The Hedge Funds Battle It Out: Is Herbalife a Pyramid Scheme?

Investing

Update on February 4, 2013: Herbalife stock tumbled on Monday after the New York Post reported that the FTC may be launching an investigation into the company’s business practices.

Update on January 18, 2013: Hedge fund manager, James Chanos, a famous short seller, commented on Thursday that the settling of the pyramid scheme argument between Loeb and Ackman will rest on whether the Herbalife products are in fact in demand and whether the distributors are actually selling a product that gets used.

The dispute between the global nutrition company HerbaLife (HLF) and hedge-fund manager and CEO of Pershing Square Capital, William Ackman, continues to rage this week. What is at issue and who are the key players?

Herbalife vs. Ackman vs. Loeb

On December 20th, William Ackman made a three-hour long presentation on Herbalife, arguing it was a pyramid scheme and announcing a billion dollar short trade in the amount of 20 million shares, from the company’s 24.4 million on loan to short sellers.

Herbalife, a weight loss and nutritional company with approximately 3.1 million independent distributors across 84 countries, operates using what is called a multi-level marketing business plan.

On Wednesday, Third Point’s Daniel Loeb, a well known hedge fund manager, announced an 8.2% stake in Herbalife betting for its rise, essentially coming in defense of Herbalife and countering Ackman’s claim and even calling it “preposterous.” Following news of Loeb’s support, Herbalife shares rose above $41.

Finally, on Wednesday The Wall Street Journal announced that the SEC would be inquiring into Herbalife and shares dropped below $38. The value has since risen and is currently at $43.51, but may remain volatile. Speculations are made as to the reason behind Ackman’s short bet, and it remains to be seen whether Ackman or Loeb will come out on top.  

‘The “Pyramid Scheme” Accusation

According to the FTC, multi-level marketing consists of individuals selling products to the public, providing them the opportunity to earn commission for sales made by distributors they manage to recruit into the company.

The tricky part is that when you start out your business, you must first buy a certain amount of inventory to be able to sell your products to its initial consumers. In addition, you also have the opportunity of earning income when you can convince a customer to become a salesperson. There are arguments made that the products however aren’t easy to sell and the average person that joins this business isn’t a savvy salesman. In the end the distributor hardly ends up making money from selling the products themselves.

The successful stories, as Ackman argues, are those that are able to make bonuses and commissions from the sales of recruited distributors. The money is therefore made through selling the business opportunity to friends and family for the most part, rather than from selling the actual products. This is why he argues that Herbalife’s business model is a pyramid scheme.

Ackman’s short bet on Herbalife

Ackman’s short bet rested on the assumption that the FTC would want to soon investigate Herbalife and a prediction that as a result the company’s shares would fall. Herbalife’s stock dropped as low as $26.06 days following Ackman’s presentation.