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How to Beat Hedge-Fund Bullies, Part II

CFOs should sniff out the intentions of activist hedge funds that are substantial shareholders in their companies, experts say.
Helen Shaw, CFO.com | US
March 26, 2007

Considering how much havoc activist hedge funds can wreak on the best-laid corporate plans and the careers of senior management, finance chiefs would do well to be on high alert when such investors gain power in their companies, industry experts suggest.

Indeed, the funds tend to be hugely effective juggernauts of change once they get rolling. Funds with hefty share holdings and a yen to shake up a company often get what they want, according to a study of 155 activist hedge fund campaigns conducted between 2003 and 2005 by April Klein, an associate professor at New York University's Stern School of Business, and Emanuel Zur, a doctoral student who combed through forms filed with the Securities and Exchange Commission by activist hedge funds.

For instance, of the campaigns the researchers analyzed, all three activist hedge funds that asked to change the chief executive officer were successful. (The study didn’t inquire into the fate of the CFOs involved). What's more, all four activist funds that urged companies to engage in stock buybacks were successful.

Klein says the chances that a company will acquiesce to a hedge fund's demands are linked to whether the fund garners a seat on the board. But besides changing the direction of a company, the firebrand funds can affect the CFO personally—in fact, the owners of such funds often become finance chiefs' bosses. "In over 40 percent of the time, the hedge fund gets a place on the board," notes Klein. "Many times, they have the majority of the board."

Other hedge fund-initiated changes involve the firm's financial condition. According to Klein, hedge funds pursue cash-rich companies that tend to pay low dividends and have a small amount of debt. On average, the firm's dividend doubles within one year of an activist hedge fund acquiring at least a 5 percent stake. "When a hedge fund comes in," explains Klein, "they reduce cash, increase debt, and pay out the dividend."

Given the ruckus activist hedge funds can stir up, finance chiefs should be well aware of any activist hedge funds that are substantial shareholders in their companies, the extent of their holdings, and what their intentions are, experts say. One way to ascertain fund motives is to pore over the 13D filings that activist funds file with the SEC. Funds that hold over 5 percent of voting equity and intend to acquire control over a company or at least influence how it's controlled must file the form with the commission on EDGAR and mail it to the company within 10 days. At the same time, if a fund owns over 5 percent and less than 20 percent, but is a passive investor, it must file a 13G form with the SEC and mail it to the company within 10 days.

Still, the long deadlines for filing after-the-fact notices of share ownership with the SEC can stymie companies' quest for information, especially since a hedge fund could have sold its position before the forms are filed and made public. Also, a hedge fund can hide its identity by requesting confidential treatment from the SEC to protect its investment strategy, says Adam Gale, an attorney at Orrick, Herrington & Sutcliffe.

To help grease the wheels, stock-watch firms can help companies figure out whether an investor is a hedge fund and narrow down a list of which ones they may be.

How can senior managers and boards anticipate where the most formidable assaults will come from? Some observers feel that hedge funds that own options on the stock don't have nearly as much clout as those that bought shares outright. Yet many activist hedge funds that own options claim ownership without having shelled out the cash, says David Krein, president of DTB Capital, an advisory firm. "Corporate management has the opportunity to identify which hedge funds they need to take seriously and which ones they don’t" by distinguishing between the two kinds of ownership, he adds.

Others however, agree with the regulatory perspective on corporate ownership: owning options means owning shares. The case against the power of option owners is as weak as the one that claims that stockholders must own shares for a certain period of time to demonstrate that they're serious about stock ownership, according to Espen Eckbo, a professor at the Tuck School of Business at Dartmouth University.

If an activist hedge fund can engender corporate changes without putting down a lot of capital, says Eckbo, "the better off [investors] are for it." Speaking from the shareholder's point of view, he rhetorically asks: "Do you care if a hedge fund bullies the firm as long as the price goes up?"




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