investors redeemed an
additional $72 million, or 20 percent. In 2002, one investor said, the
fund had redemption requests for an additional 25 percent of its capital
by September.

Now, as the hedge fund's assets are being sold, its investors must wait
to learn exactly how much their holdings have plummeted. Mr. Ackman
and Mr. Berkowitz, who both have major interests in the fund, will be
among the biggest losers. The Ziffs took their money out of the
company last year.

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It is also unclear where the state and federal investigations will lead.
But many investors and fund managers are convinced that public
scrutiny on hedge funds will increase. And almost no one in this
secretive world is happy about that.

Correction: February 16, 2003

An article on Jan. 19 about financial problems of the Gotham Partners
hedge-fund company misidentified the court that issued a preliminary
injunction against the proposed merger of First Union Real Estate Equity
and Mortgage Investments with the Gotham Golf Corporation, the major
holding in Gotham Partners' portfolio. It was the New York State Supreme
Court in Manhattan, not a state appellate court.

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