Hedge Funds Activism and Firm Performance
Hedge funds Activists want to obtain great returns through their agitation. In order to get the company to make meaningful changes that will uplift their stock price. Instead of aiming to take over a company in which they assume an equity position.
Hedge Fund Study
One study by Brav, et al. noticed that the performance of the companies improved after being targeted by hedge funds. Especially an anomalous average return of 7%. They found this out by analyzing the market’s reactions to activists. Hedge funds’ announcement assuming positions in companies over the period 2001 up to 2006. They also found out greater CEO turnover and increased use of pay for performance. They generalized how useful to powerful CEOs who may fail to bring about stock price growth hedge funds are.
In another study by Bebchuk, et al., operating performance was found to improve after activist interventions. Based on a sample of 2040 activist interventions over the period 1994-2007. Focusing on performance measures like return on asset and Tobin’s Q. They also concluded that these performance improvements were not offset by falloffs somewhat later. Which could have implied that they were just temporary and perhaps a function of accounting manipulation. This study found the same results as Solarz’ with a smaller sample. He found that if the hedge funds indicated in their filings that they made specific actions like board seats or a proxy fight, they are activists.
This kind of hedge fund also shows the short-term. And excess returns that are greater at about 10% than passive investments, as shown in the data provided by the researcher. More specifically, the study measured the performance of companies with active and passive investors. He found out that after a two-year period there were improvements in the company’s return on assets for the active group and declines in the passive group. He also found that shareholders gained through increases in leverage and a greater dividend payout ratio.
Activist Hedge Funds
As previously mentioned, activist edge funds oppose takeover bids since they included an insufficient takeover premium. Private equity buyers’ goal is to get the target as cheap as possible and to sell it later at a higher price. Target shareholders do not usually bargain for a higher premium and rely on boards to act in their best interests. But when the target shareholders’ ranks include an activist hedge fund with great stock or have at least one seat on the board. Everything is different and does not go well for the private equity buyer.
For instance, Huang found out that a one standard deviation increase in the fraction of equity of the target. That is held by hedge funds prior to a buyout announcement that was associated with a 3.6% increase in the buyout premium through an analysis of 237 buyout proposals for US public targets. He also concluded that mutual funds, pension funds, and other shared held by other types of institutional investors did not affect buyout premiums. Moreover, the premium uplifting effect was greater for management buyouts than outside initiated buyouts. And also stronger for club deals where more than one buyout firm combines to make a joint bid than solo buyout offers.
It should be remembered that managers of hedge funds will take much higher relative roles than other organizations. Because of this, diversified portfolios are not required by law. And may allow investors to commit for a period of 2 years or longer to “lock-up” their investments. In comparison, the law requires mutual funds to hold a diversified portfolio. And selling securities within a day to satisfy redemptions from investors.
Institutions vs Retail Investors
Institutions have been owning great percentages of equities than retail investors do for many years now. The former vote their shares while the latter do not bother to vote at all. Considering there are also rules adopted that limit a broker’s ability to vote uninstructed retail shares in street names. Thus, institutions become the concentration of voting power.
Aside from opposing takeover bids, activist hedge funds also do not hold very large equity positions in the target. Nevertheless, large-cap companies’ holdings represent a large financial investment for them, despite relying on institutional investors’ financial support. These institutional investors haven’t really been activists in their investment approach. And they also own the bulk of the shares in a typical public company.
Statistical Analysis
According to Broadridge Financial Solutions, Inc in Retail ownership of public company shares There is a declining percentage of total shares outstanding owned by retail investors. A few very large institutional investors have a disproportionate interest in large-cap companies. Meanwhile, according to data provided by CamberView Partners in Sullivan and Cromwell LLP Memo. Shareholders and their voting power have been more controlled by a few major financial institutions. The statistics show the percentage of shares, a rising percentage, in the S&P 500 companies held by just four firms: Blackrock, Fidelity, State Street, and Vanguard. It went from above 15% but below 20% in 2012, and above 20% in 2016.
This means that these institutions’ support for activists is really vital to the success of the activists’ campaigns. When it became clear to institutional investors that when an activist targets a company, share values can rise and performance often improves. Institutional investors gained a financial incentive to support their activist initiatives. Even if institutions have raised concerns about the short-term orientation of various activists, they are also the ones who are under short-term performance pressures and have the tendency to positively respond to proposals. That will allow them to make short-term returns and bonuses for fund managers.
Index Fund
The institutional support of activists can be even greater for index funds managers since these investors are not discretionary. They do not vote with their feet and they may be locked in an equity position in a company that generates low returns. These kinds of managers are more likely to support activists who plan to improve performance and generate higher returns. Many mutual fund investors have changed to lower-cost index funds from active funds with the increased awareness that these managers frequently fail to make enough returns to compensate their fees. Therefore increasing the importance of index fund and their voting power.
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Hedge Funds as Acquirers
Takeovers, which used to be the exclusive fund territory of private equity funds, have been eyed by businesses. Ever since hedge funds began feeling pressure from competitors to generate high returns. Some examples include Edward Lampert’s takeover of Kmart in January 2000. Nelson Peltz’s acquisition of Wendy’s in 2008 and merged it with Arby. In 2011, they sold Arby’s to a private equity firm, the Roark Capital Group.
Dramatic Evolution
In 2014, the takeover business made a dramatic evolution. William Ackman’s Pershing Square Fund teamed up with Valeant Pharmaceuticals to bid for Allergan at $45.6 billion. Ackman wasn’t only good in financing but also in skills. From being a successful activist throughout the years, purchasing 9.7% as a toehold in Allergan. But this value could fall if the bid does not succeed, which is what happened to Ackman’s innovative bid. Actavis outbid the team with a $66 billion cash and stock offer. Although Ackman did not win the bidding contest, he did win financially. As Allergan’s largest shareholder since the bid was expensive and it made good returns on Ackman’s holding.
Hedge funds take an interest in investing in companies for great returns. One of their focuses is the debt of distressed companies. In fact, they have been engaging in debt financing of M&As. Commercial banks become sources of M&A debt financing. The syndicate to hedge funds that assume what usually is second lien debt. This new origin has changed the total capital available for M7&A financing.
M&A Volume
As for activist hedge funds and M&A, the former usually have short-term goals. As they seek to obtain short gains from their share positions in the investment. Usually, one or more hedge funds offer to acquire a position in an undervalued company to be restructured. As a result, it contributes to an increase in M&A volume. Acquirers’ transaction also helps increase overall M&A volume. When activists pressure a company to sell certain assets. But if the goal of the activist is to pursue a strategic merger that pays gains long term. The hedge fund opposes the deal and it leads to a lower overall level of M&A. Activists indeed have impacts on overall M&A volume.
When the M&A volume is low, activist funds have to use different strategies. That may even lead one to become a financial engineer or one who uses balance sheets to buy back shares. One can be an operational activist. By getting more involved in the company’s operational performance and may want to have the company run differently.
Based on a study by Boyson, et al., activist hedge fund interventions significantly increased. The likelihood of the target being taken over. When another party implements a takeover, the target receives higher bids and premiums. Even when the bid failed, the operating and equity market performance of the targets improved in the years that followed. However, these positive patterns were not present when the activist was the actual bidder as opposed to a third party.
Accumulation of n Equity
Moreover, the accumulation of an equity position by an activist hedge fund can have great effects on the stock price, and that is evident in the well-known Carl Icahn’s situation. There are also various studies that prove the announcement of hedge fund activism. That has a correlation with abnormal returns over a short window around that announcement date. It is also worth noting that a study by Clifford in 1998-2005 found that companies that were targeted by activists realized higher excess stock returns. Specifically a 3.39% cumulative excess return around the announcement date. They also showed great operations proven by the return on assets.
Klein and Zur confirmed these findings and added a comparison regarding the market effects of activist hedge funds. Sharing accumulations with those of what they called entrepreneurial activists. These consist of individuals or asset managers who act for private equity firms and venture capitalists. They are activists if they aim to bring about change in the company. That would raise the stock prices and provide them with a profit from their investment as a result of their activism.
Hedge Funds
The two types are associated with positive abnormal stock returns. But hedge funds showed 10.2% returns while the entrepreneurial group was associated with a 5.1% return. Hedge funds had a 60% success rate. While the entrepreneurial group was successful 65% of the time, meaning both were often successful in their bidding. Both seemed to target different companies too. Where hedge funds target those in better financial conditions, than did the entrepreneurial activists. Hedge funds seemed to seek out companies that had higher cash resources. Then they tried to pressure them into buying back shares and make other changes. Like lowering senior executive compensation and increasing dividends. The entrepreneurial activists tended to focus more on the company’s strategy. Both also achieved their goals through a proxy process.
Shareholder Wealth Effect
Meanwhile, Greenwood and Shor analyzed the source of positive shareholder wealth effects. Through huge samples of companies that filed Schedule 13Ds. They then cross-referenced this sample to the 13F filings, which are made by institutions. Leading to a bigger sample which included many passive investors that had to be deleted. The DFAN14A filings, which are filings made with the SEC by those non-management investors considering pursuing a proxy fight were examined. The must be filed with the SEC by any registrant when there is a shareholder vote. The researchers found that period returns of greater than 5% for those companies that were eventually acquired. This is almost double of other companies’ returns. Therefore, activists have the ability to generate above-average returns because of the target being sold to their own advantage.
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Leading Activist Hedge Funds and Institutional Investors
Some of the major activist hedge funds who have been in the “activist business” for a long time. Now include Carl Icahn, David Einhorn, and Bill Ackman, as well as Nelson Peltz who are often seen in the media. Other entrants in the business include David Einhorn, Ralph Whitworth, Barry Rosenstein, Jeffrey Ubben, and Jeffrey Smith
CalPERS and CalSTRS
Activist investors have played a huge role in establishing funds. And so are institutional investors who are starting to engage more in activism, such as CalPERS, and CalTRS who have become so active in the market recently. They are well aware that activism funds generate great returns. That they are encouraged to abandon the traditional buy and hold method and other investment strategies. Funds have started to establish internal departments to address activism issues. Institutional investors sometimes even interact with the activist to support each other and benefit from the trend.
Terms of Approach
Although activists go through similar transactions, they may still vary in terms of approach. Some are aggressive and public that they may launch an attack at a company through media saturation to pressure the target company’s management and board. On the other hand, there are those who announce ownership of shares discreetly, as well as demand from the company in a toned-down manner.
Aggressive activists also have a tactic of acquiring shares in the target and then pressure them to put one or two of its representatives on the board. This would make them be able to directly monitor the activity of management. As well as the deliberations made, allowing the activists to have a say in each meeting. One example of such an event happened in 2016. When William Ackman and his activist firm Perishing Square Capital Management which owned 10% of Chipotle. Then asked to get two seats on the board of directors. Ackman and his firm agreed not to comment publicly about this for two years. They are also restricted from raising their stake above 12.9% over that same time period.
Short Term Value
These investors and the target’s management and board have common interests but the former is really short-term value investors. The activist wants to bring this about as quickly as possible and with a different means. For instance, activists may want the company to be put up for sale immediately. While management may even agree that an eventual sale is a good idea but they may not think this is the right time.
Smaller companies used to be the targets of smaller companies, but the landscape changed in the years 2012-2014. Making large companies like Microsoft and Apple targets. The large activist funds can acquire a really large percentage of a smaller target’s shares and overpower the board and management. But all companies, big or small, are vulnerable to attacks by aggressive activists. Take Carl Icahn for example. He tried to invest billions in a large company’s stock (AOL TimeWarner). However, he had trouble as he could only hold less than 5% of the shares. Still, he got positive returns on his investment in the company.
Downsides and Benefits
When an activist obtains 5% or more of a company’s share, they usually prefer a brief 13G filing. However, this is difficult to take with the SEC considering the nature of the business. They take control of the companies and take actions that result in the sale of a firm. With that, they will more likely be required significant disclosure and updating under the requirements of 13D.
The fact that any company is vulnerable to activists’ attacks has its downsides and benefits. It can be good if it encourages managers to run the company for the sake of shareholders for a good return on their equity. Moreover, it pressures them not to accumulate assets. Just like large cash holdings without showing how these are better off staying in the hands of the company to the shareholders. However, the drawback is that companies may be hindered to pursue a long-term plan. That is feasible because of the pressures of activists which are usually short-term.
With larger funds and AUMs, larger companies are needed to produce significant returns. That is why activists started to pursue larger target companies. Even if they are challenging, it can be worth it as the larger AUMs demand that bigger prey be pursued.
Near-Term Exit Strategy
It is worth noting that activists are short-term investors. After acquiring a position in a company, they usually have a near-term exit strategy. Companies are pressured to immediately take action to make the stock price rise. It enables them to exit the investment at a profit. The bigger downside here is that they might be forced to sacrifice their long-term profitability and growth. Meanwhile, a public company is pressured to meet the near-term goals of the activist. The counter-argument of activists is that it was the company that has sacrificed their long-term profitability. Way back which only gave investors a chance to correct the problem as if they’re heroes and not bullies.
The Full Control of the Board
Over time, activists even want multiple representatives on the board of their target company. Sometimes, it even called for full control of the board. The type of people nominated to boards by activists can vary. They often are people on the payroll of the fund, including possibly the head of the fund. They also could be industry experts or people who have been employed in the industry for some time. Other times, the investor already has in mind. The people who can assume active management positions at the target company if their activism is successful.
Although the process seems aggressive, there is a give-and-take process occurring. The activist may propose three candidates that include the portfolio manager of the fund and two outside industry people. The company may come back and say it accepts the two outside people but does not accept the internal fund representative. This then can lead to negotiations and will be a function of the relative bargaining positions of both parties.
This board seat issue is the main focus in terms of the activists’ demands. After this comes the return of monies on the balance sheet to shareholders including the activists. Irrelevant in the activist battles are the staggered boards or poison pills where the activist is looking to accomplish its goals. That means by replacing just a few members of the board. If this is possible, then the majority control of the board may not avoid the activist from attaining its goals. Given that it’s complicated for the staggered table. Outside pressures also forced many companies to abandon their staggered boards.
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Hedge Funds as Activist Investor
Over the past few weeks, we have discussed a multitude of topics regarding mergers and acquisitions. From tender offers, long-term mergers, structuring deals, anti-takeover measures, we have covered a lot. This article about Hedge Funds as Activist Investors opens up a whole new spectrum of topics we can discuss. This is an introduction to Hedge Funds as Activist Investors.
Hedge Funds as Activist Investors
As a substitute for open-end investment funds or mutual funds, hedge funds were produced. This limited partnership uses high-risk methods so as not to make public solicitations for capital to investors and so as not to be required to report as their mutual counterparts do. Since the reporting requirements are low, investors have less access to return data.
Hedge funds grew during 2013-2007, those were the years when the economy was strong. The truth is, it nearly doubled during those years. During those times, the industry has shrunk and many weak players had no choice but to leave the business as hedge fund assets grew.
The growth resumed in 2009 since there were large amounts of institutional capital to invest. Two years later, both the number of funds and assets outdid the progress in 2007. This progress resumed but declined later on.
The Two Types of Hedge Funds
With regard to mergers and acquisitions, there are two types of hedge funds. First, we have the risk arbitrage and second, the activist hedge funds. Both of which shall be discussed in this article. Before we continue further, it is worth noting that activist hedge funds grew in the post-recession period and even surpassed other types of investments. Hedge funds have actively entered the activist arena from 2009 to 2015 and rose to $123 billion from $29 billion during 2005.
Along with this growth comes the changes in a number of campaigns. The activist assets’ dramatic rise in terms of value is inherently linked to a marked increase in the number of activist campaigns. Two situations can be observed: the many campaigns conducted by new activists as opposed to a limited group of large activists, and the fact that these campaigns had an expanded focus, including more smaller-cap companies.
All these trends grew dramatically partly because of the great returns. In relation to this are the various deterministic macroeconomic factors that created a favorable environment. For such returns to be realized which will be discussed later on.
What is a company A target for Customer Activists?
Going back, activist hedge funds are those that make big enough investment in a company to participate in the management and firm decision-making. Hence, it enables the investors to obtain positions on the company’s boards to influence changes in the company.
Factors for Activist Investors
There are a few factors that make a company become a target for activist investors. For example, if it is not well operated, a corporation becomes a target for activist investors, has high costs, and as a private company could be run more profitable. However, it can also be a target if the activist investor has other issues that can be resolved to make them more competitive and profitable.
Another factor that makes a company a target is its past performance. It may be left with high levels of liquid assets that the investors want them to use to return cash to shareholders in the form of a stock buyback.
Carl Icahn
Such was the case with Carl Icahn way back 2014. He pressured the billion-dollar company Apple to use its cash to fund a more rapid stock buyback program. Carl Icahn got the multinational company to buyback $14 billion within two weeks. Still, he did not succeed because he took on a huge target that was pursuing a buyback program already. Apple’s shareholders failed to rally around the activist and ISS failed to endorse Icahn’s initiative.
Sign of an Activist Hedge Fund
Activist investors can be looked at as long-term oriented since they take a private equity approach to public markets. They enjoy investing in companies where management has insufficient incentives to maximize shareholder value. It’s because, without proper incentives, management can make excessive compensation and benefits and cancel free cash flow. Because of their less diverse portfolio, they vary from conventional funds. Another sign of an activist hedge fund could be the filing of SEC form 13D that must be filed when an investor purchases 5 percent or more of the stock of a company.
Evaluating Macroeconomic Factors
These transactions are related to deterministic macroeconomic factors. For instance, the 18-month long Great Recession from 2008 to June 2009. It was a very relevant downturn since the Great Depression. However, unlike other deep recessions, we had in 1973–1974 and 1982–1983. Originally, It was a very anemic recovery from the Great Recession. Particularly with respect to the labor market, which is inextricably linked to consumer spending.
US economy reached its peak after the growth in 2009, helping stimulate a rebound in equity markets. During this recovery, the stock market was quite strong and indices such as the S&P500 reached record levels. While it can be advantageous for some companies, the laggards and others were not able to keep up, becoming potential targets of opportunistic activist funds.
Additionally, the low-interest-rate environment is a macroeconomic factor that helped many activist funds. It prevailed in the United States and Europe, making the costs of debt financing lower for potential acquirers. Along with this is the fact that many companies had rising cash balances which could also be used to finance acquisitions. These factors made it easier for activists to claim that there were many potential bidders who could finance the acquisition of the target company.
Stay Tune
We hope that this article has helped you understand Hedge Funds as Activist Investors better. In the next few articles, we will discuss this topic in further detail. Tune in to our website to find out more about Leading Activist Hedge Funds and Institutional Investors, Hedge Funds as Acquirers, and Hedge Fund Activism and Firm Performance. In the meantime, check out our previous articles for more important and informative lessons about mergers and acquisitions.
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