Monday, April 06, 2009

Activist Investors Sidelined by Brutal Market


By Eric Jackson

04/06/09 - 12:12 PM EDT

S , HD (Cramer's Pick) , MOT , WEN , TIF , CSX , TGT , YHOO

Earlier this year, Ken Squire, who runs the consultancy 13-D Monitor, which follows those filings with the SEC, wrote an article in Barron's predicting that 2009 would be a "golden age" for activists (which I also predicted recently).

His article made several strong points for why this should happen, including the low valuations, a favorable political climate likely to ease hurdles for activists to challenge companies, and shareholder discontent at record levels. Yet, this activist activity has yet to materialize. Why and when will this change?

There is a finite set of large activist investors in the world today with the assets to take on large public company battles. Some of the biggest have included: Relational Investors (active in Sprint(S Quote - Cramer on S - Stock Picks), Home Depot(HD Quote - Cramer on HD - Stock Picks), and National Semiconductor(NSM Quote - Cramer on NSM - Stock Picks) last year), Trian (active in Wendy's(WEN Quote - Cramer on WEN - Stock Picks) and Tiffany's(TIF Quote - Cramer on TIF - Stock Picks) last year), Carl Icahn (active in Yahoo! (YHOO Quote - Cramer on YHOO - Stock Picks) and Motorola (MOT Quote - Cramer on MOT - Stock Picks) last year), The Children's Investment Fund (or "TCI," active in CSX(CSX Quote - Cramer on CSX - Stock Picks) last year), Jana Partners (active in Cnet last year), and Pershing Square (active in Target(TGT Quote - Cramer on TGT - Stock Picks) last year).

Like most investors, they had terrible results last year, although their previous 10-year returns have been outstanding. These activists suffered more in 2009 than other hedge funds because of two reasons: (1) they typically run long-only or long-biased funds and therefore had very little hedged going into last fall and (2) they have concentrated portfolios of typically fewer than 15 holdings, which can work very well in up years but terribly in down years.

These large activist funds have seen heavy redemptions in the last six months, and there is no reason not to believe they won't see more for the balance of this year. Even Jana Partners, which had relatively positive returns in 2008, has been hit with large redemption requests reportedly affecting 20% to 30% of assets.

As a result, all of them have pulled in their horns on potentially new activist campaigns, in favor of working out existing investments. Some activists are even exiting existing investments, after spending significant time and money on winning board seats (e.g., Relational exited its Sprint investment and TCI plans to exit its CSX investment later this year), in order to focus on a smaller set of investments within their portfolio.

To meet redemption requests, large activist founders have had to inject significant personal capital into their funds. Carl Icahn, whose fund was down 36% last year, put $500 million in. Bill Ackman recently invested a further $25 million in his Target-only fund Pershing IV.

Christopher Hohn, founder and head of TCI, who was recently regarded as one of the top activist investors in the world (and who some former employees cattily referred to as the "Sun King" made waves recently when he indicated he is considering turning his back on activism.

He complained at a recent investor day that activism was too "expensive and unpredictable," citing the recent $10 million spent by his firm on a bitter proxy battle with CSX last year (which he ended up winning, taking four board seats. He plans to give up those seats at the next annual meeting, possibly signaling an intent to sell CSX shares later).

The redemption siege mentality gripping large activist managers (which carries over to other hedge fund managers as well) is, in my opinion, the biggest reason for the drop in large activist battles. The New York Times recently reported that new activist campaigns dropped by nearly 80% in the fourth quarter of 2008 compared to a year earlier, according to data from Thomson Reuters, and activists made 59 new investments last month, compared with 87 a year earlier, according to Hedge Fund Solutions.

Of course, the evaporation of credit has taken away one "quick fix" strategy out of the quiver of some activists: Call on the company to take on an unhealthy amount of debt in order to buy back shares to artificially boost EPS and immediately dividend out this cash to shareholders -- all in the name of "creating shareholder value."

Marty Lipton, who has been corporate America's top watchdog against activist investors, recently attacked these kinds of practices, asking: "Can the global economy afford to allow institutional investors, who are seeking to maximize the price of their shares on a daily basis, determine industrial business, policy and strategy of major corporations?"

Of course, there are examples of bad behavior at both ends of this spectrum: greedy, short-termist activists enriching themselves at the expense of long-term holders, and greedy, out-of- touch boards and CEOs filling their own pockets out of the company till while driving a company's value into the ground. There can be highly effective boards and CEOs, as well as highly effective activist investors who advocate actions that are in the company's and its long-term shareholders' interests.

The fact is that Ken Squire's thesis is still correct that the broader environment has made it much more favorable for activist investors to launch campaigns. There are many companies today trading at or near their cash levels. Some of these companies are in this situation due to the wash-out of the broader market, but many are there because of their boards approving poor capital allocations (buying back stock at the top of the market or taking on large amounts of debt which cannot be rolled over), poor acquisitions, excessive compensation, or simply leading their company to value-destroying mediocrity.

A year from now, the SEC is likely to approve a new "proxy access" rule making it much less expensive for activists and other shareholders in general to challenge boards doing a poor job representing their interests in overseeing the company's direction. It's likely that many smaller activist investors will be involved. The most active activists today are the firms going after companies below $2 billion in market capitalization -- on the assumption that they can have more sway over these companies because they can hold a larger percentage of shares than would be possible if they went after the larger public companies.

Yet even the most favorable conditions will promote activist campaigns against large-cap companies if the current generation of large activists continues to be inwardly focused by their redemption and performance problems.

This could be a generational succession moment for activist investors, where the elders give way to a next generation of activist investors taking on the largest companies in corporate America.

For this next generation of activists to successfully take over this mantle of their industry, they must do the following:

  • Hedge, in order to preserve partner capital in the event of terrible years like 2008. The days of long-only are over.
  • Build a reputation for always doing right for shareholders (especially long-term holders). Some of the "quick fix" activists of the last five years never won the trust of large mutual funds and pension funds, who tend to be the biggest holders of stock of the large-cap companies. As a result, proxy contests failed to win over the support of this important constituency, for fear of how these activists would represent their interests properly.
  • Focus more on strategy and operations, less on single events. There will always be a place for activist investors to go after a company, advocating they sell a single division, or do a quick dividend to shareholders. However, these situations tend to be more prevalent in small-cap companies. Large-cap companies, by definition, have more complex problems and require more complex solutions. The next generation of top activists will understand this and have deep expertise in their firms on strategy and operations.
  • Use the tools of the Internet and social networking. In 2007, when I ran a successful activist campaign against Yahoo!, which resulted in unseating Terry Semel as CEO after a large "no" vote at the annual meeting, I owned 96 shares of Yahoo! However, I was able to get my message out to large and small shareholders via my blog, YouTube, wikis, Facebook and Twitter. More than calling attention to my ideas, these social networking tools allowed fellow shareholders to pledge support to my group and encouraged them to suggest additional ideas for how Yahoo! could improve. I was most surprised and pleased with how many existing Yahoo! employees participated. Yet, their interests were perfectly aligned with our groups: We were all stockholders of Yahoo! and wanted to see the stock price go up through needed changes, which the current board and management were not making. The next generation of large activist investors will be masters at using the Internet to conduct their campaigns.
  • Be more collaborative, less combative with target companies. It will always be necessary to run successful -- sometimes nasty -- proxy contests against entrenched boards and management. In my opinion, the Yahoo! board, for example, will never respond to a "nice guy" activist approach. It is so entrenched and disconnected from the opinions of shareholders that it would be impossible to reason with them. There's a time to knock heads. However, some activists only knock heads. They only know how to hit one key on the piano. The next generation of activist investors will be able to play hard ball but tend to be much more collaborative with the board and the CEO -- at least at the beginning, until reasonable dialog leads nowhere. Such an approach is also far less expensive than an "all-negative, all-the-time" approach.

There is a job opening in the activist investor industry. Wanted: the next generation activist investor leaders to take the lead in waging successful campaigns against large cap companies. Who will assume the mantle? We'll see over the next few years.

At the time of publication, Jackson was has no positions in stocks mentioned.

Eric Jackson is founder and president of Ironfire Capital and the general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund, Ltd.

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