Activist Hedge Funds Materials from chapter 13 (ST), covering: 1) How does the strategy work? 2) Equity swap 3) Fund performance
Shareholder Activism Certain hedge funds focus on shareholder activism as a core investment strategy An activist shareholder acquires a minority equity position in a public corporation and then applies pressure on management in order to increase shareholder value through changes in corporate policy significant minority Some of the common changes advocated by activist shareholders include reducing corporate costs, repurchasing common shares, increasing corporate leverage, increasing dividends, reducing CEO compensation, reducing cash balances, and divesting certain businesses Activist shareholders will sometimes campaign against proposed acquisitions or allocation of cash for purposes that are not perceived to create shareholder value Activists pursue a sale of a target company or a breakup of the company through a piecemeal sale or spin-off of significant operations 6 months to 2 years investment horizon
Shareholder Activism Shareholder Activism Some corporations are vulnerable to hostile initiatives by activist shareholders Hedge funds can be vocal investors who demand change in the corporate governance landscape in a number of ways: o Publicly criticizing/challenging Boards and managements o Nominating Board candidates and pursuing their agenda through proxy contests o Supporting other activists Hedge funds activist strategy has been successful by taking advantage of: o o o o o Like-minded hedge funds herd mentality Ability to overcome reputation for short-term focus Ability to skillfully use a deep arsenal of securities and financial instruments Familiarity with M&A and legal regulations and rights Readiness to go to battle and devote significant resources to full-blown public relations battles Source: Morgan Stanley
What is a proxy contest? It is an indirect method of acquisition. A strategy that may accompany a hostile takeover. A proxy contest occurs when the acquiring company attempts to convince shareholders to use their proxy votes to install new management that is open to the takeover. The technique allows the acquired to avoid paying a premium for the target. Proxy voting is a form of voting whereby some members of a decision-making body may delegate their voting power to other members of the same body to vote in their absence, and/or to select additional representatives.
Famous activists Also known as corporate raiders: Kirk Kerkorian: took positions in Ford and GM Carl Icahn: Time Warner Boone Pickens: BP Capital Management William Ackman: JC Penny; MBIA
Shareholder Activism (specifics) Activist shareholders usually acquire between 1% and 10% of a target company s shares, or create an equity exposure by entering into equity derivative transactions purchasing call options on the company s stock simultaneously purchasing call options and selling put options on the company s stock Longing forward transactions to purchase the company s stock entering into equity swaps in relation to the company s stock A relatively small share holding or equity derivative position established by an activist shareholder may enable the investor to launch a campaign to make significant changes in the company, without the added cost and time required by a complete acquisition To be effective, the activist shareholder generally must obtain the support of other large shareholders through large-scale publicity campaigns, shareholder resolutions or proxy battles for control over the board of directors
Shareholder-Centric vs Director- Centric Corporate Governance A key issue in corporate governance is whether the corporate board of directors will survive as the governing organization of the public corporation, or if shareholder activism will ultimately invalidate the role of the board In other words, will corporations become more shareholder-centric and less director-centric in their governance? Some critics of shareholder-centric governance indicate that this movement is causing a shift in the board s role from guiding strategy and advising management to ensuring compliance and performing due diligence This shift can create a wall between the board and the CEO, removing the trusted advisor role of board members, as CEOs become increasingly wary of sharing concerns with investigative and defensive boards
Shareholder-Centric vs Director- Centric Corporate Governance Based on concern about litigation, directors sometimes become so focused on their individual committee responsibility that they are less able to focus on the broad objectives of maximizing shareholder value and they become Balkanized into powerful committees of independent directors, unable to broadly coordinate the focus of the entire board Even when the board is able to focus on the business of the corporation in cooperation with the CEO, activist investors create pressure on boards to manage for short-term share price performance rather than long-term value creation. This may result in short-changing the company s relationships with its employees, customers, suppliers and communities, as well as reducing investment in R&D and capital projects that are critical to a company s longterm success
Shareholder-Centric vs Director- Centric Corporate Governance Another criticism of shareholder-centric governance is that shareholder activists could ultimately wrest substantial control from boards, causing companies to bring almost every important decision to a shareholder vote This would largely shut down the normal operating procedures of the company, slowing down decisions and creating competitive disadvantages, as previously confidential decisions that were made by the board are put in the public domain There is also concern that activist shareholders can create inappropriate pressure on boards through non-documented alignments between different activists to achieve their objectives
Financial crisis and activism strategy Stocks suffer steep share price decline during the crisis, funds experienced substantial losses
Activist Shareholder Returns Comparison of All Hedge Fund Returns vs. Activist Hedge Fund Returns, 2005 2008 Annualized total return, % 26.3% 17.8% 2.7% 9.3% 4.2% 5.0% All hedge funds (HFRX Global Hedge Fund Index) Activist hedge funds (HFRX Activist Index) -23.3% -30.8% 2005 2006 2007 2008 Source: Hedge Fund Research, Inc.
Activist Shareholder Tactics Potential Activist Tactical Approaches Activist quietly accumulates stake no contact with company Activist required to file for HSR clearance if intention is to accumulate a stake >$63MM or >50% Activist required to file Form 13D after accumulating stake of at least 5% Activist approaches Board and/or shareholders a) Calls Chairman/CEO to arrange meeting b) Sends letter outlining Plan to Board only c) Announces Plan directly in a press release / 13D filing d) Submits shareholder proposal regarding Plan e) Submits shareholder proposal nominating Board candidates Private Discussion Public Assault Primary Campaign Type: 2008 Proxy Fights Within 18 months of an initial activist 13D filing, more than 50% of targets are involved in an asset-sale and/or change in capital structure/corporate governance related outcome Board representation 63% Board control 31% Withhold vote for director(s) 2% Vote for a stockholder proposal 2% Vote/activism against a merger 2% Maximize shareholder value 1% Vote against a management proposal 1% Activists aggressively use the public domain to communicate and play out their intentions There is also a herd phenomenon in which funds will collaborate informally to increase influence This phenomenon means that a situation can destabilize quickly amid a churn in the investor base, despite small individual investments Source: Morgan Stanley
Activist Hedge Fund Strategies For an activist investor, timing is everything Their objective is to accumulate enough ownership in a targeted company to influence change, but they want to accumulate shares without drawing attention from the target and without attracting tag-along investors, whose purchases can drive up the stock price, making it too expensive to accumulate additional stock Some activist investors have utilized derivatives to help them create a large exposure to a company, without alerting either the target or other potential investors
Accumulating Shares Through An Equity Swap: CSX The SEC requires investors that own 5% or more of a company s equity to disclose their ownership through a 13D filing within 10 days of acquisition 13F filing (reports filed by institutional investment managers): An institutional investment manager that uses the U.S. mail (or other means or instrumentality of interstate commerce) in the course of its business, and exercises investment discretion over $100 million or more in Section 13(f) securities (explained below) must report its holdings on Form 13F with the Securities and Exchange Commission (SEC). To avoid tipping their hand, however, some activist investors have used cash-settled equity swaps (which do not require 13D disclosure) to create an equity exposure to the target
Equity Swap A financial derivative contract where a set of future cash flows are agreed to be exchanged between two counterparties at set dates in the future. The two cash flows are usually referred to as "legs" of the swap; one of these "legs" is usually pegged to a floating rate such as LIBOR. This leg is also commonly referred to as the "floating leg". The other leg of the swap is based on the performance of either a share of stock or a stock market index. This leg is commonly referred to as the "equity leg".
Equity Swap: Example Take a simple index swap where Party A swaps 5,000,000 at LIBOR + 0.03% (LIBOR + 3 basis points) against 5,000,000 (FTSE to the 5,000,000 notional). In this case Party A will pay (to Party B) a floating interest rate (LIBOR +0.03%) on the 5,000,000 notional and would receive from Party B any percentage increase in the FTSE equity index applied to the 5,000,000 notional. In this example, assuming a LIBOR rate of 5.97% p.a. and a swap tenor of precisely 180 days, the floating leg payer/equity receiver (Party A) would owe (5.97%+0.03%)* 5,000,000*180/360 = 150,000 to the equity payer/floating leg receiver (Party B). At the same date (after 180 days) if the FTSE had appreciated by 10% from its level at trade commencement, Party B would owe 10%* 5,000,000 = 500,000 to Party A. If, on the other hand, the FTSE at the six-month mark had fallen by 10% from its level at trade commencement, Party A would owe an additional 10%* 5,000,000 = 500,000 to Party B, since the flow is negative.
Accumulating Shares Through An Equity Swap: CSX In some equity swaps, the hedge fund has the right to purchase the underlying shares from the counterparty under certain circumstances, at which point the hedge fund would disclose ownership of the shares (but not before the shares are delivered) The key question under this arrangement is who controls votes attached to the shares that are the subject of the equity swap? Since the activist does not own the shares, they technically do not own the voting rights, and therefore may not be required by the SEC to disclose ownership under 13D rules However, since the hedge fund might be able to receive these shares before a future vote on the election of directors, the activist can theoretically own the shares when it matters most
Accumulating Shares Through An Equity Swap: CSX Equity Swaps on CSX Shares Assume CSX share price of $40 when equity swaps were executed on 62.5 million shares (a notional amount of $2.5 billion) Total returns paid on Equity Swap involving 62.5mm CSX shares $2.5 billion loan TCI and 3G The outcome of this transaction is: Interest payments @ Libor + 50 b.p. on $2.5 billion 62.5 mm CSX shares Investment Banks $2.5 billion CSX Shareholders Interest payments @ Libor + 25 b.p. on $2.5 billion Lenders TCI and 3G receive economic exposure to 62.5 million CSX shares since they receive/pay total returns from/to investment bank counterparties (quarterly appreciation/depreciation of CSX share price + dividends) Since TCI and 3G don t own shares (investment banks purchased 62.5 million CSX shares to hedge their equity swap position) the hedge funds may not need to report beneficial ownership of these shares to the SEC The investment banks receive a spread of 25 basis points between their cost of borrowing $2.5 billion and the payments received from TCI and 3G under the equity swap The hedge fund may have the right to unwind the equity swap in the future before a proxy vote by paying $2.5 billion to the investment banks in exchange for 62.5 million CSX shares
Accumulating Shares Through Equity Collars: Yahoo During February 2008, Microsoft offered to buy Yahoo at $31 per share, but Yahoo s CEO and founder rejected the offer Following this rejection, Carl Icahn started accumulating a position in Yahoo stock, attempting to benefit from an eventual sale to Microsoft During May 2008, Icahn initiated a proxy fight against Yahoo after acquiring an equity equivalent position of 59 million Yahoo shares. This position was comprised of 9.9 million common shares and equity collars on 49 million Yahoo shares The equity collars were created through the purchase of call options on Yahoo (American style calls with an unknown strike price and maturity) and the simultaneous sale of put options on Yahoo (European style puts with a strike price of $19.50, maturing in November 2010)
Accumulating Shares Through Equity Collars: Yahoo The equity collars provided the following potential benefits for Icahn The estimated cost for the equity collars could be zero, compared to the over $1.23 billion cost that Icahn would have paid to purchase 49 million Yahoo shares at the $25.15 opening share price on the date the collars were entered into Entering into a collar transaction was less visible than purchasing 49 million shares, enabling Icahn to secure his position without competing directly in the market for shares The options can be settled physically, by delivery of shares, or if Icahn does not want to buy Yahoo shares if options are exercised, he can cash settle the options Cash settlement means that, if an option is exercised, the economic equivalent of a physical settlement will be paid in cash (payment to Icahn if Yahoo s share price exceeds $32.85 or from Icahn if the share price falls below $19.15)
Accumulating Shares Through Equity Collars: Yahoo Equity Collars on Yahoo Stock Assume Yahoo share price of $25.15 when the equity collar is executed Put options on 49 million Yahoo shares at a strike price of $19.15 and an 18 month maturity can be sold for proceeds of: (i) $2.14/option Call options on 49 million Yahoo shares at a strike price of $32.85 and an 18 month maturity can be purchased for a cost of: (ii) $2.14/option Total cost for a Cashless Equity Collar = (i) - (ii) = $2.14/option - $2.14/option = $0 Economic Value Sell Put Options + Economic Value Buy Call Options $2.14 $0 $0 -$2.14 $19.15 $25.15 $25.15 $32.85 = Costless Equity Collar vs. Purchase Yahoo @ $25.15 Economic Economic Value Value $2.14 $0 -$2.14 $0 $19.15 $25.15 $32.85 $25.15
More on activist hedge funds Long biased Could long stocks but short index or basket of stocks Have a concentrated portfolio with 8 to 15 core positions Invest with a longer-term time horizon of 6 months to 2 years Match their fund liquidity with investment horizons longer lock up period See examples of activist hedge funds page 197 198, EZ
Performance of shareholder activism strategy Investor activism and takeovers Greenwood and Schor, JFE2008. Findings: Recent work documents large positive abnormal returns when a hedge fund announces activist intentions regarding a publicly listed firm Other studies attribute high announcement returns to improvements in operational performance, increases in the leverage or payout ratio, or reductions in agency costs
Greenwood and Schor (2008) -- more These returns are largely explained by the ability of activists to force target firms into a takeover construct a comprehensive database of activist filings with the Securities and Exchange Commission (SEC) from 1993 to 2006, focusing on instances where the target is a US firm -- 13D and DFAN14A filings 13Ds are filed with the SEC within 10 days of an entity attaining 5% or greater share in any class of a company s securities. The filing documents the size of the purchase and summarizes the investors intentions activist investors portfolios perform poorly during a period in which market wide takeover interest declined
Activism Summarized There is disagreement on whether hedge fund shareholder activism makes companies stronger or merely generates short-term gains that principally benefit the activist at the expense of long-term shareholders During 2008, there were more than 75 U.S. hedge funds dedicated to eventdriven, activist-style investing and these funds managed more than $50 billion in assets Some institutional investors have lined up with these hedge funds to push boards to be more responsive to shareholders In a number of cases, it appears that improvements have been made in companies that, in the absence of shareholder activism, may not have occurred In other cases, large share repurchases pushed by activists and created large opportunity costs when the repurchases occurred before subsequent steep share price drops In addition, some acquisitions pushed by activist shareholders have seen significant share price drops since closing