PSH-Annual-Report

Annual Report Year Ended December 31, 2014PERSHING SQUARE PRINCIPLESThe Pershing Square Business ModelIn order to achieve long-term success, PershingSquare must make good investments and operatewith a robust business model. With much mediaattention focused on hedge fund failures, I thoughtit would be worthwhile reviewing the characteristicsof our business model and explaining why we willwithstand industry-specific and overallenvironmental threats to the investment and hedgefund businesses. The principal factors whichcontribute to the robustness of our business modelare as follows: Our portfolio management approach isinherently low risk (where risk is defined as theprobability of a permanent loss of capital),particularly when compared with other hedgefund business models. An importantdistinguishing factor about Pershing Squarecompared to most other hedge funds is that wedo not generally use margin leverage in ourinvestment strategy. The lawyers prefer that Iput in the word “generally” to give us theflexibility to use margin to manage short-termcapital flows, but, to-date, we have not used butan immaterial amount of margin, and only for abrief period of time, and we have no intention ofchanging this approach. We generally invest in higher qualitybusinesses with dominant and defensivemarket positions that generate predictable freecash flow streams and that have modestly ornegatively leveraged (cash in excess of debt)balance sheets. We buy these businesses atdeep discounts to our estimate of intrinsic valuegiving us a margin of safety against apermanent impairment of capital. I say“generally” again here because we do makeexceptions in certain limited circumstances; thatis, we may buy a more leveraged or lowerquality business if we believe the price paidsufficiently discounts the risk. We often seek investments where we caneffectuate positive change to catalyze therealization of value. This serves to acceleratethe recognition of value, helps us avoid “deadmoney” situations, and protects us somewhatfrom managerial actions which can destroyvalue. We are diversified to an adequate but notexcessive extent. This has further benefits forrisk and operational management which I willdiscuss below. There is an inherent balance to our long/shortinvestment approach. Historically, when equityor credit markets weaken, our shorts becomemore valuable, and occasionally materiallymore valuable, offsetting somewhat the markto-marketdeclines in our long portfolio. If wechoose to unwind these short positions duringmarket downturns, we can generate capital toinvest in a now less expensive market. Theseshort investments generally stand on their ownin that they do not typically require a stockmarket or credit market decline to besuccessful. That said, they have served as auseful hedging tool during periods of dramaticmarket declines. We have been paranoid about counterparty risksince the inception of the firm. First, we tradewith counterparties which we believe to becreditworthy. Second, we have negotiated ISDAagreements which provide us with daily markto-marketcash and U.S. Treasurys equal to theprevious day’s market value of our derivativecontracts [in excess of certain minimumthresholds]. In cases where we are required topost initial margin and therefore have someexposure beyond the market value of ourderivative contracts, we have typicallypurchased CDS on our counterparties to furthermitigate counterparty risk. While our approachto counterparty risk has protected us from anycounterparty losses to date, please beforewarned there is no perfect approach toavoiding counterparty risk.Our Approach to Risk ManagementOur simple approach to investing also allows us toavoid complicated approaches to riskmanagement. Our investment strategy does notrequire us to open offices all over the globe. Assuch, we don’t need traders working around theclock. We can go to sleep at night and sleep. Ourweekends are largely our own. Our riskmanagement approach is to: (1) put our eggs in afew very sturdy baskets, (2) store those baskets invery safe places where they cannot be taken awayfrom us and sold at precisely the wrong time due tomargin calls, and (3) to know and track thosebaskets and their contents very carefully. We callthis approach the sleep-at-night approach to riskmanagement. If I can’t, we won’t.PERSHING SQUARE HOLDINGS, LTD. 15