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Titans collide in battle for Sears Canada

Much at stake in bitter and nasty takeover battle between two U.S. hedge fund wizards, ANDREW WILLIS writes

For two guys who just doubled their money on Sears Canada -- a $300-million score -- Jacques Chartrand and Claude Boulos can sure point to a lot of things wrong at the retail chain.

As the heads of Natcan Investment Management's $6.5-billion Canadian equity fund, the two money managers helped kick off the bitter takeover battle for Sears Canada by agreeing to sell their 9.7-million-share stake in the stores to its U.S. parent. Natcan headed for the exits in return for $16.86 a share, and was thrilled at the price. "Same-store sales keep falling. Canadians are going to the power centres, to big-box stores, so the traffic is going down at the malls where you find Sears," says Mr. Chartrand, ticking off challenges facing the venerable retailer. "Management has tried different approaches, nothing has worked, and they are a bit complacent. I mean, this has got to be the last North American retailer with its own fleet of trucks."

Given their pessimistic outlook, the Natcan team was all ears when they got a call last November from William Crowley, chief financial officer at Sears Holdings Corp., the U.S. parent of Sears Canada, and a partner in its controlling shareholder, ESL Investments, a $15-billion (U.S.) hedge fund run out of Greenwich, Conn., by billionaire Edward Lampert.

Backing up Mr. Crowley in presentations before the Sears Canada board, the Natcan executives had already helped push the $2.2-billion (Canadian) sale of Sears Canada's credit card division, and a subsequent $2-billion special dividend.

After three weeks of "tough, creative negotiations," Natcan agreed to sell its 9-per-cent stake -- acquired over two years ago for $150-million -- to Sears Holdings. That set the stage for the parent firm's offer for the rest of the company. The moment that bid was announced, there was a flood of investors who play on the theory that motivated buyers such as parent companies will invariably dig deep, and improve their opening bid to get a deal done. The most sophisticated of these players are known as arbs, or risk-arbitrage hedge funds.

"We got a fair price, plus protection if a second bid was made," Mr. Boulos says. "The arbs, they poured in because the statistics show that they can get a 10- to 15-per-cent bump in the bid."

The arbs drove Sears Canada stock over $18, where it has remained since December. In April, Sears Holdings did improve its offer to $18 and won support from other major investors, with Natcan also getting the sweetened price. But at that point U.S. hedge fund Pershing Square Capital Management LP went on the offensive.

After buying shares at around $18, Pershing began making strident arguments that the Canadian chain is worth up to $46 a share. On the phone with Montreal-based Natcan, you can almost hear a Gallic shrug as Mr. Boulos says: "They can always dream."

Just about every takeover of a Canadian subsidiary by a foreign parent -- and there have been more than a dozen in the past decade -- has seen tension between minority shareholders and the buyer. Occasionally, takeover bids don't get improved, and arbs get hammered, as they did when Rogers Communications dropped an offer for its wireless unit. Sometimes, the arbs clean up, as witnessed in the bidding war for Dofasco.

But no takeover has approached the flat-out nastiness of the Sears Canada fight. Hedge funds now control trillions of dollars and have become a major factor in capital markets around the globe. In Canada, we are finding out what happens when two of these powerful players go toe-to-toe.

This battle has grown so ugly that some combatants have withdrawn from the field. Sears Canada's independent directors quit the company rather than endorse the $18 offer. Said one source close to the board: "We just weren't going to be pushed around." On Tuesday, there will be a meeting at which Mr. Lampert is poised to get full control of the board.

Bystanders are being wounded. Sears Holdings unleashed its lawyers at Osler Hoskin & Harcourt to wring an apology from Ron Mayers, head of alternative strategies, at Desjardins Securities who questioned the takeover tactics. Regulators are also being summoned. When Pershing Square and its allies dragged the Ontario Securities Commission into the fray, Sears Holdings shot off a press release asserting the hedge funds are trying to "change the law to bail them out of their mistake."

Pershing Square, run by New York-based William Ackman, responded with its own release, labelling the assertions "vituperative." That means abusive. That nine-page missive also referred to Mr. Lampert as "Eddie." Friends can use the nickname. Coming from Pershing Square, sources close to ESL said it was an attempt to get under Mr. Lampert's skin.

The battle of egos, and thesauruses, is about more than chest-thumping by money managers.

Both Mr. Ackman and Mr. Lampert know their ability to do successful deals in the future -- to sway boards or raise money -- depends in part on burnishing their reputations as winners at Sears Canada. One source close to ESL said: "Lampert doesn't ever want to be known as a guy who rips off public shareholders. He's likely to be in Sears Holdings for a long time, and he plans to be in business a long time."

The rhetoric has grown louder as Pershing Square suffers setbacks. In fact, Mr. Ackman may eventually lose out because he was too clever for his own good.

Pershing Square directly owns 5.6 million Sears Canada shares, bought after the takeover was launched. But the fund also bought 5.3 million shares last year. To legally avoid paying about $20-million in Canadian tax, it entered into what is known as a swap agreement. That deal saw Pershing Square hand over its 5.3 million Sears Canada shares to a Florida bank, SunTrust Banks Inc. In exchange, the fund got a note that entitled it to any future increase in Sears Canada's share price.

The only downside to this swap was Pershing gave up the right to vote the shares. But in a number of interviews, Mr. Ackman said market convention would see those 5.3 million shares either voted his way, or at least not voted at all.

Executives at several Canadian bank-owned dealers, all of whom routinely do these tax-based transactions on dividend-paying stocks, say Mr. Ackman has it wrong. The owner of the shares must be free to vote as it sees fit, they say -- otherwise, the swap agreements might be considered tax fraud.

So who ended up owning the shares that Pershing Square swapped? That's a hotly debated subject. Pershing Square says the block ended up with Bank of Nova Scotia, an allegation both the bank and Sears Holdings deny. Mr. Ackman's best hope of torpedoing this takeover lies in attacking Scotiabank's role.

For what no one disputes is that the bank bought 4.5 million Sears Canada shares as part of a tax-driven trade. When Scotiabank decided to tender its big block to the $18 bid, it paved the way for Sears Holdings to squeeze out the remaining minority investors.

The other fact that's not in question is that Sears Holdings struck its deal with Natcan, then hired Scotiabank's investment dealer arm, Scotia Capital, as adviser on its takeover offer. Sears Holdings sources say they had no clue the bank owned Sears Canada shares, and point out that they also interviewed Merrill Lynch and BMO Nesbitt Burns for the job.

Scotiabank spokesman Frank Switzer said the two arms of his bank acted "with the utmost integrity." But the two roles in this takeover opened the door for Pershing Square to claim Scotiabank had a conflict of interest. If Pershing Square can persuade the OSC to somehow toss out Scotiabank's 4.5 million votes, then Sears Holdings is no longer able to roll up the rest of the minority shareholders. To make the whole thing even more delicious, the chairman of the OSC is former Scotia Capital chief executive officer David Wilson.

For all its troubles, Scotia Capital stands to earn the Bay Street equivalent of minimum wage. The investment bank only stood to make a lucrative success fee -- in the $3-million range -- if Sears Holdings was able to get the chain for the opening bid of $16.86, according to sources at the bank and the American company. With the offer now at $18, Scotia Capital will receive a far more modest stipend. Short of a major reversal at the hands of the regulators, Sears Holdings will take over its Canadian subsidiary early in the new year. A prolonged court fight with Pershing Square is cheaper than an improvement on the $18 bid, sources at Sears Holdings say.

What happens next -- how Sears will beat back Wal-Mart and a planned Canadian invasion by archrival Lowe's Cos. Inc. -- is the subject of enormous debate in retail circles.

Pershing Square pushes the idea of a merger with the troubled Bay and Zellers chains, which were recently taken private by American investor Jerry Zucker. An investment banker who has been through the books of both the Bay and Sears Canada says that while there's no point in putting the chains together, "once everything is private, you're going to see all sorts of wheeling and dealing with the Bay and Sears stores. You'll see Loblaws buy 25 locations, Shoppers, Canadian Tire, even Wal-Mart will buy a few."

The investors who did so well with Sears Canada as a public company say it now makes business sense to say goodbye. Natcan's Mr. Chartrand says: "The next step has to be as a private company. Do that, and you can better deploy capital, you can combine the two companies' purchasing for more clout with suppliers, and combine merchandising. But it has to be private."

Head to head

Meet two fund managers facing off in the Sears Canada takeover, who both claim to follow the value-investing philosophy of Warren Buffett. Strike that. Make it: Meet two money managers who both aspire to be the next sage of Omaha, with the same universal acclaim for their investing acumen, and fortunes in the neighbourhood of Mr. Buffett's $42-billion (U.S.). You decide who stands a chance of emulating Mr. Buffett's incredible four-decade run at Berkshire Hathaway.

William Ackman

The value-based activist investor

William Ackman is a child of the New York suburbs; his father is a successful commercial real estate investor. Mr. Ackman jumped straight into hedge funds after graduating from Harvard Business School in 1992. Starting with just $3-million, Mr. Ackman and a pal built Gotham Partners into a $568-million fund in eight years, backed by investors such as Harvard competition guru Michael Porter.

The wheels came off Gotham in 2002. New York Attorney-General Eliot Spitzer took a long look at the fund's practice of publishing and promoting lengthy research reports -- positive and scathingly negative -- on stocks that Gotham was long or short. Courts held up Gotham's plans to merge two companies where it held stakes, a debt-ridden golf course and a cash-rich real estate trust. The fund was liquidated in 2003, after several investors pulled their money.

Mr. Ackman bounced back with Pershing Square Capital Management, which now has more than $350-million in assets under management, according to Bloomberg News.. The 38-year-old bills himself as a value-based activist investor. He used derivative-based strategies and aggressive, public tactics to push money-spinning restructurings at Wendy's International, which spun off Tim Hortons, and McDonald's, which sold a Mexican fast-food chain. After one recent New York speech to plug his views on McDonald's, Mr. Ackman invited listeners and the media to keep the conversation going at Dizzy's Club Coca-Cola in the Time Warner Centre.

Pershing's current 5.6-million-share direct stake in Sears Canada was purchased after the company's U.S. parent tabled its takeover offer. In addition to running money, Mr. Ackman is a modern art collector who shows his works in New York galleries.

Edward Lampert

Numbers geek with a long-term view

Edward Lampert was a 14-year-old in the suburbs of Long Island, N.Y., when his father, a lawyer, died of a heart attack. His mother took a job as a clerk at Saks Fifth Avenue to pay the bills, her son started working after school in warehouses to help out. In a recent Fortune magazine article, Mrs. Lampert said: "He was a child, and then suddenly he was a man."

After graduating with top marks from Yale University, he landed a job at Goldman Sachs in what's known as risk arbitrage, making bets on stock moves with the house's money. At age 25, Mr. Lampert decided he would prefer to invest his own money. He left Wall Street for Texas, and started ESL Investments -- the letters are his initials. He briefly held a stake in the Texas Rangers baseball team, along with future president George W. Bush. ESL backers include computer entrepreneur Michael Dell and record mogul David Geffen. ESL eventually moved to Greenwich, Conn., and now holds $15-billion. Forbes Magazine puts Mr. Lampert's worth at $1.7-billion.

ESL has just 20 employees. They tend to study the heck out of companies, then take large positions for long periods. Kmart staff told Fortune that Mr. Lampert is a numbers geek, the single-biggest user of IT that the retailer uses to track sales, margins and inventories. Along with a four-year involvement in Kmart and a six-year holding in Sears, ESL has owned a stake in Autozone since 1997, and seen a fourfold increase in the value of the car parts chain.

Mr. Lampert is 43 and married, with a young daughter and a $20-million Greenwich mansion. He never discusses ESL holdings and keeps a low social profile, understandable in view of a 2002 kidnapping that saw the money manager imprisoned in a motel bathroom for 39 hours before being released at the side of a highway. Mr. Buffett earns $100,000 a year as chairman of Berkshire Hathaway. Mr. Lampert doesn't take a salary as chairman of Sears.

© 2007 The Globe and Mail. All rights reserved.

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