Picking a worthy target is only the entry point for the types of deals that activist hedge funds take on. It is in the summoning of shareholder interest, restructuring of management and execution of rewritten corporate objectives that the manager succeeds or fails to generate the kind of ‘proactive alpha’ they seek. SIMON MUMME reports.
Even seasoned corporate siege-makers such as Chris Hohn of The Children’s Investment fund (TCI) and Warren Lichtenstein of Steel Partners find generating alpha from their targets can be stymied by the boards of those companies. While Hohn’s financial stake in US railway company CSX has nearly doubled since he bought it in 2006, the target’s ongoing lawsuit against his fund’s method of upping its economic ownership of company stock through derivatives is damaging the fund’s reputation.
Meanwhile, Lichtenstein’s efforts to take over Japanese Worcestershire sauce company Bull-Dog has seen his firm be lambasted as an “abusive acquirer” by the Tokyo high court and forced to take a poison pill. But these high-profile stories belie the reasonably amicable world of hedge fund activism, and the consistent successes that these managers have achieved, according to a recent report by Harry Liem, principal and hedge fund specialist with Mercer Investment Consulting (Mercer IC).
In the paper, entitled You’ve got greenmail!: A closer look at the merits of hedge fund activism, Liem points to research from US academics April Klein and Emanuel Zur covering 194 Securities and Exchange Commission 13D filings, submitted between January 2003 and December 2005, in which a hedge fund targeted a publicly traded company. The paper finds that in the time periods surrounding the initial 13D filing, the targeted companies generated returns an average 10.3 per cent higher than untargeted companies and a sample of other firms used as ‘controls’ in the study, whose classifications were based on industry, firm size and book-to-market ratio.
In the year following the activists’ acquisitions of their initial holdings in their targets, company dividends per share approximately doubled. Of all of their demands made in the filings, 60 per cent were successful. In this, 73 per cent of demands for board representation were met. Sieges of big companies such as Hohn’s battle in 2005 with Deutsche Börse aside, activist funds commonly target smaller firms: on average, just 6.5 per cent of businesses targeted were from a major index, the Mercer IC report finds. And these firms were not usually ailing but profitable and financially sound businesses. Nor do activists necessarily choose to antagonise targets: “most good activist managers don’t force change; they work with boards,” says Greg Liddell, head of implemented equities at Queensland Investment Corporation (QIC), which has invested in activist managers focused on European and Japanese markets.
The “proactive alpha” of activist managers is different alpha to that pursued by other, more passive, investors, Liddell says. Rather than requiring the market to take a certain turn or present opportunities, “an activist goes into a company and creates value rather than extracts it,” Liddell says. Their ability to generate this value depends on their knowledge of markets and business, their networking skills and contacts in the corporate world, which sometimes include allies who can be called upon to become directors.
They are “very proprietary in what they regard as their intellectual property,” Liddell says, which includes keeping secret the timing of their investments in companies, to avoid being front-run by other investors. Mercer IC’s Liem believes that in the future many hedge funds will rely on their own resources and specialised capabilities to generate alpha. He observes that an activist manager’s specialised skill-sets and ability to network and build relationships will be increasingly valued as “pure alpha”. “It is likely that more and more hedge funds will trade no longer purely on the availability of public information but will rely instead on change management skills and strategic thinking.” In a world of hedge funds where statistical arbitrage models have become more common and zeroed in on a wider array of opportunities, spoiling the attractiveness of certain arbitrage strategies that operate in short timeframes, Liem believes that the case for activist hedge funds will become stronger. “Despite the increased competition and the late stage economic environment reducing the universe of potential opportunities, we consider it likely that hedge fund activism will gain more and more traction.”
Words will never hurt me
A successful activist will often gain control of the target firm’s agenda, increase its debt load, reduce the amount of cash on hand and pay out increased dividends to the shareholders. While the funds appear to be effective in executing their aims and “optimising the financial structure” of target companies, Liem writes, these same actions prompt criticism.
Among other claims, activist funds have been accused of weakening their targets by directing resources away from long-term corporate strategies designed to create value. However a 2006 academic study by Alon Brav, Wei Jiang, Randall Thomas and Frank Partnoy that examined 900 instances of hedge fund activism from 2001 to 2005 concluded that hedge funds act as both value investors and shareholder activists.
The study found that outperformance of 5 to 7 per cent observed in the weeks surrounding the incidents of activism showed no apparent reversion to previous performance in the following year. And, over the subsequent two years, the researchers found a discernible improvement in the operational performances of the targeted companies.
Another accusation is that activist strategies can cut back aggregate employment levels in companies, since an obvious method of improving the profitability of a business is curtailing the number of staff. Here, solid evidence of the effect of activists’ actions on the workforce has not been found, Liem writes.
Finally, critics sometimes claim that hedge fund activism is really just bullying. That activist funds ‘sell out on the hype and leave the company to grapple with its own problems’ is a common accusation. In the aftermath of Deutsche Börse’s attempt to merge with the London Stock Exchange in 2005, which was scuppered by TCI’s Hohn, the German finance ministry appealed to market regulators to place restrictions on “short-term profit-oriented foreign investors”.
But stoic opposition from the US, which favours a market-based approach to regulation, resulted in Germany relinquishing its attempts at regulatory change.
Power in numbers
“There are more activist managers out there than you think,” says Kevin Wan Lum, a portfolio manager with Liddell’s team at QIC. Mercer IC estimates that at the end of calendar 2006, there were between 100 and 120 activist hedge funds globally, collectively holding about US$50 billion in funds under management.
Although these funds account for a sliver of the US$1.8 trillion hedge fund industry, the rise in their number is significant, given that they have influence and that, five years ago, there were about 40 of them. “They often have the ear of major institutional investors,” Liem writes, “and this may lead to the demise of a prominent CEO if they appear to have lost their golden halo.” While big institutions are capable of shareholder activism, these tasks may be best left to hedge funds.
They are less constrained than institutions, Liem writes, having the ability to own more than 10 per cent of the outstanding securities of any company. Given their remuneration arrangements enable them to take a slice of outperformance, they can personally benefit from activism, unlike mutual fund managers. And the lock-up conditions on investors’ capital set by some hedge funds allow them to build long-term positions.
According to Liem, “the available empirical evidence indicates that compared to traditional institutional investors engaged in activism, activist hedge funds are particularly effective”. Their effectiveness can be heightened if managers band together with a common target in sight. “The new activists often band together and swarm all over management,” Liem writes.