When the CEO’s of the big three U.S. auto makers arrived in Washington in February, hats in hand and looking for a government bailout, they arrived in three separate corporate jets. The uproar over this extravagance at a time of crisis, for both the companies and the global financial system, led Barrack Obama to move more quickly and brutally than any hedge fund to remove Rick Wagoner as the boss of General Motors.

As the significant shareholder in a number of other firms the US government is now starting to flex its muscles and remove management (from Ken Lewis at Bank of America to the entire derivatives team at AIG) and intervene in pay decisions, where all of Bank of America, Citigroup, GMAC LLC, AIG, General Motors, Chrysler Group and Chrysler Financial have been subjected to highly publicised reviews by Kenneth Feinberg, the Treasury Department’s Special Master on Compensation.

For most observers, this activist approach to ownership is highly welcome. The excesses of corporate executives and bankers seem particularly inappropriate in a recession, and even more so after their businesses have been bailed out with taxpayer money.  However the government is not the first investor to seek to take unproductive and wasteful corporate managers to task. Activist investment strategies, a sub-class of the approximately $1 trillion hedge fund industry, have long sought to remove or discipline corporate managers who are not deemed to be adding or extracting the appropriate amount of value from an asset.

The Critics

However, activism - the investment approach of initiating company change to unlock value - is a strategy that is widely criticised by regulators, other investors and management teams as not adding long-term value for shareholders. A few examples of why this might be the case can be quickly thought of. One is the recent sale of Phibro, Citigroup’s commodity-trading arm and one of its few consistently profitable divisions. Concerned at the idea of a public backlash against the pay package of star trader Andrew Hall (estimated at $100 million) the government forced Citigroup into a fire sale of the unit for $450 million, approximately 1 x the annual net profit of the unit.

Another example of activist investment strategies destroying long-term value for shareholders can be found at Carrefour, the giant French retailer, where investors led by Colony Capital, a US private equity firm, are rumoured to be pressurising the board to dispose of the company’s fast-growing and highly profitable Chinese and Brazilian operations. Their motivation appears to be linked purely to the resulting special dividend and also to the failure of their original plan to spin off the Carrefour property portfolio in a separate listing. Such a sale, however, would ruin Carrefour’s long-term growth prospects and limit Carrefour to low-growth European markets, in several of which it is struggling.

More generally, the criticism of activist investors is that they are short term in their thinking and this has the potential to prejudice other important players in the company capital structure, namely creditors. Pressure from investors to force through increased leverage, spin-offs, acquisitions or share buybacks typically has the effect of generating a short term gain for the firm’s equity investors, but at the expense of damaged credit quality and hence long-term prospects.  

An alternative view

However two recent comprehensive studies have confirmed the value proposition of the activist strategy. The first, “Hedge Fund Activism, Corporate Governance and Firm Performance,” conducted by four university professors, analysed nearly 800 activist events in the US from 2001 to 2006. The authors found that success or partial success was attained in nearly 2/3rds of the cases. The study highlighted that the target firm typically outperforms the market by 7% to 8% over a four week period before and after announced activist campaigns by hedge funds. If this boost in performance was temporary and the activist funds did little to generate value, the stock price would have reverted back over the course of the investment but the study concluded that this was not the case.

The second study, “Hedge Fund Activism” by April Klein, a professor at New York University, examined a sample group of 155 activist campaigns. Her conclusion was that in many cases the perceived threat of a proxy fight was sufficient for the activist to achieve its goal. The study reaffirmed many of the same conclusions as the first study, including the abnormal stock returns surrounding the initial announcement. The study also found that the abnormal returns of activist targets during the subsequent year were even greater, roughly 11%, confirming that activists generate returns significantly beyond the initial market reaction.
    
The Activist Investor “Toolbox”

The basic theory of activists is that companies do not always do what is in the best interests of shareholders. Shareholders typically remain relatively powerless because of collective action problems, insufficient incentives, conflicts of interest, legal obstacles and management power. Activist investors are different because they have enough shares to overcome collective action impediments, are sufficiently concentrated in their holdings to provide incentives, understand the legal and corporate governance methodology for enacting change, are able to attract support from existing shareholders and turn over the shareholder base with other like-minded institutional investors’, and can pay the legal fees needed to execute the strategy.  

Within the agency problem framework the activist investor has a “toolbox” of strategies with which to seek change, namely financial, strategic, corporate governance and /or operational catalysts.

Conclusions

In addition to the unique skill set that has been required to be a successful activist investor in the past, this past year has demonstrated the importance of being able to recognise and incorporate the macroeconomic environment into the value creation thesis. Over the past 15 months macroeconomic factors have completely overwhelmed fundamentals, causing companies to trade at or below intrinsic value for extended periods despite the activist manager’s otherwise thoughtful plan to unlock value.

However, despite these challenges (faced by the entire hedge fund asset class), the comprehensive studies referenced earlier in this article appear to give some credibility to a view that, in normalised markets; activism is successful in creating value.