First in a series. See Hedge Fund Activism and Corporate Governance.
A hedge fund is a special type of investment vehicle. Hedge funds differ from most investment vehicles in the United States because they are substantially unregulated. Specifically, virtually all hedge funds are exempt from registration under the 1940 Investment Company Act. Accordingly, they have much more freedom to engage in transactions such as short-selling and margin trading, and they have fewer obligations to their investors than regulated investment company managers.[i] Hedge funds have this freedom because only sophisticated investors, typically wealthy individuals and/or other financial institutions, can invest in them.
Hedge Fund Activism is an investment strategy where the Activist acquires a significant interest in the equity securities of a public corporation. Sometimes this action is taken in collusion with other Activists to magnify the Activist’s power.[ii] The Activist then demands the corporation to make certain changes in its operations or financing that the Activist believes will increase the market price of the corporation’s equity securities, thereby enabling the Activist to realize a fairly quick profit on its investment.[iii] Sometimes, the corporation’s Board of Directors (“Board”) does not acquiesce to the Activist’s demands, and the Activist may engage in hostile tactics, including launching a proxy contest or making a takeover bid.[iv] Whether or not the Activist succeeds in forcing the changes is not that important to the Activist, because evidence shows that the market price of the target’s equity securities typically rises for a short period of time after the Activist announces it plans, thus enabling the Activist to make a quick profit[v].
Activists usually target corporations that they believe have low stock price value compared to what the Activist believes is the fundamental value of the corporation. They are more likely to target firms that have sound operating cash flows, but low (sales) growth rates, leverage, and dividend payout ratios.[vi]
Hedge Fund Activism has become a significant threat to public corporations.[vii] Almost one-sixth of U.S. public corporations in the S&P 1500 have faced an Activist campaign, with some corporations experiencing multiple campaigns.[viii] Increasingly, corporations are facing pressure to deliver short-term results at the expense of long-term value, whether through excessive risk-taking, avoiding investments with long-term horizons or taking on more leverage to finance special payouts to investors, and significant strain from misallocation of corporate resources and energy into mandated Activist initiatives.[ix]
Among the most prominent firms engaged in Hedge Fund Activism are: Icahn Associates, Jana Partners, Pershing Square Capital Management, and Pirate Capital.[x] However, there are dozens of such firms currently engaging in this investment strategy. Activist Hedge Funds in the U.S. hold close to $100 billion in assets.[xi]
The pace of Hedge Fund Activism has been increasing. For a twenty-month period in 2005-2006 there were only 52 Activist campaigns[xii]; however, there were 1,115 from 2010 through the first six months of 2014.[xiii] For the first six months of 2014 Activists targeted 161 companies, a 7.3% increase from the comparable 2013 time period.[xiv] Notable targets this year have included eBay, Symantec and PetSmart. The main reason for this increase is that Hedge Fund Activism is profitable: Hedge Funds run by Activists have gained 6.5% for the first six months of 2014, which is double the average return for all Hedge Funds for the same period.[xv]
Finally, Activists are having success in the outcomes of their hostile campaigns. Activists were successful in electing one or more candidate to corporate Boards 68 percent of the time in 2013, compared to only 43 percent success in 2012.[xvi]
- [i] See The Conference Board (2008).
- [ii] This popular Activist tactic has become known as a “Wolf Pack”. See Coffee and Palia (2014).
- [iii] The median duration of investment for Activists is 266 days and the mean duration is 376 days. However, the mean duration for Activists who use more “hostile” tactics is only 229 days. See Brav, et al (2009).
- [iv] See The Conference Board (2008).
- [v] See Bebchuk (2014).
- [vi] See Brav, et al (2009).
- [vii] A public corporation is defined as one whose equity securities are traded on a public exchange.
- [viii] See Khorana, et al (2013).
- [ix] See Lipton (2014).
- [x] See The Conference Board (2008).
- [xi] See Hedge Fund Research, Inc. (2014).
- [xii] See Copeland (2014).
- [xiii] See Hoffman and Benoit (2014).
- [xiv] See Gallardo, et al (2014).
- [xv] See Gallardo, et al (2014).
- [xvi] See Foley (2013).