Activist Investors Sidelined by Brutal Market

From TheStreet.com

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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Tampa Bay Business Journal: Warning lights shine as railroad giant CSX engages in proxy fight

Friday, May 23, 2008

Tampa Bay Business Journal - by Tony Quesada Jacksonville Business Journal Staff Writer

JACKSONVILLE -- The campaign rhetoric is getting more biting, and the expenses are reaching tens of millions of dollars as the time for voting draws near.

The deadline for those with a stake in CSX Corp. to decide the class 1 railroad's fate is June 25, the day of its rescheduled annual meeting in New Orleans.

If the activist hedge funds The Children's Investment Fund Management LLP and 3G Capital Partners Ltd. succeed in getting five members on CSX's 12-member board and gaining approval for various shareholder proposals, it will likely change the company's culture. The hedge funds are seeking greater shareholder ability to call special meetings for any reason and to nullify bylaws changes made recently by the board.

CSX (NYSE: CSX) warns TCI/3G's ideas for maximizing shareholder value threaten the company's long-term health.

CSX and TCI/3G have released proxy filings almost daily in advance of the railroad's annual meeting. Each carefully crafted and legally reviewed filing is geared toward convincing shareholders that the company is or isn't on track and that each side's plans will secure CSX's future while the others will derail it.

"In many ways a proxy contest is like a political campaign," said Andrew Siegel, an investor relations consultant with Joele Frank Wilkinson Brimmer Katcher, a nationally known firm retained by CSX.

Whoever prevails, the proxy fight over the Fortune 500 company will be among the most expensive involving a railroad. CSX had spent about $10 million related to the proxy fight -- expenses not normally incurred for a typical annual shareholder meeting -- and expects to spend about $22 million total before it's done, according to its proxy statement. That includes up to $1.25 million being paid to Innisfree M&A Inc. as a proxy solicitation consultant, but it doesn't include the salaries and wages of employees who are working on the proxy fight.

TCI/3G's proxy bill also is substantial. It has retained D.F. King & Co. as its proxy solicitor for up $1.5 million. It estimates it will spend $9 million for services such as legal, accounting, public relations, advertising, printing and transportation. As of April 28, it had spent $3.5 million.
Filings flowing

In every year since 1995, CSX has made one proxy filing before its annual meeting; in 2006, the company filed a preliminary proxy statement 13 days before the final one. This year -- actually beginning in December with proxy soliciting materials filed by TCI/3G -- there have been 43 proxy filings by the two sides combined as of May 20.

Keeping the filings flowing, even at the risk of inducing proxy fatigue among shareholders, is typical, said Eric Jackson, president of Naples-based activist investment fund IronFire Capital LLC. "Most shareholders tend to mail in the last thing they receive."

Besides making multiple filings, both sides are counting on their proxy solicitation consultants to help them press their messages with large proxy holders.

Many institutional shareholders, because they hold many companies' stock and lack the resources to research every proxy contest in a given year, rely on proxy advisory companies to help them decide.

Under the shadow of litigation

CSX filed a lawsuit in the U.S. District Court for the Southern District of New York alleging violations of federal securities laws. The lawsuit alleges TCI and 3G have employed swap agreements to evade certain filing requirements and that TCI's disclosures regarding its 11.5 percent swap position in CSX shares are materially misleading because they don't disclose that swap counterparties intend to vote their shares with TCI.

CSX cited concerns for voting integrity being undermined by alleged violations as a reason for rescheduling its annual shareholder meeting from early May to June 25.

TCI and 3G responded with a countersuit accusing CSX of misleading shareholders and violating its corporate insider trading policy. Alleged violations include setting "spring-loaded" stock grants for "CSX insiders" while knowing material nonpublic information.

A bench trial was scheduled to begin May 21, and a decision could be rendered before CSX's annual meeting. The outcome could have implications on future reporting requirements, said Keith Gottfried of Blank Rome LLP in Washington.

Besides rescheduling its annual meeting, CSX is holding it in a rail yard in New Orleans, a departure from the usual hotel conference space. Company spokesman Garrick Francis said CSX is looking to showcase the work that's been done there recovering from Katrina's damage.

tquesada@bizjournals.com 265-2220

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TheStreet.com: CSX Stands Ground Against Activists

Cross-posted from my TheStreet.com article from today:

In the face of a gloomy economy where consumer spending is tepid, some of the smartest minds in the investment world have recently made big bets on the sleepy railway transporters. First it was Warren Buffett buying a big stake in Burlington Northern(BNI - Cramer's Take - Stockpickr). Bill Gates' investment vehicle also has a large stake in CN Railway. Both have been winning bets, appreciating 27% and 6% respectively in the last year.

But both of these transporters' gains have been eclipsed by Jacksonville-based CSX(CSX - Cramer's Take - Stockpickr), which has racked up a 45% increase in its share price in the last 52 weeks -- mostly coming in the last three months.

While Buffett and Gates have been passive investors in Burlington Northern and CN Rail, CSX has generated this performance while battling a group of activist investors led by Christopher Hohn of London-based The Children's Investment Fund (or TCI).

You might remember Hohn teamed up with Atticus Capital in 2005 to battle the German stock exchange Deutsche Borse. The two firms adamantly protested the German stock exchange's plans to merge with the London Stock Exchange(LSE - Cramer's Take - Stockpickr). When other investors sided with this view, Werner Seifert, the CEO of Deutsche Borse at the time, quit. It was reported that Hohn had told Seifert that his investor group was so powerful that they could nominate Mickey Mouse and Donald Duck to Deutsche Borse's supervisory board (board of directors) and have them approved by other investors. Seifert later titled his memoirs Invasion of the Locusts, referring to Hohn and the others he battled against.

Hohn had an equally high-profile and successful battle with ABN Amro(ABN - Cramer's Take - Stockpickr) in 2007. He bought up a 1% stake in the Dutch bank and began to call for its sale. After ABN lined up a deal with Barclays, TCI agitated for a better price. RBS(RBS - Cramer's Take - Stockpickr) finally swooped in to buy the bank and helped deliver a 70% return for TCI for a few months of work.

With these and other successes, TCI has delivered a 41.98% three-year annualized return, making it the ninth best performing hedge fund in the world, according to Barron's. The EuroHedge Awards crowned TCI the "Fund of the Year" in 2004 and 2005. Assets swelled from $3 billion in 2004 to over $15 billion today.

But the CSX investment has also proved a challenge for Hohn. TCI went public with its criticisms of CSX last October, with a long list of complaints that were mostly governance-related. They wanted the Chairman and CEO roles split, new directors to replace those with tenures of over a decade, and asked that shareholders be able to call special meetings. They also criticized that the company wasn't managing its costs well and had under-performed its peers of late. This was true for the 12 months prior to TCI's complaints, but CSX had significantly out-performed its peers if you went back further back in time.

CSX shot back at TCI in November, rejecting its demands. Most damning to TCI in the response was that CSX brought some previously private demands TCI had made over the previous 10 months to light. According to CSX, TCI had asked CSX to do a leveraged buyout, to lever up the company with "junk" debt to fund a massive share buyback, to commit to doubling its prices to customers over the next decade and to "freeze capital spending for growth until Congress determines the outcome of an issue that has been the subject of its policy debate for more than 20 years."

But CSX didn't stop there. The company proceeded to sue TCI for improperly disclosing its actual CSX ownership that was held in SWAPs. They also successfully managed to paint TCI as an ominous foreign threat to U.S. national interests, getting local politicians to question the "aggressive" actions of Hohn and TCI.

For his part, Hohn fought fire with fire and has, in turn, counter-sued CSX and accused the board of insider trading. TCI has announced its own slate of directors to be elected to the board, and a proxy battle appears set for June.

It's not clear whether Hohn will win the support of other institutional investors.

Although CSX's stock is up 29% since TCI first announced its complaints, investors need to weigh who will do the best job of overseeing CSX's activities beyond the annual meeting. Will other shareholders see TCI as a short-term opportunist or a long-term steward of CSX's best interests? CSX has effectively portrayed TCI as having inconsistent and poor ideas for how the company should be managed.

The battle is reminiscent of the first proxy battle Carl Icahn ran against Motorola(MOT - Cramer's Take - Stockpickr) last year. The handset maker was able to convince shareholders to trust them over Icahn due to the activist initially calling for increasing its debt-load and doing a buyback just as the company was about to see its sales fall sharply, causing it to need every dollar on its balance sheet.

Hohn's been successful with a "rough edges" and aggressive style of activism. For his 2006 Christmas card, his family trumpeted to friends that "Chris has had an exceptionally exciting year overthrowing German CEOs and expanding his investment conquests to China and Brazil."
CEOs have long bristled at TCI's demands for change and recently some investors have too. Yale's pension fund, which was one of the original investors in TCI when it started in 2004, pulled its $500 investment in 2006 after TCI retroactively raised its fees to existing investors presumably because of the hedge fund's success.

Hohn's initial successes as an investor were all event-driven. He became the loudest voice of shareholders in favor of or against a merger or buyout happening. When he started to broaden his approach to go after targets in an activist way (with a long-term time horizon for improving a company absent any specific "event"), he's run into problems. CSX has stiff-armed him to date in the U.S. and he's hit another brick wall in Japan with his investment in the utility J-Power.
Chris Hohn and TCI are still very successful, as their Barron's hedge fund ranking shows.

However, they've made several mistakes in the CSX battle which they -- and other activist investors -- should learn from for future campaigns:

- A battering ram approach that is publicly critical of targets can be very successful in an event-driven context but does not always work in activist situations. Negotiation, diplomacy, cajoling, humor and tact are just as important when meeting with an activist target as the threat of "going negative" in a public battle. TCI's successes in the activist realm will increase as they demonstrate their abilities in these softer skills.

- Avoid inconsistencies. This applies to politicians and activist investors alike. Your words can be easily used against you by your opponents in a debate, so don't give them any ammunition. Activist investing requires a lot of up-front work in selecting targets and the kinds of actions you think would create value if implemented. If you advocate changes that come across as potentially weakening the company in the long-term (such as taking on significant debt), expect a tough time convincing your fellow institutional and pension fund investors to go along with your prescriptions.

- CSX didn't exploit this, but TCI initially disclosed in October that it held "shares in other US railroads but has not had to launch similar campaigns there because managements have been more co-operative." If I was a CSX shareholder without holdings in CSX's competitors, this would be a red-flag. It says to me that the company has mixed motives -- even if it doesn't. Activist investors need to avoid any perceived conflict of interest and should therefore avoid investing in competitors.

I would bet that CSX will likely prevail in the June proxy battle for the same reason that Motorola's investors refused to embrace Carl Icahn in his first attempt at a board seat last year. On top of that, CSX's relative performance to its peers and the market has been good in recent years. It's tougher to rally the troops in opposition to management when that investment is one of your better performers.

If his proxy fight fails at CSX, Chris Hohn will then have to decide whether to stay on as an investor and look to fight another day or cash in his winnings and move on. Activist investing is still a place which allows the "loser" to walk away with a 30% gain. That should help nurse TCI's wounds.

At the time of publication, Jackson was long MOT.

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

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