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Activist fund managers can be brutal, but there are ways to fight back.
David M. Katz, CFO Magazine
June 1, 2007
If the Fox Network were ever to launch American Business Idol, Robert Chapman would be its Simon Cowell. The activist hedge-fund manager and founder of Chapman Capital once called the 78-year-old chairman of a target a "helpless Mr. Magoo–like figure" and referred to its CEO as "the dummy" in a 13-D filing. He called former executives at Vitesse Semiconductor "the Three Stooges." And he once provoked the CFO of Embarcadero Technologies to swear at him and then recounted the incident, profanity included, in a Securities and Exchange Commission filing.
His actions can be just as aggressive as his words. He sometimes uses private investigators to dig up dirt on managers. Last year, Chapman demanded that Embarcadero put itself up for sale and threatened to publicly reveal the results of a probe of the board and executive team if the company did not oblige.
Chapman is one of a new breed of corporate raiders — hedge-fund activists who instill fear in managers of underperforming companies. Unlike the raiders of the 1980s, who generally took controlling interests in their targets, activist hedge funds take relatively small positions in companies and seek to impose their will by pursuing a few seats on the board and agitating for change. Their aim is to boost the stock price by pushing for a strategic move such as a spin-off, sale of assets, a large buyback or dividend, or a change in management. They can make life miserable for CFOs and other executives as they promote their agendas.
Some of their names are familiar: Carl Icahn and Nelson Peltz are among the most active. But a new group of hedge-fund managers, like Chapman, are garnering a reputation as aggressive, but effective, gadflies. Ralph Whitworth and David Batchelder, co-founders of Relational Investors LLC, are credited with shaking up Home Depot and ousting CEO Bob Nardelli. Batchelder, who forced his way onto the board in February with a measly 1 percent of the shares, claims his firm wasn't entirely responsible for the CEO's departure: "We showed up just in time to yell 'timber' on the Nardelli firing," he told a group at the Milken Institute Global Conference in April. "The board was already working on it." Relational Investors seems to be just as proactive in its dealings with Sprint Nextel, taking a 1 percent stake and pushing for a slowdown in capital spending and a possible sale of the company's long-distance business.
In most cases, activist investors like to operate behind the scenes, working with management to encourage a change at the company. "Our goal isn't to get into a fight," says Phillip Goldstein, the managing member of activist hedge-fund firm Bulldog Investors. "It's to try and make money." Activist investors prey on underperforming companies that, in their view, aren't living up to their full potential. And when one hedge fund moves in, other funds smell blood and quickly follow.
When discretion fails, some activist hedge funds will take their cases directly to the public, where their outcries can embarrass corporate management teams. In May, for instance, Icahn took out a full-page ad in the Wall Street Journal to print an open letter asking Motorola shareholders to vote him onto the board of directors. In the letter, he pilloried Motorola management for "a critical failure in oversight and leadership." Other companies that have been the target of activist hedge funds include Wendy's, H.J. Heinz, McDonald's, and Bally's Total Fitness. Citigroup is thought to be a prime target because critics claim it would be worth more broken into pieces.
"Management Lost Its Halo"
Menacing as the new activism may seem to management, however, a more complex picture of the phenomenon has begun to emerge. Contrary to the common portrayal of activists as short-term plunderers out for a quick buck, new research shows that they tend to hold on to their shares for a relatively long time. While some activists do harbor takeover dreams, the majority prefer to stay on as independent directors with an advisory role. Most activist hedge funds don't seek to remove management, and many fund managers become activists only after stints as passive stockholders.
By some estimates, of the approximately 8,800 hedge funds (with combined assets of $1.2 trillion), fewer than 10 percent are activist funds, but the activist subsector is one of the fastest growing. Why the current surge? The rise has been fueled by a convergence of factors, says Goldstein, who is known for successfully suing to strike down the rule requiring hedge-fund advisers to register with the SEC. He says that increased investor skepticism is one reason for the rise of activism. "After Enron and WorldCom," he says, "management lost its halo." Activist hedge funds, which have been wildly successful at raising funds, are also less encumbered by the rules that make it harder for mutual funds and pension funds to influence companies. And the Internet has dramatically cut the cost of shareholder campaigns.
Most of all, the number of activist funds is burgeoning because they have been remarkably effective at making money for investors. "I think it's simply that activists have been successful," says Goldstein. "Success breeds imitators." When news of potential activism breaks, the return on the investment jumps 5 to 7 percent above the norm as a result of stock-price appreciation, according to a study authored by Duke University's Alon Brav, Columbia University's Wei Jiang, the University of San Diego's Frank Partnoy, and Vanderbilt University's Randall Thomas. The gains are long-lasting. The research shows no apparent reversal of the trend for a year after the fund reveals its intentions. "The activism clearly generates a kick [in the stock price] once it's announced, and we don't see the price going back down," says Brav, an associate professor of finance at Duke University's Fuqua School of Business.
Another study shows that activist investors are remarkably successful at forcing changes at companies in which they invest. On average, the target company's dividend per share doubles within one year of an activist hedge fund's acquisition of at least a 5 percent stake, according to a study of 155 activist fund campaigns conducted between 2003 and 2005 by April Klein and Emanuel Zur of New York University's Stern School of Business.
"When a hedge fund comes in," explains Klein, "it reduces cash, increases debt, and pays out the dividend." According to Brav and his colleagues, funds that set out to remove a CEO succeed almost 58 percent of the time. Their study found that funds that target specific goals spawn higher returns than activism stated in general terms. Hostile actions generate higher returns than friendlier measures. The biggest bang comes from dramatic strategic events like a spin-off or a company sale. But the market response to proposed capital-structure changes (debt restructuring, recapitalization, dividends, share repurchases) is "statistically insignificant," according to the study.
Fighting back against activist investors is no easy task, especially since it is often hard to detect their presence. A fund manager might ramp up from a passive to an assertive stance so quickly that executives could find themselves in the middle of a proxy firestorm before they even know it.
Part of the difficulty in predicting activist moves stems from the latitude that 13-D forms provide. The forms must be filed and mailed to the SEC within 10 days after a hedge fund buys more than 5 percent of a company's voting equity with the purpose of acquiring or influencing its control. But the 13-D permits the fund to state its purposes in the broadest possible terms — such as merely wanting to discuss the company's direction with the board or monitor changes on a regular basis.
"We certainly see a large number of interventions that are very vague initially," observes Brav.
Much tougher to detect are hedge-fund managers who pursue activism without seeming to do so. They can, for instance, quietly amass large holdings in a company in preparation for an activist move without actually filing as an activist, though a fund that manages more than $100 million in securities must report its holdings to the SEC on Form 13-F within 45 days after the last day of each quarter. Unlike 13-D, however, the form doesn't ask for information about the fund's intentions. A hedge fund can also hide its identity as a shareholder by requesting confidential treatment from the SEC to protect its investment strategy, says Adam Gale, a lawyer with Orrick, Herrington, — Sutcliffe in New York, though such treatment is hard to obtain.
Another legal tactic that can anger management is hedge funds' borrowing of shares to change the outcome of shareholder votes. Called "empty voting" or "vote morphing," such moves enable funds to hold voting rights in companies in which they have little or no economic interest. A cottage industry of companies that facilitate share lending has cropped up to service such aims. Pension funds, which can often benefit from the actions of activist hedge funds, can make millions by lending out their shares.
Short of stiffened shareholder-disclosure rules or voting mandates, companies may not be able to do much to curb the negative effects of this kind of activism. But managements and boards can attempt to protect themselves from destructive confrontations with funds that have a genuine economic stake in the company.
In the most extreme cases, that may mean circling the wagons. A strong activist sally "warrants the same kind of preparation as for a hostile takeover bid," wrote Martin Lipton, the father of the poison pill, in a recent advisory memo. "In fact, some of the attacks are designed to facilitate a takeover or to force a sale of the target." Among the tactics he suggests: create a team to deal with hedge-fund activism and run periodic "fire drills" to maintain a state of readiness.
Good performance, of course, is the best way to keep activists at bay. But bad accounting or poor reporting can fuel aggression like little else, says Mark Sunshine, president and chief operating officer of First Capital, a West Palm Beach, Florida-based firm that provides back-office accounting services to hedge funds and lends money to companies in the funds' portfolios. If activists "get squishy answers" to their accounting questions from their target companies, he says, "they go nuts."
Another way to avoid straining activist nerves is to refrain from firing off confrontational comments. "Public statements can be very dangerous," says Henry Gosebruch, managing director for mergers and acquisitions at JPMorgan. "So our advice would be: Do not engage in a PR battle with activists." Exorbitant executive compensation is another attraction for activist hedge funds. (Chapman, for one, takes issue with companies that provide "free stock-option grants that are nothing short of lottery tickets for the recipients.") Companies that fear an attack should revisit their pay plans.
The Cost of Ineptitude
Just as there are degrees of activism, there's a range of tactics in defending against it. As part of its Hostile Defense Advisory practice, for instance, JPMorgan works on three levels with clients facing hedge-fund challenges.
The investment bank works with management, the board, and the legal team just after a fund files a 13-D, in what Gosebruch calls a "more reactive setting." But Morgan also counsels clients before any funds publicly express activist intentions — observing, for instance, that a company with an underperforming subsidiary or a low level of debt might do well to consider a buyback to avert a potentially aggressive move by activists. The firm also advises clients to perform a defense review every 6 to 12 months. The review, says Gosebruch, should look at recent trends in the market, hedge funds that might become agitators or make an offer for the company, and what "the attack theme" might be for potential activists.
Companies under attack might also want to point out that hedge-fund activism doesn't always turn out so well for shareholders. For example, Chapman's involvement in Vitesse Semiconductor turned out to be a disaster. Shares in the company were trading at about $1.15 in early May, well off the $1.50 Chapman reportedly paid to acquire his 7.3 percent stake. And Vitesse has yet to be sold, despite Chapman's calls for a sale. He recently reported that he had reduced his stake in the company to 2.5 percent.
Given the activists' ability to profit from corporate ineptitude, though, the Vitesse case is more the exception than the rule. "I would hope that we get to the point where Corporate America is sufficiently well run that activist hedge funds no longer have a business," says Crestmont Research president Ed Easterling. "But as long as we have human nature and misplaced management teams, we'll have a place for activist hedge funds."
David M. Katz is deputy editor at CFO.com. Additional reporting by Helen Shaw.
Meet the New Raiders
Activist hedge-fund managers and some of their recent targets.
Pershing Square Capital Management
Ceridian, Borders Group, McDonald's
Breeden Capital Management
Vitesse Semiconductor, Agile Software, Embarcadero Technologies
Motorola, Time Warner, Blockbuster
Trian Fund Management
H.J. Heinz, Wendy's, Tiffany
Titan International, Mirant
Home Depot, Sprint Nextel