Chapter 1 – Growth of Activism and Why Corporate Raiders Aren’t Around Anymore
The past few years have seen a major increase in the number of hedge funds and 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 outperform- ing 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.
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 corpora- tions in the United States and around the world. In 2006, they prodded and engaged managers at dozens of large companies, including 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 are contributing to the rise of the transactional-focused activist industry. For example, 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 corpora- tions to improve their corporate governance. All that and a transform- ing 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
During the past five years alone, hedge fund assets under management doubled to well over $1 trillion, according to HFR. Recent estimates put hedge fund assets at $1.6 trillion. To put things in perspective, in 1996, hedge funds managed only $256 million. More capital for hedge funds means more assets in search of new profitable strategies such as activist hedge fund investing. 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. A decade ago the majority of this group of pension plan administrators would have steered clear of hedge funds. Now they are piling in.
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 are experiencing a major expansion of merger-and-acquisition (M&A) activity. More deals and deal makers generally translate into 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 has 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 are 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. when Verizon 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, an- nounced plans to vote against any MCI plan to be acquired byVerizon that was $1 billion less than any 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 signif- icant premium to what Verizon had originally bid.3 A few activist hedge fund managers set off a similar but much larger multibillion dollar bid- ding battle among banking institutions for Dutch bank ABN Amro.
Factor 3: Private Equity Funds
A tangential trend is the growth of private equity (PE) companies with billions in investable 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 rising presence increases the potential buyer pool and likelihood that an activist’s target will be acquired, particularly if activists start agitating for a merger. George Mazin, a partner at Dechert LLP, notes that the recent increases in the number of PE funds and the assets they have under management have definitely fueled activist invest- ing.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 com- panies that are forced into a sale by activists.“A proliferation of diverse equity funds with different mandates has broadened the array of compa- nies that meet buyout firm requirements,” Morgan Joseph reports.
Buyout shops have been around for decades, but in recent years their numbers have increased dramatically. Not only are there more buyout shops competing with strategic buyers ready to jump in and purchase companies, but PE firms also have more assets under management than ever before. In the 1970s few people knew about buyout firms, but today they have emerged to become a mainstream form of corporate finance.
Buyout shops with additional assets are more likely to make bigger bids for larger companies, a trend that complements the phenomenon of activists agitating at larger companies with their insurgent-style efforts, says Morgan Joseph’s managing director, Randy Lampert.
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 shopVeritas 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 are emulating 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 their offers and acquisitions are contributing to the expanding M&A environment (see Figure 1.3).
In addition to lending for leveraged buyouts, corporations have access to much more debt financing for other purposes than ever before, and the cost of all that debt is lower than it has ever been. This new source of cheaper debt lends itself well to the activist manager who wants to press 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, have a wide variety of financing options available to them as they either contemplate taking the company private or engaging in a leveraged recapitalization.“There’s a ready exit waiting for companies to go private,” says Lampert.
Other reasons why a company would hike its debt load include buying a new division or reinvesting in company operations. Activists often press for these kinds of changes as well. A company that has no leverage and a lot of cash could easily become a target for activists, particularly when debt financing is so readily available.
Lampert notes that 10 years ago when a company wanted to raise debt financing, it had very few places to go to find it. The main institutions where corporations could go to raise debt financing were commercial banks and financing companies like CIT Group Inc. or Heller Financial Inc.
Today, companies that want to raise debt can go to new sources, and in many cases these debt lenders are flush with much more capital than at any other point in their existence. One such source that recently has emerged is other hedge funds focused on the debt market, known as credit funds. Yes, activist hedge funds are turning to their own kind and, in some cases other divisions of themselves, to provide debt funding for companies. This situation can present all sorts of interesting conflicts of interest.
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.
Cerberus’s managing director, Daniel Wolf, agrees that activist hedge funds are having an easier time pressing companies to hike debt levels, simply because of the variety and availability of debt. “All the new incremental forms of capital available have made it easier for anyone, including activists, to press a company into a buyout or affect other types of changes such as a leveraged recapitalization,” Wolf says.
But he adds that activists must be careful about how much they push their targets to accept in debt.“It can be dangerous if you load up these companies with debt and they become overleveraged,” Wolf says.
Corporations seeking new debt funding can go to other types of money managers such as institutions that offer collateralized debt obligations, which are investment-grade securities backed by a pool of bonds and loans. There are numerous other forms of debt lending available to small, medium, and large public corporations, including bridge loans and other refinancing options.
Distressed and bankrupt companies also have many more options available to them.“As the bank loan industry has transformed into a market that is more actively traded, we’ve seen a tremendous increase in the amount and variety of companies offering bank loans,” Lampert says. “All this has given activist managers a broad spectrum of alternatives when approaching a corporation’s management either privately or publicly with strategic options to improve share value.”