James Williams, Hedgeweek

Short-term activism could wane once rates start to rise


The US has seen a real resurgence in activism over the last couple of years. Last year, for example, there were 247 activist campaigns; the highest number since 2008 when 284 were recorded according to FactSet data. 

Over the last 10 years, assets in activist hedge funds have grown six-fold to an estimated USD120 billion according to a report by AIMA, written in conjunction with law firm Simmons & Simmons. And investor interest continues to build. 

This is being helped, in part, by the strong performance of this sub-set of the hedge fund universe. According to Hedge Fund Research, the HFRI Fund Weighted Index (a global benchmark of hedge fund performance) has returned 5.33 per cent over the last 12 months. By comparison, the HFRI Activist Index has returned 12.09 per cent. 

According to eVestment's February report, activist hedge funds accounted for almost all of the USD2.6 billion in new assets in February that flowed into event-driven hedge fund strategies, of which activism is a sub-set. Indeed, a paper produced last year by Schulte Roth & Zabel LLP in conjunction with Mergermarket, entitled "Shareholder Activism Insight", found that an astonishing 98 per cent of corporates and activists in the US and Europe expected the volume of shareholder activism to increase "over the next 12 to 24 months". 

Eleazer Klein is co-head of the Global Shareholder Activism Group at Schulte Roth & Zabel. He comments: "Shareholder activism continues to be on an upward trend. I think this is due to a confluence of different factors including more capital flowing in to the space and the growing recognition that activism is a legitimate asset class. 

"We have a UK and European activism practice where activism is more slowly accepted than in the US and Canada where it is recognised as a legitimate tool when dealing with companies. However, as activism continues to grow and become more accepted, we should see the evolution of the strategy with institutional investors getting more comfortable putting pressure on companies." 

One sign that a strategy is flourishing is the amount of new talent coming to market. The likes of Bill Ackman at Pershing Square Capital Management and Paul Singer at Elliot Management are well-established big-hitting names. But a raft of new managers – some with decades of experience just not in running their own fund – are building strong reputations and giving investors plenty of options when it comes to capital allocation. 

One of those newer managers is Connecticut-based Lone Star Value Management LLC, set up by Jeff Eberwein in 2013. Eberwein has a rich pedigree, having worked as a portfolio manager for Soros Fund Management and Viking Global Investors. Although neither are traditional activist shops, Eberwein had a reputation for hands-on value investing. 

"I would typically meet management and board members and would often write letters to the management and board on topics such as dividend policy, acquisitions, stock buybacks. We wouldn't make those letters public however," says Eberwein. "I left Soros at the end of 2011 and had a 1-year non-compete. I started Lone Star Value Management in 2013 and the fund officially launched on 1st October 2013."

Eberwein looks for deep value situations. During 2012, and free to invest his own personal capital, Eberwein ended up joining the boards of five different public companies. 

"A few large shareholders at these companies thought it would be helpful to add someone with experience on Wall Street to the board. So I was already thinking about starting my own activist fund in 2012, focusing on small-caps because you can really get close to management and help steer the direction of a company. I bought stock in the five companies whose boards I sat on and I rolled those positions, along with external capital, into the fund when it launched a year later," recalls Eberwein. 

Another US activist manager, which has also been operating for the last couple of years, is Philadelphia-based The Horton Fund, run by industry veteran Joe Manko. The name of the fund comes from the Dr Seuss books. One of the characters is Horton the Elephant who hears the cry of a speck of dust and places it on a red clover for safety. "The idea of the Horton Fund was to look for companies that no one else can see because we've always got our ear to the ground," says Manko. 

"We are a collaborative activist fund that focuses on small and micro-cap stocks; good companies trading at cheap valuations that need help to increase in value and attract bigger investors. They tend to fall beneath the radar and aren't covered by sell-side research teams. Our philosophy is to seek out the gems."

Some commentators believe that the energy sector in particular could yield such gems given the dramatic drop in the oil price since the summer of 2014. One of Eberwein's core areas of focus happens to be energy. He notes that between October 2013 and September 2014 performance in the fund was strong, but in the last 12 months it has been slightly more challenging. 

"Activism is very much a bottom-up company specific exercise. Whenever the oil price drops 50 per cent, however, no amount of activism is going to help push the stock price up if it's an energy company," says Eberwein. "We had three or four years where the oil price was around USD100 and if you looked at the energy sector you could find a stock that was up 50 per cent and another stock that was down 20 per cent. Most of the time in energy, even though everyone obsesses over the oil price, the company specifics are the most important factor; what management teams are doing. And activism can be useful because many of the top CEOs aren't great capital allocators.

"Their training is in petroleum engineering, geology, drilling, etc, and they rise to become CEO of an energy company and they aren't necessarily good at investing company cashflows for the long-term benefit. They don't really have the training to do that. There are plenty of companies in the energy space that are poor capital allocators. So I do think energy is a fertile sector for activism, in general, but not because of the falling oil price." 

Klein agrees. In his mind, the talk seems to be out of proportion to the reality in terms of what's going on in US energy. 

"Everyone's been saying that the sector is rife with activist managers; I haven't seen that yet. The problem with energy is that market prices are way down. That means that companies are making less money. It's not that there are necessarily major internal problems that need fixing; it's a market problem. There are going to be opportunities in any distressed area where companies need to consolidate or try to sell certain assets. I'm not suggesting that any distressed area doesn't represent opportunities for activists, it's just not an obvious play in my opinion because I don't see an abundance of clear fixes that an activist would be jumping on," says Klein. 

Activism is a polemic subject. There are critics who state that hedge fund activism is unhealthy because it focuses on short-termism and is all about generating maximum value for shareholders at the expense of all else; indeed Steve Denning, writing in Forbes in February 2015, highlighted what he called the seven deadly sins of activist hedge funds. 

"Investors should look at the manager's background; do they have a lot of experience in working with businesses? Are they willing to roll their sleeves up and get their hands dirty? In my space of the market, there is no such thing as short-term. We focus on collaboration, so you really have to build the trust of the management and have the same objectives when it comes to trying to improve the business. I often refer to the leverage of logic; if what you are proposing makes sense, chances are institutional investors will support you.

"But there are short-term managers. They see what the bigger activist funds are doing and call themselves an activist just because they support the big guys. A share buyback or special dividend might be good in the short-term and boost the fund's performance but is that really how the company should be looking to grow its business?" questions Manko.

According to Eberwein, activism can be split into two categories: financial engineering activism and true operating activism. 

"I regard myself as an operating activist manager because I'm chairman of the board of several companies and have changed management, got companies sold, changed strategies; basically a lot of the things you would see a private equity manager do. This is a more permanent opportunity set. There are thousands of companies out there. My portfolio is concentrated in 15 positions which I typically hold for two to three years so I only need to find four or five really good ideas each year. 

"Financial engineering is more temporary in nature. It has more to do with low interest rates and how much value you can create by goading management to buy back stock. At Lone Star, we look for small-cap stocks that are cheap and need to make dramatic changes to close the value gap; that's a long-term play," says Eberwein. 

There are activists that push for change just for the sake of it; their only agenda is to make returns and part of the criticism that people levy at activists is, `Are you trying to improve a company or are you just trying to make short-term returns?' There are, however, large well established activist managers who are well respected. Take Cevian in the UK; they are a highly regarded manager. They are very concentrated in terms of what they look for and quite often, companies welcome them when they show up. 

"There's a wide range of managers in the activism space, some more and some less experienced, and that's only going to continue as more and more people get attracted to it. The seasoned activist managers out there do, in my mind, bring real value to companies," argues Klein. 

Manko's approach is not to engage in fights with management when trying to initiate change. Given that the Horton Fund analyses a universe of some 3,200 companies, typically within the infrastructure, industrials, telecoms, and, to a lesser extent, medical technology sectors, if management aren't open to change "we quickly move on to the next one. We always look for like-minded people. We would regard ourselves as more of a European-style activist manager. Our aim is to buddy up with management and collaborate."

Eberwein is willing to go further. The fund's philosophy is to look for stocks that are cheap relative to the intrinsic value of the company – this could some sort of asset value, liquidation value, takeover value, private market value etc. The next question is to determine why the stock is cheap. Is it because management is doing something wrong? Do they have the wrong strategy? Are they destroying shareholder value? 

"I then think about how to close the gap between the intrinsic value of the company and it's share price and that's when I get involved with management. I try to also meet people on the board, explain what I'm seeing and why I'm investing. My preference is always to start off friendly and constructive. There are times when that works," says Eberwein. He says that it often doesn't, however, because management knows they are underperforming and they entrench themselves. 

"They keep the board stale and basically adopt a mindset of wanting to protect their empire. I then move in to phase two, which involves putting out public press releases to explain why I think a stock is cheap and here's what they should do. This second phase often yields results but if it doesn't I will reluctantly enter phase three, if there is no other way to instigate change, and that is to run a proxy battle. We had several proxy battles in 2014 and we won every one of them. Maybe it's a coincidence, but so far in 2015 we haven't run any." 

Most activist managers will look to engage on a private basis before they cross the 5 per cent ownership threshold to try to enact change. Sometimes they might want board seats, sometimes they push for share buybacks, spin-off divisions and so on. 

One evolutionary aspect that has led to the continued growth of activism, according to Klein, is that companies have become more sophisticated, by and large, in engaging with activists. 

As a result, they might agree to settle or come to some arrangement with an activist investor at the point where they still remain private; phase two that Eberwein refers to earlier. 

"If that doesn't happen, usually the next step will be to cross the 5 per cent threshold and go public with your position to up the pressure on the company. If that doesn't result in change, an activist might then put forward a slate of directors to get elected," says Klein. Asked whether he thinks the barriers to entry for new activist managers have risen, he responds: "I don't believe they have. There's so much interest in activism today that if you know what you're doing, or can convince investors that you have a valid campaign, you'll be able to raise assets because people better understand what activism is. 

"A number of years ago you needed 5 per cent, and preferably closer to 10 per cent, to garner enough credibility to conduct a campaign. That's not the case anymore. If your story is strong enough and people believe in what you're doing, you can do a campaign with only a 1 per cent stake in the company." 

Eberwein is in no doubt that activism has become more socially acceptable and that the trend will continue, not just in the US but globally. "I do think the financial engineering aspect may wane, however. It's more a function of the low interest rate environment we've been in," suggests Eberwein.

As a final word of caution to investors – and managers thinking of entering the activism space – Manko offers the following concluding remark: "Activism is a lot harder than some people anticipate. There are some companies who need a kick, but activism is not a publicity game. And I think some managers think that it is. A good manager is one who is willing to do the hard work it takes to be successful."

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