From the January 2008 issue of Wealth Manager Web • Subscribe!

January 1, 2008

Getting Active

Early in 2007, HSBC took a $6.3 billion charge because of exposure in the sub-prime mortgage market. Shortly thereafter Knight Vinke Asset Management announced it would "undertake a fundamental review" of HSBC Holdings' bank strategy. One would expect such an announcement by a major shareholder, but New York-based Knight Vinke owns less than 1 percent of HSBC. Knight Vinke, however, is one of a new breed of privately owned investment management firms that makes money by investing in under-performing companies, and then pushing for institutional changes to improve shareholder value. "Activist investors" or "activist funds," as these firms are frequently called, are shaking up the corporate world and giving investors above average returns.

It used to be that when a company performed poorly, investors voted with their feet--by selling shares. Formal complaints or shareholder requests to remove badly performing managers were unheard of. That no longer holds true. Often locked into investments, institutional investors--including public pension funds and endowments--became pioneers in using activism to boost overall returns. Soon after, hedge funds and private equity funds threw their hats in the ring.

Early investors in activist funds have been handsomely rewarded. The California Public Employees' Retirement System has some $6.1 billion managed by Relational Investors, an activist management firm, that from 1996 through November 2005 materially outperformed its benchmark, the S&P 500 Total Return Index, on a cumulative basis. Between 1996 and 2006 Third Point, a $5 billion activist fund, generated annual returns of more than 22 percent. Jana Partners LLC and Pirate Capital LLC, two other activist hedge funds, have generated annual gains of 23 percent and 25 percent since inception.

Activist funds' returns have not gone unnoticed. While still a relatively new investment strategy, in the last few years activism has become mainstream, and money has flooded into new funds promising to employ the strategy.

Activist funds are also making a mark on the corporate landscape. In 2004, Knight Vinke and other activist investors successfully forced Royal Dutch Shell to end its dual British-Dutch structure. In January 2007, activist funds, including Relational Investors, were instrumental in the ouster of Home Depot's CEO Robert Nardelli. Furthermore, according to a Harvard Business School study by Robin Greenwood and Michael Schor, between 1994 and 2006, the number of public firms targeted for poor performance by hedge funds grew more than ten-fold.

Fueled by institutional successes, investment in activist funds is now trickling down to wealthy individuals. While investing directly in most of these funds is out of reach of all but the wealthiest clients, opportunities do exist for advisors to place such investments for clients who are "merely" wealthy.

Because activism is uncorrelated to the market and historically has been remarkably effective at making money, advising clients to invest in such funds can be a good strategy, says Robert Davis, CFA and chief investment officer at Round Table Services LLC in Westfield, N.J. Each client should be viewed individually, he says, but it could be a good investment. And William A. Pusey, Jr., vice president, Family Office & Non-Traditional Investments at JoycePayne Partners in Richmond, Va., thinks the strategy "is appropriate for all retail clients who qualify with an appropriate allocation and family goals in mind."

However, it is not without risk. Activist investments can make sense if "you're on the right side," says Jordan Berlin, the CEO of Weiser Capital Management in New York. Some activist managers are better then others, he says, and advisors also need to determine for which of their clients these types of investments are appropriate. Furthermore, while activist funds have achieved phenomenal returns in the past, some question whether those returns will continue in the future.

How They Work

The theory behind the strategy is simple. Activist funds seek out companies with low stock prices that could be doing better, and then agitate for changes which will improve value. Generally, activist funds buy up stakes in companies they consider to be poorly run, says Greenwood, who is a professor at the Harvard Business School. The median size of an activist stake is 8 percent, and the average is 10 percent, he says. After that, the fund works to make institutional changes in the target to unleash value and increase share price.

Issues addressed by activist funds include the shedding of extraneous divisions, debt load, dividend size, poison pills and share buybacks. Activists also try to move ineffective executives out and bring new ones in, often removing board members and replacing them with their own representatives. Funds may also argue for selling the entire company or waging a proxy battle.

Another way that activist funds unleash value is to use financial leverage, says Davis. For example, former corporate raider turned activist hedge fund manager Carl Icahn typically leverages the balance sheet and buys back shares or gives payouts to shareholders, he says.

The strategy does seem to work. A study by the Columbia School of Business showed that more often than not, activist hedge funds get what they want from target companies, succeed in improving the business and make substantial returns. Furthermore, their actions often increased the payout, resulting in robust returns for investors. Hostile intercessions brought more favorable results than friendly activism.

Furthermore, the Harvard Business School study also showed that activist funds create shareholder value through anticipation of change. According to the study, just by announcing their targeting of a firm, hedge funds generate returns of over 5 percent.

In other words, hedge funds create immediate shareholder value by putting firms "in play," says Michael Schor, an analyst with Morgan Stanley's Investment Banking Division in New York. Whenever activist funds announce a new target, the share price for that target immediately jumps up 5 percent to 10 percent, he says. The market reacts this way, explains Schor, because activist funds are very successful in getting the companies they target taken over. The market, in effect, expects that because of the activist fund's involvement, the target will soon be acquired at a sizable premium. Overall, share prices increase 20 percent in the short term. This leads to greater returns for investors in these funds, he explains.

Getting In

Approximately 80 funds sport the activist label, and the leaders in the field include Shamrock, Barington Capital, Jana Partners, Chapman Capital, Third Point and Steel Partners. However, investing directly in any of these funds is probably out of the range of all but the wealthiest clients. Most of these funds are geared to institutional investors, Davis explains, and require a $5 million to $10 million investment and two- to five-year lock-up period.

"Generally speaking, private clients have a hard time accessing such managers because of high minimum purchase requirements," says Pusey. Direct investments in activist funds would only be appropriate for ultra-high-net-worth families to avoid having a portfolio over-allocated in one investment, he continues. Pusey's firm does serve several ultra-high-net-worth clients who can make these investments--if it makes sense for their portfolios, he says.

On the other hand, there are funds of funds that invest exclusively in activist funds that may require minimum investments as low as $1 million, Davis adds. And some of these funds allow registered investment advisors to be considered a single investor, no matter how many clients are actually invested. For example, fifteen clients each investing $1 million would be viewed as one $15 million investment. However, most funds still require that each individual investor in the pool qualifies as an "accredited investor" under SEC rules. In fact, says Davis, the funds Round Table works with require all investors be "qualified purchasers"--with a minimum of $5 million in investable assets.

Both UBS and Oppenheimer have funds of funds that allocate investments to external hedge fund managers considered to be activists, says Davis. The lock-up period for a fund of funds generally ranges from two to three months, he adds, although typically, investors have to alert the fund three to six months in advance of a withdrawal.

However, there is another way to give clients access to these funds. Smaller clients of JoycePayne Partners who have portfolios that merit an allocation to activist investment strategies are pooled into the MJA Special Opportunities Fund, a limited partnership run by the Richmond firm. Approximately 20 of the firm's private clients and family vehicles are currently invested in eight managers--some of whom employ activist strategies. All of these clients are either "accredited investors" or "qualified purchasers" under SEC rules. "By pooling private clients' funds into a limited partnership, they can invest and not be over allocated," Pusey says.

However, advisors should be on the watch for overcrowding. Because traditional hedge fund strategies have become crowded and are not producing expected returns, many funds have moved into activism, explains Schor. But as more funds adopt the strategy, activism, too, is getting crowded. In addition, the more profitable targets have already been rooted out. There are fewer undervalued situations now than there were a few years ago, he says, making it harder to find potential new targets in the future.

Furthermore, says Harvard Business School's Greenwood, in today's tight credit world, it may be harder for activists to force a sale. This, he says, will make takeovers more difficult, and that will make it harder for activist funds to generate the returns they had in the past. It also means that if the market believes a takeover is unlikely, share prices may not rise as much as they had in the past when a target was announced, Greenwood points out.

And with debt more expensive, says Davis, an activist that has generated returns by leveraging up the balance sheet and giving cash to shareholders may realize less robust returns going forward. But he adds that the situation could get interesting as activist funds move into the European and Asian markets where he says, there are entrenched managers at many firms along with bloated infrastructure. Investors could again see good returns as funds go overseas to shake things up.

Of course, there are those who debate whether this activism is good for shareholders in the long run. That, however, does not diminish the investment value for those investing in activist funds, the experts say. And, according to Greenwood, historically, activist strategies have been money makers for those who invest in them-- if not for the long-term shareholders in the company. "There is a debate as to whether activism is good for shareholders. Whether or not it is, it is good for investors, and ultimately we want to make money whether markets go up or down," says Pusey.

Not All-or-Nothing

Oftentimes a hedge fund or private equity fund only partly engaged in activism is still referred to as an "activist." For example, says Michael Schor of Morgan Stanley's Investment Banking Division, only 10 percent to 25 percent of Third Point's portfolio takes activist positions; the rest of the portfolio is engaged in traditional hedge fund strategies such as long/short and derivatives. In fact, according to Robin Greenwood of the Harvard Business School, Carl Icahn is the only investor who runs a fund that engages exclusively in activist investing.

Elayne Robertson Demby, JD, has covered executive compensation, employee benefits and financial issues for more than 10 years.

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