The Untold Story of ESL Investments and the Great Decline of Sears
Welcome to the 86th Pari Passu Newsletter.
A few weeks ago, we reached 10,000 subscribers and today we have a special article to celebrate this amazing milestone. Today, we are exploring the untold story of Eddie Lampert and Sears.
Eddie Lampert has been referred to as many things: “The Next Warren Buffett,” “The Best Investor of His Generation,” “The Steve Jobs of the Investing World,” and simply, “genius.” In more recent years, however, this reputation gave way to different names: “practitioner of predatory capitalism,” “egomaniac,” and “Icarus-like.”
This article explores the rise of Lampert’s ESL Investments, the engineered takeover of Kmart and subsequent merger with Sears, and the drawn-out decline and ultimately liquidation of Sears Holdings. While this 35-year sequence of events was highly impactful and broadly influential, involving two major bankruptcies and countless corporate transactions, it is a story that remains relatively obscure [1, 2, 3, 4].
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The Rise of ESL Investments
The son of a successful lawyer and homemaker, Lampert grew up in a town on the North Shore of Long Island. He had a comfortable childhood until the age of 14, when his father died of a heart attack, plunging the family into financial instability. With his mother working as a sales clerk at Saks Fifth Avenue Garden City, Lampert was forced to take on odd jobs and grow up quickly. However, he powered through, winning multiple awards at his high school, and went on to Yale to study economics with the help of financial aid and student loans. Having been introduced to the world of finance by his grandma, who taught him about the handful of blue-chip dividend stocks invested in as a hobby, he knew he wanted to enter finance [1, 5].
Equipped with strong connections made on campus through membership in the Skull & Bones society and through his roommate, Steven Munchin, whose father was a senior partner at Goldman Sachs, Lampert secured a coveted internship at the firm. Early on, Lampert showed an aptness for cultivating powerful people who could help him advance in the world of finance. During his internship, he once helped Robert Rubin, the head of risk arbitrage department, carry his briefcases to a rental car, and with that relationship, he ended up landing a job in the then-legendary risk arbitrage department post-graduation, reporting to Robert Freeman (who was later convicted in insider trading related to fallout from the collapse of the junk bond fueled buyout bubble in the 1980s facilitated by Michael Milken) [1, 5].
At Goldman, Lampert had met Texas billionaire investor Richard Rainwater, who offered him a job. Lampert earned a reputation for working around the clock, tirelessly pouring over investment ideas. Primarily backed by Rainwater, Lampert left within a year in 1988 to found ESL Investments, named after his own initials, with $28mm. While the fund was focused on risk arbitrage and value investing, Lampert wanted to be able to pursue control investments instead of just trading positions, something that Rainwater prohibited, leading to a then-hostile falling out concluding with Rainwater withdrawing his capital. As Rainwater put it, “He’s so obsessed with moving in the direction he wants to move that sometimes people get burned, trampled on, bumped into. I think he has gone about alienating himself from almost everyone who he’s come into contact with” [1, 5].
Ultimately, Lampert never made any control investments, instead managing a highly concentrated long-only portfolio for the next decade and a half. While Lampert charged a relatively standard fee structure of 1 and 20, he forced investors to accept a highly uncommon five-year lockup period before they could withdraw capital (compared to permitted annual withdrawals traditionally). Additionally, he refused to tell his limited partners any details about his investments, requiring full trust. This gave him the flexibility to think about long-term strategy without having to worry about monthly same-store sales, specific targets, or quarterly guidance, which he did by obtaining board seats and influencing companies from within. With a focus on value, he described himself as being an active, but not activist investor, and cited Warren Buffett as his role model. Early wins in the 1990s such as IBM and American Express were followed by grand slams in Autozone and Autonation in the late 1990s and early 2000s [1, 2, 5].
Before investing in Autozone, now considered his greatest win, Lampert reportedly visited dozens of stores himself, and had an analyst spend six months calling hundreds of stores posing as a demanding customer. According to a 2001 shareholder letter, ESL employees had visited or spoken with people at 690 of the more than 3,000 AutoZone stores. Ultimately acquiring 30% of the company, Lampert pushed aggressively for stock buybacks that drove up Autozone’s EPS and reduced shares outstanding, which increased the stock price. Trading at a little over $20 per share in 1997 when he began building his stake, Lampert ultimately exited this investment for between $500 to $600 per share in 2012 for a total of approximately $1.5bn. From 1988 to 2002, ESL’s gains averaged 24.5%, nearly double that of the S&P’s 13% annual return, with only one down year in 1991. AUM rose from a mere $28mm to $5bn, with prominent L.P.s including media mogul David Geffen, Michael Dell of Dell Computers, and Ziff Brothers Investments. Although he briefly contemplated retiring, Lampert compared himself to Michael Jordan, saying that people kept criticizing him, but he kept on winning [1, 2, 5, 6].
Control Over Kmart
In January 2002, Kmart filed a voluntary petition for reorganization under Chapter 11, a process expected to take two years. Al Koch of restructuring advisor AlixPartners, then Kmart's interim CFO, later summarized the situation bluntly: “To most people, Kmart looked like a pile of trash.” However, Lampert believed otherwise. After spending hundreds of hours analyzing Kmart’s financials, he came to the conclusion that Kmart’s bankruptcy was actually avoidable. According to Lampert, the retailer had squandered billions on unproductive store improvements and excess inventories. He believed that prevailing wisdom, which held that Walmart and Target were outcompeting Kmart and stealing its sales, which in turn required Kmart to spend more to fight back to maintain its dwindling market share, was completely wrong. Instead, he believed that Kmart should be managed for profitability, not sales growth. Additionally, Lampert believed Kmart’s real estate could be sold off, and that it could be done at a value higher than the $800mm it had been valued through liquidation analysis in bankruptcy court [2, 7].