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107 107 7 Activist Hedge Funds T O N Y C A L E N D A Head of Special Projects, Geller & Company C H R I S T O P H E R M I L L I K E N Vice President, Hennion & Walsh A N D R E W C . S P I E L E R Professor of Finance, Frank G. Zarb School of Business, Hofstra University Introduction Activist hedge funds (AHFs) have increased over the last two decades, growing rapidly as an asset class and having an increasing impact on the management of public com- panies. AHFs methodically seek to generate attractive returns by directly influencing management of investee companies, typically urging them to take specific corrective actions. By intervening directly with the investee, AHFs seek to create their own cata- lysts to achieve desired investment returns. Although hedge funds labeled as “activist” use activism as their primary strategy in a majority of their investments, they may use additional strategies for their remaining investments. Although this asset class continues to deliver superior returns for investors, it draws mixed public reaction. Support for activism is fueled by the belief that such hedge funds are helping shareholders combat self- serving or inefficient corporate management and governance. Others view these hedge funds as causing more damage to a company’s stake- holders than they do to help shareholders. The media attention that these hedge funds generate is partly due to the techniques used to effect change in corporate governance as well as the high- profile companies that have been targeted in recent years. This chapter reviews the techniques used by AHFs and the policy discussion surrounding these topics. History of Activism Activism on the part of shareholders came to light in the late 1980s when public pen- sion funds began pressuring the management of companies to modify certain corporate governance policies that were put in place to protect existing management from “corpo- rate raiders.” According to Gillan and Starks (2007), Jesse Unruh, the former treasurer of California, helped create and lead the Council of Institutional Investors in 1985 and OUP UNCORRECTED PROOF – FIRSTPROOFS, Sat Apr 01 2017, NEWGEN 01_part1-2.indd 107 4/1/2017 12:26:03 PM 108 THE STRUCTURE OF HEDGE FUNDS ushered in the era of shareholder activism by pension funds. This effort was an attempt to ensure the fair treatment of all shareholders after Texaco repurchased shares in 1984 at a premium from a single “raider” without extending the offer to the public pension funds that also owned a stake in the company. This repurchase maneuver known as “greenmail” is discussed later in the chapter. Under the direction of chief executive officer (CEO) Dale Hanson, the California Public Employees’ Retirement System (CalPERS), the largest public pension fund in the United States, embarked on an effort to identify security holdings that were under- performing and attempted to persuade management to change how it operated in order to unlock value for shareholders (Crutchley, Hudson, and Jensen 1998). Beyond repeal- ing antitakeover measures, CalPERS hired consultants to investigate target firms where share price performance could be enhanced and would offer to meet with the manage- ment of such companies to effect change before launching a public proxy battle. In 1992, CalPERS started publishing its list of target firms, applying further pressure on the tar- get’s existing management to carefully consider CalPERS’s proposals. Similar to the pension fund example in the previous paragraph, other types of inves- tors, such as private equity firms, wealthy individuals, or hedge funds, may use activist techniques when they identify an opportunity for an investee company to create share- holder value by implementing operational or financial (i.e., capital structure) changes. In some respects, AHFs act like private equity firms, creating value by improving gov- ernance and financial performance, except without having to necessarily acquire a con- trolling interest in the company. Some AHFs have taken companies private as well. Tracing their roots to the aforementioned “corporate raiders” of the 1980s, such as Carl Icahn, Ron Perelman, the Bass brothers, T. Boone Pickens, and Saul Steinberg, the first generation of today’s AHFs began in the 1990s. The term greenmail was coined during the raider period. Greenmail refers to the practice of a raider offering to sell his accumulated shares back to the target company at an above- market price in return for abandoning his activist campaign. Greenmail essentially entailed a target company’s board using shareholder money to protect its interests, and the practice has since been restricted in the United States. For example, a New York State statute prohibits a corpo- ration from buying back more than 10 percent of its stock from a shareholder for more than market value unless approved by its board of directors and a majority of sharehold- ers. According to Section 5881 of the U.S. Internal Revenue Code, a 50 percent excise tax is payable on profit from greenmail. Carl Icahn, who was one of the original “raiders,” remains an activist investor. His career, now spanning five decades, illustrates the development of the asset class. Icahn has focused on generating profits by identifying undervalued assets and then execut- ing a plan to unlock their hidden value. In the 1960s, Icahn’s firm concentrated on risk arbitrage and options trading, in which the hidden value existed in the form of small differences between prices of the same security in different markets. Icahn’s firm would exploit market inefficiencies by simultaneously buying at the lower price and selling at the higher prices to realize a riskless profit. In 1975, he earned profits from the differ- ence between the market value and underlying asset value of closed- end mutual funds, which often trade at a discount to their net asset value, by lobbying to have the tar- geted funds liquidated. The following year, he issued what has been called the “Icahn Manifesto,” in which he stated, OUP UNCORRECTED PROOF – FIRSTPROOFS, Sat Apr 01 2017, NEWGEN 01_part1-2.indd 108 4/1/2017 12:26:03 PM tcalenda Highlight a Act iv ist Hedge Funds 109 109 It is our contention that sizable profits can be earned by taking large posi- tions in ‘undervalued’ stocks and then attempting to control the destinies of the companies in question by a) trying to convince management to liquidate or sell the company, b) waging a proxy contest, c) making a tender offer, or d) selling back our position to the company. (Carlisle 2014, p. 4) Icahn has challenged companies such as eBay, Apple, Time Warner, RJR Nabisco, AIG, and Gannett with great success. Although the raider- era activists sought to acquire 51 percent of their targets to wrest complete control from existing boards and management, today’s AHFs may exercise influence on their investees by holding or controlling much less. This amount is usually 5 to 10 percent, but in some cases can be as little as 1 to 2 percent of outstanding shares. This relatively low percentage of share ownership has allowed AHFs to take on large targets, such as Amazon and Microsoft, without marshaling the huge sums that would be necessary to actually execute a hostile acquisition. The current generation of AHFs contends that its approach improves corporate gover- nance and bridges the divide between ownership (shareholders) and operational control (board and management). AHFs accomplish this goal by giving shareholders of pub- licly traded companies— who are typically dispersed and less capable of collective action on their own— a stronger hand in shaping corporate strategy, which in turn can impel self- serving management or complacent boards to take needed actions to deliver higher returns. AHFs typically have large individual stakes and focused holdings resulting in a strong incentive to act aggressively to successfully influence their target companies. Meanwhile, critics maintain that AHFs generate hefty returns for themselves and are short- term focused, without necessarily benefiting others, particularly long- term shareholders. Hence, AHFs may leave weakened, vulnerable companies after they exit their positions. Prominent corporate attorney Marty Lipton decried such activism as “scorched- earth activism” (Tan 2016). This chapter attempts to objectively cover both sides of the argument. Activist Hedge Fund Strategies and Tactics Due to the fact that hedge funds are typically private and each has developed its own proprietary techniques, the inner workings of their strategies and tactics are difficult to pinpoint. At a high level, explaining how a long- focused AHF’s basic strategy is exe- cuted is possible. The approach varies depending on several factors, including the attri- butes of the target, current market environment, and landscape of the target’s industry. The first step is for the AHF to identify an undervalued or underperforming pub- licly traded company. After identifying the target company, the hedge fund develops a strategy to increase shareholder value. This strategy may include returning cash to shareholders in the form of dividends or share buybacks, selling a specific business line, or trying to improve corporate governance. When the hedge fund is comfortable with its likelihood of success, it crosses the line from theoretical investment modeling to actual stock share or option purchases or both. The goal is to acquire a large stake in the investee or target company at a price that reflects its prechange prospects. OUP UNCORRECTED PROOF – FIRSTPROOFS, Sat Apr 01 2017, NEWGEN 01_part1-2.indd 109 4/1/2017 12:26:03 PM tcalenda Highlight pre-change 110 THE STRUCTURE OF HEDGE FUNDS Once the AHF has a stake in the business, it can, as a meaningful shareholder, effec- tively lobby for change. This lobbying is likely to include influencing and pressuring company management to execute the shareholder value creation plan developed by the AHF. Such an approach is considered “soft control.” Should management prove unco- operative, the AHF is likely to attempt to gain board seats, which is an action consid- ered “hard control.” Once the AHF initiates the process of voicing objectives and taking action, the target’s share price may increase in value, and this appreciation, whether sus- tainable over the long term or not, is the investor’s ultimate goal. A factor that AHFs also appear to consider is the percentage of the target company’s shares outstanding that passive investors hold. Unlike active investors, a passive inves- tor does not need to file a Schedule 13D when it breaches the 5 percent ownership level. Instead, a passive investor files the less intensive Schedule 13G and pledges not to exert control (Giglia 2015). Appel, Gormley, and Keim (2016) find that higher passive ownership leads to an increase in campaigns seeking board representation rather than pursuing a change in corporate policy