Activism - a hedge fund strategy comes of age, but a key US report doubts its longevity

One of the strategies of the day, activism has had its future opportunity set questioned by one US report. Not all of the strategy's practitioners agree, however

If you are invested with an activist hedge fund, stick with it, may be one of the messages from recent research by US investment bank Morgan Joseph on hedge fund activism. Returns almost triple from 6% at 120 days after a campaign's inception, to 16%, on average, 360 days after the campaign begins.

"Activist investment strategies have yielded returns in both the short and long term and, in fact, average cumulative returns increased as the length of time increased beyond the campaign's initial catalytic event," the report stated. Its launch coincided with that of Morgan Joseph's Shareholder Activist Group.

Morgan Joseph's research, Management in an Era of Shareholder Activism covered 94 campaigns from January 2004 to March 2006 by 29 hedge funds, and calculated returns as cumulative, less the beta-implied equity return based on the S&P 500 Index's total return. These returns, suggests Morgan Joseph, will cause growth in the strategy's inflows, and in the number of funds, and "engagement with potential target companies."

quality, not quantity

However, the report questions whether the quality of activists will persist as new entrants join the strategy. "Some of the new entrants may not have the same level of experience as current activist funds in developing sound, rational and beneficial changes to a company's strategies or operations.

"As opportunities dwindle, activist funds may begin to focus on less straightforward situations, causing the quality of activist proposals to decline - just as the frequency of them increases."

This, says the report's authors, spells bad news for targeted corporate managers, "who must nonetheless defend themselves at tremendous expense in terms of time and expenses." Indeed, Phillip Goldstein of US activist group Bulldog Investors says the first thing targeted management will do when they hear from him is "throw an army of lawyers at you."

However, he believes opportunities will continue to emerge. Goldstein does not believe the activist bandwagon is yet overcrowded or losing momentum. He sees activists primarily as value-seekers, for whom there will always be opportunity. "There will always be stocks that trade at below their intrinsic value, otherwise everybody would get out of the market. The only difference between an activist value investor and a passive value investor is that they're looking for a catalyst and we're looking to be that catalyst. When you think about it that way, I don't think activism is ever going to saturate the market. I'm cynical about human nature; there are always going to be bad managers looking to enrich themselves at their shareholders' expense and the stock price of their company will reflect that."

The emergence of activism has already resulted in a 31% increase in proxy fights from 61 in 2001 to 80 in 2006, Morgan Joseph says, with dissidents' success rate in such fights increasing over this period from 43% to 57% in 2006.

In terms of proxy fights, 89% have been waged over board representation or control, and 3% opposing mergers, while regarding all stockholder campaigns, including proxy battles, maximising shareholder value represented 45% of campaign aims, 32% board representation or control and 11% against mergers. Enhancing corporate governance was the key goal of just 6% of campaigns, the report found.

"Our goal," says Phillip Goldstein, "is to kick that manager out or effect other structural change. I don't think that's ever going to change." Neither does he think that the opportunities for activists are drying up: "It's a busy situation. There's always going to be an opportunity if you're willing to get your hands dirty and go through the agony of pushing to unlock value. You have to have thick skin."

fuelling the strategy

While the absolute returns from activism help encourage inflows to the strategy, Morgan Joseph also attributes part of activism's popularity to falling returns from other hedge fund approaches - citing market-neutral's three-year rolling returns falling from 15% in 1999 to just 6% in 2005, according to the CSFB/Tremont Hedge Fund Index.

The ability to raise low-cost debt has also helped, fuelling M&A, the report notes, while "the growth of hedge funds, private debt funds, CDOs and other non-bank financial institutions has led to an explosion in the population of particpants meeting the debt capital needs of buy-out transactions." Buy-out fund raising of $105bn in the first six months of 2006, against $174bn for all of 2005, supports the investment bank's contention.

The Morgan Joseph study also notes the self-fulfilling nature of activism, that if an activist has researched its target well, there will likely be other disaffected investors, and more 'opportunists' could join the fray once the campaign has begun in earnest.

The study breaks activists into four distinct groups. 'Leaders' seek out transactions, get involved and agitate. 'Followers' then join the bandwagon, while 'disgruntled shareholders' may also voice support. Finally 'opportunists' could buy in, without committing people, time or money to the campaign.

Goldstein says Bulldog could take positions in companies with a market capitalisation of up to $300m. "As you take in more money, you can take a bigger stake.

"The simple fact is that when you try to influence management, you're going to have a lot better chance if you have 10% of the stock than if you had 2%. We were more limited to companies worth $120m-$130m but now we've got more money under management."

More money, then, means bigger targets. "It has been a good time for a few years now," said one event-driven manager who used to agitate on behalf of Mellon HBV's activist fund before moving to another hedge fund (who would keep him quiet), "but the evolution we are seeing is that activists are now able to move ever bigger companies.

"A few years ago, you wouldn't have thought it possible to effect change in a $10bn company. Now with the size of hedge funds increasing, it starts to be do-able. The trend will be for hedge funds to 'attack' bigger companies. It's easier now to join up with different [shareholding hedge funds] and build a big stake in companies worth upto $3bn.

"It's starting to be an interesting game to be in, and there's still a lot of upside. It's on a case-by-case basis, obviously - you need to find an undervalued company with the right fundamentals, a really big upside, and perhaps most importantly, one from which you can unlock the value." Realisable assets could include real estate and any cheap company is a target.

Even other hedge funds are becoming targets. J&W Seligman's closed-ended funds have been the subject of attention from the Karpus Group of investors, which includes Phillip Goldstein's Bulldog Investors. The group has acquired more than 30% of the Seligman fund's outstanding shares, which is expected to be enough to replace three of the board's nine members in a proxy vote on 19 October.

The plan is to secure majority board representation next year when three more board seats are up for vote. In the meantime, the activist group will follow the pattern started two years ago to accumulate as many shares of the closed-end fund as possible.

The ultimate goal of the dissident investors, once they have gained control of the board, is to either replace the management and convert the fund to open-end status or to liquidate the fund.

"I would have been happy if they would have just open-ended the fund," said Goldstein.

The fund's shares trade at a 7.5% discount to their net asset value, and its five-year annualised discount up to 16 August is 11.4%. "If they can't manage the NAV, they can't close the discount, and if they can't manage the dividend, they can't help the NAV," said Sharon Thornton, senior analyst at Karpus, working on the Seligman fund.

"We're persistent. I think that having that reputation and credibility of being serious helps.

"Sometimes you end up with what some people might refer to as a 'wolf pack'. It's not that there's any acting in concert, but if we see another activist group in a company, or especially in a closed-ended fund, we're naturally inclined to look at that and say: 'Is that a good investment?' and it's likely that we're going to be thinking along the same lines.

"If I see Laxiy or Elliot Associates, or here in the US, Steel Partners or Pirate Capital, we'll look at it.

"We know them well, we have respect for each other. I think it's psychologically more powerful as a group so the [target company's management] doesn't try to pick us apart and play us off against one another."

In the US, an investor must register any shareholding over 5%.

As for ensuring the interests of activist shareholders in alliance are aligned, Goldstein admits: "It's always possible in any endeavour that people get into a partnership and then get into a fight. That hasn't happened so far, but in general, while there may be strategic or tactical differences, we are working toward the same goal."

However, Sean Ewing, CEO of Absolute Capital Management (ACM), which runs the Absolute Activist Value Fund is wary of the syndicated approach to activism. "It needs to be handled very sensitively. There is always a danger when acting in concert," Ewing says. "We don't have a problem writing to companies and advising them as to what our thoughts are relating to generating value from the balance sheet of the company. There can be a healthy discussion, shareholders own the company, not the management." The danger, he notes, is that it can turn into a takeover position, and that the fund will end up in a position where it is required to manage a company.

battle for betterness

Morgan Joseph's report notes that while the actions of these groups is often portrayed in the media as combative, this is not always the case. "Activism is not necessarily a drawn-out or adversarial process," the report's authors say. "The activist fund, like all investors is interested in seeing its holdings appreciate and believes that it has a plan that in the portfolio manager's mind is superior to the management's in achieving that goal."

In the study from its Shareholder Activist Group, aimed primarily at helping corporate managers avoid activists, or have plans in place if they cannot, Morgan Joseph also questions some activists' ability to see the long-term good of companies they invest in, for the short-term goal of shareprice growth.

"Clearly, as an outside shareholder, the fund may not be privy to the realities that motivate management's decisions, and as a result, the whole situation may deteriorate rapidly." Further criticising some activists,the report's authors say that, while an increased focus on corporate governance is welcome, the altered climate vis à vis corporate governance and rise in activism may have negative long-term implications .

"Chief among these is the increased pressure on managers to focus on short-term performance, or to implement a more leveraged capital structure. This may limit a company's financial flexibility and deprive the corporation of capital needed to build long-term value.

"As a corrolary, an activist fund as an outsider may propose changes that may ostensibly provide immediate benefits to shareholders but at the loss of greater longer-term gain," the report concludes.

Phillip Goldstein notes, "generally, we're not going into an operating company to turn that company around. It's usually overcapitalised and we will think either that it should be sold or that they should realise the value in some other way, such as a buy-back.

"We're not going to micro-manage a company and bring in new management. Other people might say: 'If we can just bring in new management and marketing, we can make this company grow,' but that's not our thing - we've been burned too many times on that because while you're campaigning for that, you're bleeding cash. I've seen a stock go to zero like that. On that other hand, there's a huge payoff if you can do it - just like Eddie Lampert did at Sears.

scandanavian spirit

However, Tomas Meerits, an associate at Stockholm-based Cevian Capital, says: "If you want to contrast operational activism to what everybody else is trying to do, we have a broader spectrum of action that we want to take. We don't rely on one big idea, whereas other activists might revolve around one idea, say, to do with capital structure, such as share buy-backs or returning cash to shareholders.

"We tend to have four different pillars and we like to create value from all of them. The first is corporate governance, whereby typically, we take a board seat - that's our modus operandi. That may set us apart from many of our peers. We think it's important to monitor the change programme that you have in place to make sure that it's being done and in a timely fashion.

"Within that corporate governance pillar, we want to see that the rest of the board and the management are people that we think can enhance the value of the company, and are correctly incentivised to do so.

"The second pillar is operational improvement, which ranges from pure cost-cutting to revenue enhancement through improved pricing or moving into new markets and new products.

"The third is changing corporate structure and strategy, which might entail spin-offs, divestments or acquisitions, re-orienting strategic priorities between areas as sometimes the board that is in place doesn't necessarily see where to create value or, indeed, has inertia towards changing the company structure, especially the downsizing of their company.

"The fourth pillar is the financial structure. ensuring optimal capital structure by achieving the right balance of debt and equity.

"Typically, we try to make improvements to all or several of those areas, so as not to rely on one idea, which, should it not work, would leave you stuck. That also means we have a longer time horizon than most other funds.

Historically, Cevian has had an average holding period of more than two years. "The change you cannot make in three years probably can't be made at all," says Meerits.

Sometimes, the market is kind enough to price that in before you fully implement it, which sometimes shortens our holding period.

"What enables us to do this is the fundamentally different nature of Scandinavian corporate structure. We think it's the best availableenvironment for activism. For anybody to wield this kind of influence as a minority shareholder is much easier than in other environments.

absolute rule

"In Scandinavia, there is a very clear hierarchy, with the shareholders at the top nominating a board, which, in turn, appoints a CEO. Representatives of the largest shareholders form a board nomination committee - this is codified in the corporate governance code here and has spread through most public companies. The role of the committee is to evaluate the existing board and nominate members for a new board. The final decision lies with the shareholders through single majority vote at the annual general meeting.

"In the Anglo-Saxon system, the chief executive officer (CEO) has a very strong position, almost like the king of a company, wherein he may also be chairman and the board effectively nominates itself, while the shareholders are left on the outside to bark in and make suggestions. The activist is thus reduced to a 'suggestionist'

"Whereas in Scandinavia, the CEO's main role is to deliver operational performance. It's typical that he is not a member of the board."

Cevian Capital has just released its second fund - Cevian Capital II - with a hedge fund-like structure (even though the fund is, obviously, long-only). "It's a paid-up structure where you call the capital down and reinvest whatever you realise." Although its predecessor did exactly the same thing, taking significant minority stakes in public companies, it had more of a private-equity structure on account of the market's immaturity when the fund was raised in 2002.

"It was the only option as hedge fund structures all had quarterly or monthly liquidity. Now longer lock-ups and side pockets make a hedge fund structure a viable option for us, while private-equity structures have a definite life cycle, which is coming to and end for our first fund," Meerits said.

Cevian Capital II opened and closed in one day, on which it raised $2bn, which will be taken in quarterly tranches.

concentration needed

"We look for companies that are fundamentally undervalued and to which we can add value through active ownership," Meerits says.

Cevian also looks for opportunities to double its investments over three to four years, but with a very limited downside. "Given that we run a very concentrated portfolio, we don't want to lose money on any deal," says Meerits.

So far, so good, it would seem, as Meerits claims the Cevian team has lost money on only one position in 10 years.

Given the intensely hands-on nature of the strategy, highly concentrated portfolios are an occupational hazard for activists. From its "idea list" of up to 30 target companies, Meerits expects Cevian II to run 8-12 positions, about half of which will be active at any one time, with the others being bought up or sold off.

While Cevian invests mainly in Scandinavia, where it knows most of the companies that are on its radar, it has no industry bias, although it avoids companies such as one-product biotech firms or commodity-driven enterprises, where it feels its best efforts on the board may not make up for impact from factors outside of Cevian's control.

Meerits admits to getting the occasional tip from hedge funds attempting to find a catalyst to move their positions, or from companies' individual board members or management who feel they are not getting support from their board, but he is aware that "people have their own agendas, which may not be well aligned with ours."

in-built diversification

Meerits says that activism brings with it a degree of diversification as you cannot sit on the board of two companies in the same sector, and that activist funds can "only run so many positions".

However, he says: "The best thing you can do to protect your portfolio is to know your companies really well before you invest, and add value through active ownership during your investment."

blurring boundaries

Activism is a key area at the vanguard of the blurring of the lines between private equity, hedge funds and investment banking, ACM's Ewing says. The activist fund has a 12-month lock-in with a penalty for leaving the fund between 12 and 24 months of the initial investment.

Absolute Capital Management's (ACM) Absolute Activist Value Fund invests globally utilising a concentrated portfolio of holdings, allowing it to concentrate 10%-15% of its portfolio on each company. It targets 15%-20% returns, though it has so far exceeded this with annualised performance of 52.69%.

"It may be that our approach is slightly different to private equity. They look for a gateway quickly, whether it is an IPO or a trade-sale. We may not necessarily be playing in that short-term space if we think there is significant value to be derived over a longer period."

european space

He notes Europe is currently an especially good place to be active because, compared to the US, there is such a small number of players exploiting the opportunities.

As well as taking a bottom-up, stock-picking approach, selecting companies the fund's managers believe have potential to increase shareholder value, it takes a top-down approach.

It looks for sectors it believes will structurally enhance the company's chances of delivering strong performance. The Italian banking sector, for example, constituting 200 banks, is unsustainable and on the cusp of major consolidation that will benefit the banks that emerge from the process with the business. ACM has exposure in this area.

ACM looks for companies it believes have strong businesses but where assistance for the management team could unlock extra value. It is about taking an opportunity to create and assist strong management teams, says Sean Ewing, chairman of ACM.

"We want to be in a position where we can add one and one and make three," he explains.

"Activism is a multi-strategy approach as any investment is," says Ewing "When you look at activism, it is about how managers are utilising their balance sheets., what type of capital flows are returning to the earnings per share relative to the capital in the company. From there, you can see how management are utilising and leveraging the assets they have."

As experienced investors, ACM believes it can deduce how competently a management team is working from, among other factors, its price to earnings ratios, returns as investments and use of cash.

ACM counts a number of ex-management consultants among its staff, able to appraise the strengths and weaknesses of the boards of its investments. It also uses Ceres Capital as a partner. "These aren't some drunken investment bankers sitting in the City trying to get companies together to generate juicy fees, these are real hands-on businessmen," he says.

more than just active

"It is not activism for the sake of shouting, it's about being able to contribute to the general well-being of a business. A successful contribution is reflected in a mature part-ownership so we can be a catalyst for change, influence it and assist in making it happen, which we hope will be reflected in the share price."

This can include management buy-outs.

"There is no question that when management have blood on the table, returns on the investment tend to be higher," he adds.

It can also utilise various different securities to exert pressure in different ways.

"We may have situations where we put in mezzanine finance together with ordinary down to preferred equity, and the mezzanine may come back in six months but we are running with our equity and as a result of the mezzanine we have an option on some additional equity," he explains.

"Activism is a blend of smart investing, identification of value and assisting the right people to extrapolate that value."

Although it is preferable to have a good relationship with the managers, it will not liquidate its position if faced with opposition from the board over its advice. In extreme cases, this could also involve taking a short position in the company concerned, Ewing says.

In one instance, where a Scandinavian company was making an acquisition of which ACM disapproved, it took a significant short position in the company to profit from the expected negative impact it would have.

It does have stop-losses built in to protect the fund, and Ewing says the managers are not so obstinate as to believe they know better than the market.