Will the credit crunch impact hedge funds' ability to launch activist campaigns?
When credit markets dried up briefly in the summer of 2006 it caused significant ripples throughout the world’s financial system, raising concerns that even the huge hedge fund sector might run into financial difficulty. The event passed with a handful of spectacular blowouts, but few, if any, serious structural problems. A few firms had to quietly withdraw, but that is not an unusual situation given that there are now over 10,000 hedge funds vying for advantage and continued life in a very competitive market.
That shudder in the summer raises questions now, however, as credit markets undergo much more severe strains that stretch back six months or more and show no signs of easing. Most prominent among the questions is how much hedge funds will suffer this year and, moreover, how that may that impact fresh activism as the 2008 proxy season unfolds.
First it must be pointed out that the number of activist hedge funds is a relatively small one, given all of the (so-called) ‘hedgies’ out there. Of more than 70 categories listed by Hedge Fund Research Incorporated of Chicago, only one is strictly identified as ‘activist’. But those who do engage in rattling cages manage to make headlines and they have the potential to make out-sized impacts when they choose to be irritants in a boardroom. As a result, their appearance on shareholder lists gets immediate c-suite attention.
Weathering the storm
In any case, they – along with the more moderate players in the hedge fund world – appear not at all daunted by the current credit market crunch. This was deemed a shock by folks at FactSet Sharkwatch, a Connecticut-based research firm that keeps tabs on such things. Announcing the fourth quarter 2007 figures showing that 135 new activist campaigns were launched in the period, product manager John Laide said: ‘We expected them to drop off significantly. A lot of times, activists will force a company into selling assets or the whole company, but if the buyers can’t get financing, it’s a
moot point.’
Contrary to this expectation, however, the 135 campaigns represent what Laide believes is the busiest quarter ever – capping a year that in total saw 501 new activist campaigns launched. It appears then that the activists are simply taking a longer term view, scooping up opportunities and seeking alpha while companies are making it possible for them to gain a foothold, whether through missteps or simply poor market conditions.
Laide said 36 of the actions registered in December included requests that the target companies put themselves up for sale, a clear indication that the hedge funds feel there is plenty of capital ready to move into the buyer’s box. And there is evidence they are correct. While there may be a shortage of standard loan availability in the credit markets, other cash is on the sidelines and ultimately it is in no one’s interest to keep cash idle for long.
Hedge funds themselves are holding onto cash. One estimate, bruited at the Inovest 21 investor seminar ‘Strategy and sector outlook for 2008’, states that as much as 25 percent of hedge fund assets are in cash at present. And Merrill Lynch said in its February money managers survey that 41 percent of institutional investors ‘are overweight cash, the highest since September 2001’s terrorist attacks. Investors have a shorter-term focus than at any time since March 2003.’
Perhaps more of an issue than whether there is enough capital to meet hedge fund expectations is the matter of their own borrowings. Most hedge funds get their money from wealthy private investors, endowments and, increasingly, conservative money managers. But the day-to-day operations need funding and, more importantly to this question, some hedge fund operators are in the market with rather heavy leveraging.
Depending on how they invest, that can be a big risk as banks and prime brokers, their main sources of leverage, are tightening lending criteria in the current market. A pull on the purse strings that coincides with a bad bet with client money can result in nasty outcomes, even destruction, for the unwary.
Indeed, even without a pile of debt, things can, and do, go wrong. The investment community took a major shock earlier this year when the well-regarded Sailfish fund, run by Mark Fishman and Sal Naro, went down the chute. A top performer for years and one that attracted a good deal of conservative money, Sailfish upended because its investment plan failed. The fact that so highly regarded an investment team could be taken unawares sent another ripple through the investment community.
But experts point out that this is all part of the game. Hedge funds by their nature are risky. They often do not disclose what they are doing because in doing so they can lose market advantage. They take risks and that’s how advantage is gained when it comes to returns.
Decreasing returns push activism pressures
That said, the returns aren’t what they used to be. In fact, a close look at reported numbers – as offered by Wharton professor of finance Richard Marston – shows that investors need to be reasonable in their expectations. Interviewed for the business school’s online publication last year, Marston gave as an example the Yale University endowment, run by alternative investment pioneer David Swensen. Despite its $20 billion asset power, the endowment closed 2006 with only a 6 percent expected return on hedge fund investments, after adjusting for inflation. ‘That ought to be an eye-opener for investors,’ Marston said.
Corporations have seen steadily rising assaults by activist groups, ranging from the relatively quiet approaches that a TIAA-CREF or CalPERS often make, to outright grabs for directors’ seats in order to turn things around that are more common among the hedge fund groups. In an example of the latter, fund manager Ralph Whitworth found a seat this year on the board of Sprint, the telecom company he has been hounding for change for some time.
Of course getting on a board is not the same as forcing a company to act in a way that simply lines an activist’s pocket. Once on the board, the hedge fund has a real stake in what happens and is, in theory, more likely to move in ways that are advantageous for other shareholders. This beneficial effect is often overlooked in the waves of publicity that accompany hostile approaches demanding action. Many interventions by hedge funds are handled quietly and end up being beneficial to all shareholders as external hedge managers bring insight to companies that may be stalled or otherwise working below optimum levels.
In another mid-February action, famed investor Carl Icahn moved in on Alliance Data Systems (ADS), saying it – like many of his targets – was undervalued. Icahn represents a different kind of player who moves on a number of bases; in this case into the middle of a deal between Blackstone Investments and ADS which at the time looked to be going a bit sideways. He has a record of raising stock values in many of the deals he has entered, although there have been some exceptions.
In addition to aggressive buyers who see a need for change, there are many other buyers who do not necessarily have the company’s long-term interests in mind. These use investment strategies which may be trade-related or purely event-driven, such as during mergers and acquisitions or when bankruptcy occurs.
Don’t give away the farm
According to HedgeFund.net and Institutional Investor News, hedge funds and hedge funds of funds now have a total of $2.8 billion invested, a pile that has never stopped growing since they came on the scene more than 40 years ago. Their investment styles cover everything from sector and industry plays to complex trade-related strategies. With all those investment interests, target companies are being forced to take a close look at hedge funds, but they are being cautioned not to go overboard, especially when it comes to responding to their demands for meetings.
One London-based company advisor is telling clients they must examine carefully the hedge funds that are showing up in their shareholder rolls. Unless there is a serious problem at the company that has attracted an aggressive buyer, such as Icahn, Whitworth or former SEC chairman Richard Breeden, they do not need to feel all hedge fund shareowners require top management attention.
Getting a foot in the door
This has created a struggle and a change in the way companies deal with the stock market. Brokerages, who for most of the past few decades devoted their main effort for buyside customers to providing research to managers like the hedge fund operators, are turning to providing management access. Behind this shift are hedge fund managers who are quick to splash out very large fees for such service. This drives brokers to persuade management to visit the funds. As a result, companies are finding themselves asked to schedule more and more in-person meetings.
The new advice then is to screen the funds, either doing so in-house, or requiring brokers to show the value of individual meetings. Looking for stability in much the same way a prudent endowment manager might do before investing in a hedge fund is a good guideline for the examination. Long-term investment horizons, well-structured management teams with a degree of transparency and solid funding translate to the kind of hedge fund that top management should pay attention to. Screening for these qualities along with knowing the overall investment goals of the funds will have a big impact on management’s time.
There is no doubt the hedge funds will carry on with activist campaigns. And while the current tight credit market problems will hurt some percentage of funds and thus reduce their leverage in shareholder contests, this appears of little consequence to activism overall. FactSet notes that in the first weeks of 2008, 72 actions were set in motion with 38 of them coming from hedge funds, clearly not being hobbled by the credit markets situation. In the same period a year ago, there were 21 hedge fund moves among 54 actions set in motion.
Thus, senior management needs to be sure it has the capacity now to deal with the forthcoming increased shareholder pressure. In doing so, it would be wise to take a tip from the buyside. The conservative approach that fiduciaries take with pension money looks to be the right tactic to use when the hedge fund label appears next to a big shareholding. Just as the investors on the other side of the funds do, look carefully before you engage.
