RONALD D. OROL is a financial reporter for MarketWatch, where he reports on hedge funds, banking regulation, and also the Securities and Exchange Commission. Prior to MarketWatch, Orol spent seven years as a senior writer for The Deal and The Daily Deal, covering the activist hedge fund industry as well as other topics. He is also a commentator on BBC World Television, CNBC TV, CTV, and National Public Radio. In addition, Orol regularly organizes and moderates panels on hedge funds and banking regulation. Prior to his work at The Deal, he was a reporter with Dow Jones Newswires and the Washington correspondent at the Providence Journal. Before moving to Washington, Orol spent three years as a business and finance reporter for the Prague Post in the Czech Republic. While in Prague, he also reported for Southam Newspapers, the Montreal Gazette, and the Toronto Star on Eastern European privatization and the political transformation of the region. Orol earned his bachelor of journalism honors degree from Carleton University in Ottawa, and received a business and economics journalism master’s degree from Boston University, where he graduated with distinction.

Extreme Value Hedging

How Activist Hedge Fund Managers Are Taking on the WorldBy Ronald D. Orol

John Wiley & Sons

Copyright © 2008 John Wiley & Sons, Ltd
All right reserved.
ISBN: 978-0-470-45024-6

Chapter One

Growth of Activism and Why Corporate Raiders Aren’t Around Anymore

The past few years have seen a major increase in the number of activist hedge funds in the United States and abroad. As of September 2006, Hedge Fund Research Inc. (HFR), a Chicago-based database and analysis company, estimates that roughly 150 full-time activist hedge fund managers have functioning investment vehicles-roughly double the 77 activist managers that existed in 2005. Activist funds in 2006 more than doubled to $117 billion in assets, from roughly $48.6 billion in assets in 2004, according to HFR (see Figure 1.1).

Also, activists appear to have produced strong results by outperforming the marketplace over the past number of years. In 2004, when the Standard and Poor’s (S&P) 500,a noted benchmark of large-capitalization companies, returned 10.86 percent, activists produced 23.16 percent, according to HFR. In 2005, activists returned 16.43 percent while the S&P 500 reported 4.91 percent. In 2006, activists produced 16.72 percent, while the S&P 500 returned 15.78 percent. As the financial crisis expands, many new opportunities have emerged for activist hedge fund managers with the capital to invest. In an October 2008 report, Philadelphia-based consultancy Hedge Fund Solutions estimated that 1 in 10 companies in the United States were trading below their cash/share value. There are similar valuations in Europe and Japan, where activism is on the rise. In the United States, Damien Park, president of Hedge Fund Solutions, counted 54 activist campaigns in August 2008, 57 in September 2008, and 50 in October 2008.

They also are engaging and agitating for change at a wider spectrum of companies, many of which for the first time are the largest of corporations in the United States and around the world. In 2008, they prodded and engaged managers at dozens of large companies, including the Zale Corporation, Whole Foods Market Inc., CSX Corporation, Sun-Times Media Group Inc., and Longs Drug Stores Corporation. Activist Jana Partners LLC’s industry-expert candidates helped facilitate a $1.8 billion sale of Cnet Networks Inc. to CBS Corporation in May 2008. Other previous targets of activism include embattled Citigroup Inc., General Electric Co., ABN Amro Holding NV, Motorola Inc., Time Warner, McDonald’s, Wendy’s International Inc., Heinz, Vodafone Group plc, Cadbury Schweppes plc, and Kerr-McGee Corporation. The list goes on and on. But it hasn’t always been this way.

How did this once small group of insurgents explode into the massive players they are today? The answer relies on various factors that have come together to make them into full-fledged activists.

For one thing, all hedge funds, including activists, have become recipients of additional capital from individuals and institutions. Other major factors have contributed to the rise of the transactional-focused activist industry. For example, between 2004 and 2007, an increase in the cheap availability and variety of debt and a huge spike in deal activity, including a spike in private equity buyouts are all advancing activist goals.

The collapse of Enron, Worldcom, and other major corporations has bestowed a greater credibility on shareholders that engage corporations to improve their corporate governance. All that and a transforming regulatory and legal landscape that has converted once powerful corporate raiders into activists have contributed to their evolution. Meanwhile, other previously coveted strategies, such as convertible arbitrage, are experiencing diminishing returns, leading investors to seek out new approaches, one of which is activism.

Let’s break down the various factors, one at a time.

Factor 1: Asset Explosion

Between 2003 and 2007 hedge fund assets under management doubled to well over $1 trillion, according to HFR. By mid 2007, hedge fund assets were estimated to be roughly $1.6 trillion. To put things in perspective, in 1996, hedge funds managed only $256 billion. As a result of the financial crisis, hedge fund assets have dwindled as investors have pulled their money out. However, even with lower numbers, activist hedge funds and the billions they have under management represent a significantly growing piece of the total industry. Insurgent investors represent roughly 10 percent of the total hedge fund industry, HFR reports (see Figure 1.2).

Also, funds of hedge funds, which are funds that own stakes in many hedge funds, have begun investing with activists in a big way. Institutional investors such as endowments and public and corporate pension plan administrators have expanded their allocations to insurgent-type investors, particularly governance-focused managers. Consequently, activist managers are experiencing a very different investor climate than 10 years ago when their client base was more likely to be made up predominantly of a few individual high-net-worth investors. With so many assets under management, activists are under pressure to target more and bigger companies to continue producing the sweet returns their investors have grown to expect. Many traditional professional managers with expanding asset sizes are also converting into activists under the assumption that the strategy can help them maintain returns their investors have grown to expect.

Factor 2: Deal Flow

The United States and many other countries experienced a major expansion of merger-and-acquisition (M&A) activity in the early 2000s. More deals and deal makers resulted in more opportunities for activists to engage in one of their favorite share value-generating strategies: pushing companies into transactions.

In fact, a phenomenon known as deal jumping emerged, partially due to activist hedge fund managers pressing for more deals and better premiums on mergers. Once a company has already agreed to be acquired, another company, known as an interloper, comes in and makes its own bid for the target corporation. Activists in many cases have been driving or, at the very least, fanning the flame on the deal-jumping phenomenon. Their goal is to launch a bidding war, which will drive up the stock price.

Take Verizon’s successful snag of MCI Inc. The former long-distance operator had already struck a deal to be bought by Qwest Communications International Inc. whenVerizon came in with its own offer. Qwest and Verizon each made increased bids, spurred on, in part, by activist hedge fund managers pressing for higher share valuations. Shareholder Elliott Associates LP, at one point in February 2005, announced plans to vote against any MCI plan to be acquired by Verizon that was $1 billion less than a rival acquisition offer from Qwest. Elliott Associates sent that information in a letter to MCI’s board. In the end, MCI’s board approved Verizon’s $8.1 billion bid. Even though it was 14.4 percent less than Qwest’s $9.75 billion offer, it still was a significant premium to what Verizon had originally bid. A few activist hedge fund managers set off a similar but much larger multibillion dollar bidding battle among banking institutions for Dutch bank ABN Amro.

Factor 3: Private Equity Funds

A tangential trend has been the recent growth of private equity (PE) companies with billions in assets. This type of investment vehicle brings together a group of investors in a fund that buys companies, typically undervalued ones, and seeks to turn them around by a variety of means such as installing new management teams that concentrate on making them more valuable. Once the portfolio business is restructured, the PE firm then either sells the business or finds another exit strategy such as a public offering. Their presence increases the potential buyer pool and likelihood that an activist’s target will be acquired, particularly if activists start agitating for a merger. However, private equity firms became the first victims of the recent credit crunch. With confidence in the markets dwindling, they have temporarily disappeared as a potential buyer for a company an activist is seeking to have sold. George Mazin, a partner at Dechert LLP, notes that the increases in the number of PE funds and the assets they have under management have definitely fueled activist investing. The years 2005 and 2006 were stellar years for buyout funds.

In its 2006 report, “Management in an Era of Shareholder Activism,” New York-based investment bank Morgan Joseph & Co. reports that the growth of the PE industry has created a ready market of buyers for companies that are forced into a sale by activists. “A proliferation of diverse equity funds with different mandates has broadened the array of companies that meet buyout firm requirements,” Morgan Joseph reports.

James Hyman, the CEO of Houston-based Cornell Companies a builder and operator of correctional facilities, says he definitely sees a connection between activists and PE companies. Hyman was brought in as the chief executive of the Houston-based company after activists there pressured the previous CEO to step down in 2005. His stint was short. The company was sold in October 2006 to buyout shop Veritas Capital of New York.

“They are co-dependent enablers,” Hyman says. “The PE companies encourage the hedge fund guys to put companies in play and the activists take positions in companies and pressure for auctions enabling private equity firms to get a hold of divisions or entire companies they might otherwise not have been able to.”

A connected phenomenon is that activists themselves in some cases have emulated buyout shops by making bids and buying companies with the intention of turning them around. Certain activists would prefer a strategic or traditional PE company to ultimately make the acquisition, but buyout shop offers and acquisitions contributed to the explosive M&A environment (see Figure 1.3).

In addition to lending for leveraged buyouts, corporations had access to much more debt financing for other purposes than ever before, and the cost of all that debt was lower than it had ever been before. This new source of cheaper debt lent itself well to the activist manager who pressed corporate executives into completing a leveraged recapitalization-in other words, raising debt levels and using the proceeds to buy back shares or issue a special shareholder dividend. Morgan Joseph’s Lampert points out that company CEOs, under pressure from deal-hungry activist shareholders, had a wide variety of financing options available to them as they either contemplated taking the company private or engaging in a leveraged recapitalization.

New York-based hedge fund and buyout firm Cerberus Capital Management LP, an early adopter of the concept of hedge fund debt lending, has provided financing capital for over 10 years. In 2006,the mega fund, named for a three-headed dog that in Greek mythology guards the gates of hell, acquired General Motors Acceptance Corporation (GMAC),the financing unit of General Motors. Later in 2007, it made an even more astonishing acquisition, picking up U.S. automotive giant Chrysler Group from DaimlerChrysler AG for $7.4 billion. That deal more than any other transaction has propelled buyout shops and hedge funds out of obscurity and into the national debate. However with the markets in turmoil, both Chrysler and GMAC have fallen on difficult times. Both auto companies sought and received billions in government bailout funds in 2008 and 2009.

Factor 4: Fraud

The collapse of Enron Corporation in 2001, followed shortly by the implosion of WorldCom Inc., Global Crossing Inc. and the emergence of fraud at several other major corporations, sent a loud and clear message to the United States government. Lawmakers on Capitol Hill in Washington passed laws seeking to make sure corporations wouldn’t misappropriate millions of dollars again. In 2008, a whole series of other regulatory problems, dealing with mortgages and derivatives, led to the collapse of Lehman Brothers and the government mega-bailouts of Bank of America, Citigroup, and American International Group. In response, regulators again took up legislative steps to take control of markets and to beef up enforcement of the financial sector.

The landmark Sarbanes-Oxley Act (SOX), co-authored by Senator Paul Sarbanes (D-MD) and Representative Michael Oxley (R-OH), passed in 2002 and made major stabs at reforming boards and accounting practices. Controversial corporate governance rules requiring chief executive certifications and auditor independence followed shortly afterward. Separately, The Nasdaq Stock Market Inc. (NASDAQ) and New York Stock Exchange adopted regulations that would require their member companies to have more independent directors, with little or no financial or family ties to corporate management. These regulations sought to respond to the problem of boards composed predominantly of insiders that were more interested in keeping the CEO happy rather than satisfying the company’s shareholder base. Those governance rules and the financial crisis that has emerged in 2008 and 2009 created an opportunity and a ready audience for governance focused activists and their engagement style. Previously passive institutional investors have been willing to give activists a chance, especially if a central part of their campaign focuses on a lack of independent directors on a particular board. In the environment of the market meltdown, institutional investors are even more likely to support activists that have a long term governance agenda for corporations or financial institutions. When activists focus on governance issues, in recent years, they have gained credibility, which contributes to their ability to provoke change. Burned by corporations in the past, institutional investors are now more likely to support an activist that wants to put a director or two on a corporate board, as part of their effort to make corporations more accountable to shareholders. “There have always been underperforming companies and underperforming boards, but there haven’t always been a significant number of funds out there that were willing to challenge them,” says Morgan Joseph’s Andrew Shiftan.

In the pre-Lehman era, institutional managers would either vote with their feet by selling their stakes in companies they had lost confidence in or hold on to the shares and accept management problems. As the financial crisis has emerged many previously passive institutional investors have either thrown their support to insurgents or become activists themselves.

Institutional investors such as pension funds that have invested billions in public securities markets are beginning to understand the importance of strong governance at corporations, says Corporate Library’s Nell Minow. “They’re recognizing that aiding an activist’s efforts may be the best way to bring in the governance changes they recognize as being necessary at a corporation,” she says.

Hedge Fund Solutions’ Damien Park says that he agrees that activists with the right intentions can help improve the governance of corporations in a way that produces long-term share improvement. However, he argues that real governance activists are patient and understand that improvements take time. At the same time, he says, there are many fakes out there who claim to be governance experts as part of their effort to achieve a personal gain at the expense of other investors. CEOs have responded to both the fake and real governance focused activists by finding ways to leave the public markets. The hike in regulatory related costs, along with the increased difficulty many companies faced finding willing and able directors, all began to contribute to the trend of going-private transactions. In November 2006, a private-sector group headed by Glen Hubbard, dean of the Columbia School of Business, and John Thornton, chairman of the Washington think tank Brookings Institution, and former president of Goldman Sachs & Company, produced a report pointing out that regulatory requirements associated with SOX were a major contributor to why companies sought to exit the public market. The report pointed out that section 404 of the law, financial reporting of corporate internal controls, created a particularly hostile world for many public companies, particularly smaller ones. According to the report, the cost for companies complying with section 404 in the first year was, on average, $4.36 million.

(Continues…)

Excerpted from Extreme Value Hedgingby Ronald D. Orol Copyright © 2008 by John Wiley & Sons, Ltd. Excerpted by permission.
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