Is Herbalife (NYSE:HLF) a Pyramid Scheme?

“[T]he organization is deemed a pyramid scheme if the participants obtain their monetary benefits primarily from recruitment rather than the sale of goods and services to consumers”. Peter J Vander Nat; William W Keep

The legendary hedge fund manager Bill Ackman, founder of Pershing Square Capital Management, believes so and since December 2012 he has embarked on what has been referred to as a “crusade” against Herbalife. Ackman says his fund has spent over $50 million investigating the company and last Tuesday he delivered a presentation on Herbalife which he called “the most important presentation that I have made in my career”. His mammoth presentation along with his research, including undercover work, is posted online at http://www.factsaboutherbalife.com/.

Herbalife describe themselves as “a global nutrition company that has helped people pursue healthy, active lives since 1980”. Whereas Ackman claims “the customers are fictitious, the business opportunity is a scam, and the university degree is a fraud” (referring to the Herbalife “Success University” training program). The core issue is whether the company is deriving their revenue from the sale of a product or through the recruitment of new individuals (“independent distributors”), sold the dream of what their website calls “a proven business opportunity”.

Check out this video from a couple of “Chairman’s Club Members” entitled “Duplication is the Key to Stable Royalties”. Cindy sells the audience the dream, the rise from poverty to building their own home on an “unlimited budget” and ‘spending $100,000 in a Paris flea market in five minutes’. The reaction from the audience to her nonsense would suggest that Herbalife are definitely appealing to the desperate who just want to ‘believe’. Anyway, fast forward to 8:20 on the video for the “recruitment” spiel from her husband Kurt. What is he drawing? Looks like a pyramid to me!

Ironically, the Herbalife (HLF) stock price rose 25% the day Ackman made his career defining presentation. This has left him open to ridicule from the media but Ackman has been here before. He spent the best part of six years taking on MBIA Inc., and in effect the system, which reportedly made his investors more than $1 billion. The story is chronicled in the book Confidence Game: How Hedge Fund Manager Bill Ackman Called Wall Street’s Bluff which I am currently reading. On a side note his current fund is up a reported 25% this year, so those questioning whether Ackman has taken his eye off the ball for his investors, by getting personal, are misguided.

You may ask, why should we care about the Ackman v Herbalife story? I believe it again raises question marks over some of the guiding principles of modern finance but most importantly it reminds investors of why we have active management. I am not talking about active managers who hug their benchmark, paralysed by career risk; I am talking about real active managers, like Ackman. Hedge funds have a bad name, mostly because of their high fees and the wealth of their founders, but they serve an important purpose in the financial system and for investors searching for uncorrelated returns.