“We are primarily value investors” - Gotham Partners Investment Treatise

Back before Pershing Square was formed in 2004, Bill Ackman had started an investment partnership called Gotham Partners with his fellow business school grad, David Berkowitz.

The catalyst for forming Gotham was Seth Klarman’s “Margin of Safety” book. It wasn’t the typical current Pershing mantra of “predictable, cash flow generative, high quality businesses” but more deep value with a catalyst.

One of those deep value investments was Circa Pharmaceuticals that helped them get out of an initial drawdown.

Gotham Partners

Gotham opened it’s doors March 1, 1993 with only $3 million in AUM right out of Harvard Business School. One year later they would have 10x that amount as a result of being up 21% in their first 10 months. Initially both partners tried working full time jobs during the day and investing at night but that wasn’t going to cut it as they viewed this way as the riskier approach by not going all in.

They got their initial launch capital by cold-calling more than 100 members of the Forbes 400 list with only four ending up investing. They also created a 17-page “investment treatise” that was sent to potential investors. The document outlined everything:

their investment approach
the current state of the equity markets
how they view risk
their target partner

The first month of launching their fund got off to a bit of a rocky start:

One investment that helped them turn the fund around in the early days was Circa Pharmaceuticals.

The Hatch-Waxman Act

A little history of the generic pharma industry is needed first.

Before the early 1980’s, getting a generic drug to market proved to be too slow of a process because generic pharmaceutical companies had to:

Wait until the patent on a pharmaceutical expired before running tests. Any time prior to this would be patent infringement.
Once the patent expired and a company could run tests, the generic had to under go the same testing as if it was a brand new drug, running a full NDA (New Drug Application). Running an NDA is extremely costly and takes years.
The FDA had no fast track process or bioequivalence testing (what is now ANDAs) i.e., the generic had to run all the same tests the patented product did to prove it was bioequivalent.

Not only would a patented product get their usual exclusivity period, but they would also get the period from when the patent expired to when a generic was approved many years later.

The Hatch-Waxman Act was a piece of legislation passed in 1984 that fixed these problems by establishing the ANDA (Abbreviated New Drug Application) process and allowing bioequivlaence testing (meaning no new clinical trials typical of NDAs were needed). Because of this piece of legislation, generics went from 19% of the US prescription market back then to now 90%.

Incidentally the 1984 verdict in the court case of Circa Pharmaceuticals (formerly called Bolar Pharmaceuticals) is what caused a huge uproar in the US Congress that led to the Hatch-Waxman Act. I won’t bore you with the details but you can read about it here.

Circa Pharmaceuticals Scandal

Circa (formerly Bolar) was the largest generics drug manufacturer in the US, but once the Hatch-Waxman Act was passed, they decided to try to skirt around this new law as did many other generic companies.

In 1990, the FDA accused Circa of submitting false data in order to get approval for their generic drugs, primarly a hypertension drug called Dyazide. Dyazide was the generic industry’s top selling drug and from 1987 to 1990 it did $142 million in sales. By “submitting false data”, the FDA meant that Circa was literally taking the already approved patented pharmaceutical’s powder, putting them in Circa capsules and submitting it for bioequivalence. Then hiding, falsifying and destroying the records of doing so!

What came next were formal charges and indictments on most of the top level executives of Circa, including the CEO. Followed by a bunch of lawsuits, fines and jail time.

The FDA made Circa withdraw all of their current selling generic drugs from the market and they were prohibited from manufacturing or selling generics until the FDA deemed their manufacturing facility was in compliance. This affected 180 of Circa’s products. The FDA essentially froze their business for the time being.

To top it off, the CEO also admitted to price fixing this drug with their competitor, Vitarine Pharmaceuticals, to stifle competition.

The stock went from $50 to $4 between 1990 to 1993 as headline after headline kept the company in the spotlight and the large legal overhang weighed on the stock.

Summer 1993

Circa was the classic left-for-dead stock.

The CEO and other executives thrown in jail.
$78 million paid in fines over the past few years
The FDA in April just gave notice that it can manufacture and submit trials for new products again

The only real remaining legal issue outstanding was the price fixing scheme.

Gotham, after being down 3% in their first month of March 1993, started buying and paid as low as $4.12 and up to $6.25 for an average price of $5.18. They entered the investment some time in-between March 1993 and July 1993. I could only find a balance sheet for December 31, 1993 but it would have been approximately the same during the time of their purchase as the few million dollars paid in fines in November 1993 were offset by some shares forfeited back to the company by prior executives. Here’s a general overview of what Circa’s capitalization would have been:

And if you looked at the most recent March 1993 10Q or the past 3 years annual reports (1992-1990) it didn’t paint a pretty picture. The income statement was a mess, with fines, sales decreasing due to the FDA freeze and losses piling up.

In 1992, the company did $89,015 in total sales. Down 99% from two years prior.

But if you had dug a bit deeper, you would have seen there was value to be had.

Circa Valuation

Circa had an extremely strong balance sheet to make up for its lack of operations.

Cash and marketable securities totalled $51 million. They owned their own 161,500 square foot manufacturing facility in Copiague, New York that was worth roughly $25 million. They had a 50% JV interest with Mylan in Somerset Pharmaceuticals which produced a drug called Eldepryl that treated Parkinsons. Somerset was doing about $40 million a year in earnings and they were sending roughly $20 million of that in dividends to Circa. While the Eldepryl drug exclusivity expired in a few years, they were going to turn it into a patch to extend its life. Putting a 7x multiple on the potential extended earnings stream would value it at around $140 million.

They had some off balance sheet assets like a $71 million NOL. Tax affecting this at 35% would value it at $25 million. And they also had approximately 38 drugs in the pipeline that they could bring to market due to the FDA’s recent restriction lift.

On the liability side, they had legal reserves taken that were backed by securities held in a trust. Their only real form of debt was a JV liability (different from the Somerset JV above) of $15 million that was to be paid down based on the royalties now being earned on the drug in that specific JV. Summing it all up and this is what the underlying value was:

$10.18 was double the average purchase price Gotham bought it for. What gave investors pause was the uncertainty with regards to how much Circa would have to pay to settle their price fixing lawsuit. But there was a large margin of safety as anything less than a $100 million fine, based on my math, and investors would have come out ahead.

Outcome

Over the summer and into the fall of 1993, the price of Circa started rising as the market realized that the legal overhang was almost over as they were able to settle their price fixing lawsuit for just over a million dollars. In about October 1993 Gotham sold their shares for $9.47 getting an average return of 83%. Not bad for a few month holding period but based on what happened after they should have held on.

In 1994 Circa started getting some drug approvals and filing some ANDA’s and NDA’s while making other investments. The company's earnings increased substantially in 1994, reporting $17 million in net income or $0.80/share. So Gotham paid essentially 3x EV/FCF.

In 1995, Watson Pharmaceuticals bid $600 million, or $32/share. Had Gotham held they would have earned 6x their money in 2 years.

Even though they didn’t capture most of the price appreciation, they were able to claw back their initial 3% drawdown right out of the gate and finish the year up 21%.

Gotham Windown

Gotham would eventually have to liquidate their fund in the early 2000’s as a result of taking more illiquid bets while at the same time facing investor redemptions from the negative headlines of the MBIA Eliot Spitzer investigation.

They reached a peak AUM of $568 million in 2000 but then received $108 million in redemptions that year.

One of the more well known moments for Gotham was their 1995 plan to recap the Rockefeller Center Properties due to excessive debt via a rights offering vs the Sam Zell/Disney/GE group proposal with Goldman ultimately winning the bid for the property.

If you want a better understanding of why they were forced to wind down Gotham, there is a great article by Gretchen Morgenson from 2003 that I’ll include here that does it better than I could.

Gotham Partners Case Study

Update on Some Smaller Positions