APRIL 2010

Hedge fund activists 2.0: They are back!

Creating value through pro-active strategies in response to
hedge fund activism

Marc Zenner
marc.p.zenner@jpmorgan.com
(212) 834-4330
Henry Gosebruch
henry.gosebruch@jpmorgan.com
(212) 622-2299
Tomer Berkovitz
tomer.x.berkovitz@jpmorgan.com
(212) 834-2465

HEDGE FUND ACTIVISTS 2.0

1. Hedge fund activism 2.0: Ripe for resurgence

Times are a-changing: Three years ago, hedge fund activists were making the front page of

the Wall Street Journal almost on a daily basis. Unprecedented liquidity in the credit markets
allowed hedge fund activists to acquire material stakes in both large and small companies. A
testimony to the success of activism was the growth in activist hedge funds assets under
management, which increased from about $20bn in 2004 to almost $55bn in 2007 (Figure 1).
The burst of the credit bubble and the beginning of the recent financial crisis, however,
brought the wave of activism to an end. Capital markets shut down and the attention of
investors and companies shifted to liquidity and survival. Without the support of active
capital and M&A markets, activism became a less visible part of the markets in 2008 and
2009. In turn, activist funds outflows in 2008 and 2009 equaled the inflows of the previous
four years. Times have rapidly changed. In the first quarter of 2010 there have been several
visible campaigns by Carl Icahn, Relational and others. Will more activism return to the
markets in 2010? With vibrant capital markets, record levels of corporate and investor cash,
impatient investors, and declining organic growth opportunities, we believe that the
conditions are ripe for a resurgence in shareholder activism.
Figure 1

Hedge fund activism in recent years

Activist funds have experienced significant outflows
Assets under management ($bn)
Net Flow of funds ($bn)

and have initiated fewer campaigns

Campaign letters
Proxy threats
328

$54.8

$47.5

293

$29.2

$32.3

292

$34.2

190

182

$19.5
$3.7

$3.4

$6.5

$3.5
48

($4.3)
2004

2005

2006

2007

2008

34

18
($12.3)
2009

Source: HFR Industry Reports HFR, Inc. 2010

2005

2006

2007

29
2008

17
2009

Source: FactSet and J.P. Morgan

Commentary

Hedge fund activism has declined precipitously over the last two years
Activist hedge funds have seen a net outflow of funds of over $16bn since the beginning of 2008
Assets under management have dropped by more than 40% since 2007

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Likely targets: During the previous activist wave, targets tended to display a number of

non-mutually exclusive characteristics: poor performance, excess cash, low leverage and asset
portfolios that could be reconfigured to create value. As firms focused on liquidity over the
last two years, they de-levered actively and cut back on capex, R&D and distributions.
Corporate cash balances are now at record levels. Interestingly, most large non-finance firms
have not taken advantage of this flexibility to buy cheap assets. Some activists might
suggest that they have maintained too much flexibility.
Common attack strategies: Activists are ultimately seeking to create catalysts to improve stock

price performance (most prominently a sale of the company). Activist attacks, however,
commonly center around a few themes designed to achieve that ultimate goal. These Trojan
Horse activist tactics might come in the form of demands in the following areas: (i) improving
governance practices or executive compensation (taking advantage of this popular theme in
the broader markets); (ii) optimizing portfolios (separating non-core assets, focusing on core
businesses); (iii) utilizing the balance sheet to return capital to shareholders; (iv) criticizing
announced M&A transactions (either ill-perceived acquisitions or a sale of the company at the
wrong price or time); or (v) suggesting operational improvements (benchmarking margins,
corporate spending, etc. against peers).
Offense is the best defense: : How should senior decision-makers and Boards of Directors

prepare for activism? We recommend a pro-active three-pronged strategy to engage the

Board in preparing for the new activism wave. First, the Board should be aware of the main
drivers of activism, be familiar with the key activist funds, and understand their tactics,
investment horizons, and common attack
strategies. Second, we recommend that
EXECUTIVE TAKEAWAY
the Board use our customized checklist
of likely activist issues relating to asset
Firms have accumulated record levels of cash
mix, operational performance, capital
while facing a sharp decline in growth
structure, excess cash, and distributions.
opportunities. The recent normalization in
We recommend that management
capital markets and M&A activity suggests that
regularly evaluate its financial and asset
activist hedge funds are poised to return from
mix decisions against this checklist. Third,
if the firm makes a pro-active decision
hibernation. Who will they target? What will they
regarding asset mix or financial policy, it
look for? What is the best defense?
should clearly communicate this decision
What is the best way to create long-term value in
to its investors.
this environment? Senior decision-makers
should anticipate that hedge fund activism will
be back, and they should pro-actively engage
the Board to consider potential vulnerabilities
and defense strategies.

HEDGE FUND ACTIVISTS 2.0

2. Back from hibernation in 2010?

Hedge fund activism comes in different shapes and forms, but it typically flourishes when
liquidity is abundant, capital markets are open, and markets for corporate assets are active.
From 2005 to 2007, for instance, the number of campaign letters and proxy fights almost
doubled as credit markets provided easy and cheap access to debt financing, equity markets
rallied, and mergers and acquisitions (M&A) activity reached record high levels.
The financial reality of the last two years, however, led many firms to shore up the balance
sheet to weather the financial markets storm. Challenging access to debt markets coupled
with higher risk premia and a massive flight to quality by equity investors, limited the
firepower of private equity and strategic buyers. The value maximization proposition of the
boom cycle years, which commonly incorporated higher leverage, increased shareholder
distributions, and asset sales/spin-offs was less appealing in 2008 and 2009. Many hedge
fund activists, struggling with significant net outflows and reduced leverage capacity, either
focused on smaller firms or adopted new strategies (e.g., investments in distressed firms).
Recently, many of the trends that drove hedge fund activists into hibernation have reversed
(Figure 2). Improvement in credit and equity markets, record levels of corporate liquidity
and private equity capital commitments, and investors who are refocused on shareholder
distributions and corporate governance, are expected to support the comeback of hedge
fund activists this year.

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Figure 2

Activists are coming back from hibernation

Why were activists in hibernation?

Why are they back?

Leverage

Focus on liquidity and balance sheet strength

Record levels of cash, cost of capital minimized at

lower rating compared to the peak of the crisis

Markets

Capital markets frozen and high cost of debt

financing

Improvement in credit markets, all-in debt yields

approaching historical lows

Distributions

Massive cuts in buybacks and distributions

due to focus on liquidity

Investors focused on distributions as capital gains

from growth are elusive

Spin-offs

Financial synergy benefits for large

diversified firms

Investors are more focused on corporate clarity

Asset sales

Private equity firms not getting leverage,

strategic firms concerned about their own
financial condition

Private equity has record high capital commitments,

strategic firms looking for growth through M&A

Operational
Benchmarking

Limited room for incremental operational

improvements as firms were already focused
on liquidity

Operational improvements enhance investor returns

in the absence of top line growth

Governance

Investors focused on survival and balance

sheet strength, less on governance

Investors and media are less patient with what they

perceive as poor governance

Source: J.P. Morgan

EXECUTIVE TAKEAWAY
The recent financial crisis led to a significant
reduction in hedge fund activism. As capital
markets continue to improve and investors shift
their focus from fortress balance sheets and
liquidity towards corporate governance, asset
portfolio mix, and shareholder distributions,
hedge fund activism is expected to re-emerge.

HEDGE FUND ACTIVISTS 2.0

3. Who are they? From the Icahns to Steel Partners

The universe of activist funds can be categorized in several different ways:
(1) Specialist vs. occasional: The specialists funds take a few large positions and generally

pursue activist strategies. Prominent firms in this arena include Tracinda, Relational, and
Icahn. At the other end of the spectrum are funds that occasionally become activists, but do
not always pursue such strategies. Examples include SAC, GAMCO, and Sandell.
(2) Sector specialists vs. broader economy: Sector specialists tend to focus on a limited
number of sectors. For example, Nelson Peltz focuses on consumer products and Pershing
Square focuses on retail. Other funds are generalists who look for ripe targets in all sectors
of the economy (e.g. Icahn, Relational).

(3) Large vs. small: The large funds are capable of taking on the largest targets (e.g., Icahn,
Pershing Square). Alternatively, mid-cap specialists may have long activism track records but
focus on small to mid-sized firms (e.g., Steel Partners, MMI).
(4) Common attack strategies: Certain

funds tend to use specific attack strategies

(e.g., Relational governance, GAMCO
shareholder rights plans). Most funds do,
however, tend to pick from the usual menu
of attack themes.

EXECUTIVE TAKEAWAY

The figure below includes a list of some of

the most dominant activists over the last
several years and how they fit into the
categories described above.

shareholder base against a long list of activist

While most executives recognize Carl Icahns name

and are likely to be familiar with his track record,
companies must carefully cross-check their

funds some of which may not have previously

made investments in the companys sector.

Figure 3

Who are the most dominant activists?

Profile of selected activists
Icahn
Led many of the landmark activist campaigns in recent years, mainly active in healthcare/biotech,
technology/media, real estate and natural resources

JANA

Not a pureplay activist, but conducted several high-profile campaigns, often in partnership with
other activists

TCI

Historically a European activist, TCI has also been active in US markets

Pershing Square

Traditionally focused in retail and consumer sectors, recently expanded to other areas including
real estate

Relational

Launched campaigns across a variety of sectors, including telecom, metals & mining, financial
services, energy, business services, and healthcare/biotech

Tracinda

Focused on value investing with interests in autos, oil & gas and casinos

Elliott

Particularly focused on distressed situations

Trian

Historically focused in operational activism in the foodservice, restaurants and consumer sectors

Knight Vinke

European activist hedge fund, mainly focused on the energy and financial services sectors

Atticus

Not a pureplay activist, but conducted several high-profile campaigns particularly in the metals &
mining, energy and financial services sectors

Source: J.P. Morgan

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4. Does hedge fund activism create shareholder value?

To gauge whether hedge fund activism creates shareholder value, we examine the market
reaction to shareholder activism. Existing research and our own analysis suggest that investors
have responded positively to shareholder value related activism. Activists intend to create
value in various ways, such as encouraging firms to increase shareholder distributions, change
their asset mix (sell non-core assets), or revise their capital allocation and M&A strategies.
To better understand the investor reaction, we studied the stock market performance of 85
targeted firms from 2005 to 2009. We focused on three time windows. The first window starts
a week before the first activism announcement and ends a day before the announcement.
During this window targeted firms outperformed the market by 2% probably because the
hedge fund was accumulating a stake during this period and/or information about the
forthcoming targeting was leaked out. The second window is around the announcement day,
when the targeted firms outperformed the market by 3.3%. The third window starts the day
after the announcement and ends a week after the announcement. During this time the
targeted firms continued to outperform the market by 0.7%. Overall, the targets
outperformed the market by 6.1%.
Figure 4

Market reaction to activism announcements

Market-adjusted performance1 following activist campaign announcement
6.1%

3.3%
2.0%
0.7%
(-5,-1)

(-1,+1)

(+1,+5)

(-5,+5)

85 Activist announcements (2005-2009), with target

market capitalization of at least $500mm
Only 10 announcements after the Lehman crisis
Total market-adjusted return of 6.1% in the two
weeks starting a week prior to the announcement
Stronger market reaction during 2005-2007
(6.8%) relative to 2008-2009 (4.3%)

Days relative to
announcement
Source: FactSet and J.P. Morgan
1

Market adjusted performance defined as company stock return less S&P 500 index return * company beta

EXECUTIVE TAKEAWAY
Our analysis and other research suggest that, on
average, equity investors respond positively to
hedge fund activism. The overall gains appear to be
around 6%. There is scant evidence that targeted
firms were forced to make decisions that help in the
short term but hurt their performance during the
recent financial crisis. There is, however, much
evidence that firms with liquidity and fortress
balance sheets outperformed during the crisis.

HEDGE FUND ACTIVISTS 2.0

5. Activists vs. long-term shareholders: different goals

and incentives
Hedge fund activists often adopt investment tactics that diverge from long-term shareholders.
A shorter investment horizon, higher leverage, and the use of financial derivatives suggest a
return profile that favors myopia, volatility and a greater appetite for risk.
While activists obtain significant influence on a firms financial strategy by acquiring voting
rights through common stock, some activists complement their holdings with call options
and/or total return swaps. Figure 5 demonstrates how the return profile of a call option holder
differs from that of a common shareholder. Stock options tend to have a short maturity,
provide levered returns, and benefit from increased volatility. As a result, activists could favor
a risky financial strategy which may drive high returns in the short term but destroy long-term
value (e.g., excessive leverage during boom years). This phenomenon is particularly
pronounced in cyclical sectors, where long-term shareholders experience the full business
cycle while activists exit after only a few months.
Figure 5

Activists vs. long-term shareholders

Horizon

Illustrative Return Profile

Equity holder
500%
400%
300%
200%
100%

Option holder

Activists maximize returns over the short term

Activist hedge funds often purchase short-dated call
options on a stock before initiating a campaign
Activists typically hold shares for 12-20 months
Leverage

Activists boost returns through three layers of leverage

Fund level: hedge fund utilizes its own debt capacity
Security level: leverage embedded in stock options
Company level: often encourage companies to increase
leverage and shareholder distributions

0%

Volatility
-100%
-200%

Higher expected volatility increases the value of a call option,

but may not be consistent with long-term value creation
Asymmetric payoff for option holders vs. shareholders
More pronounced for at-the-money options

Source: J.P. Morgan

EXECUTIVE TAKEAWAY
Boards and senior management should be
aware of the different investment horizon and
return profile that hedge fund activists may
have relative to long-term shareholders.
Understanding activists goals and incentives can
help in evaluating proposed strategies to ensure
they do not only boost short-term returns, but
also maximize long-term shareholder value.

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6. Who are likely targets?

There is not much debate about the characteristics of firms targeted by hedge fund activists.
Hedge fund activist targets tend to have poor stock returns and depressed valuations. In
addition, activist hedge funds focus on firms with disparate asset portfolios or lazy balance
sheets. Amongst firms with these characteristics, the most likely targets are small to
midsized firms and firms with relatively diffuse share ownership.
Figure 6

Who is a likely target of hedge fund activism?

Target characteristics relative to peers

Performance

Poor performance and low valuation metrics relative to peers

Capital structure

Low leverage, but substantial debt capacity

Distributions

Steady cash flow, but low shareholder distributions

Asset mix

Diverse set of assets, but strategic fit can be challenged

Ownership

Diffuse ownership, high institutional ownership, liquid stocks

Governance and size

Small to midsize, poor governance (e.g., more takeover defenses)

Source: J.P. Morgan; Hedge Fund Activism, Corporate Governance, and Firm Performance, Journal of Finance, 2008

EXECUTIVE TAKEAWAY
Likely targets of hedge fund activism tend to
be poorly performing firms with significant
financial flexibility including excess cash,
unused debt capacity, and non-core assets.

HEDGE FUND ACTIVISTS 2.0

7. Being pro-active and preparing the Boards response

to activism
A pro-active strategy is superior to a re-active strategy. Senior management should discuss
hedge fund activism targeting risk with the Board on a regular basis. To facilitate this
process, we have provided a checklist of discussion points. We suggest a pro-active value
maximizing strategy, which includes enhancing Board awareness to hedge fund activism;
identifying potential threats and vulnerabilities; and revisiting the firms asset portfolio,
capital allocation process, capital structure, and shareholder distribution strategy.
Figure 7

Checklist for preparing your Board for shareholder activism

 Board awareness

Explain to your Board why activist hedge funds are likely to re-emerge
Discuss whether any of your peers have been recently targeted

 Shareholder structure

Review key shareholders and their expectations

Flag any potential activist shareholders

 Asset portfolio

Has the strategy for non-core assets been communicated to the market?
Are there likely buyers for these non-core assets today?
Communicate to the Board areas that may be targets for acquisitions

 Operational benchmarking

How do you compare to peers from an operational perspective?

If you are an outlier, are the underlying reasons well understood?

 Capital structure

Review current capital structure strategy and compare to peers

Can an argument be made that more leverage would enhance value?

 Distributions

Review current distribution strategy and compare to peers

What are the good reasons for distribution levels that are lower
than peers?

 Public relations

Have you effectively communicated your financial policies to investors?

How is your firm viewed from an environmental and stakeholder
perspective?
Prepare for a more pro-active public relations campaign

Source: J.P. Morgan

10

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We strongly believe that it is critical to communicate key financial policies clearly and
effectively to investors. Adopting a value creating strategy only due to public pressure by
activists may reflect poorly on both the management and the Board or may suggest that the
strategies have been adopted to benefit only a small, yet vocal, subset of shareholders. We
have developed analytical tools to
evaluate the appropriateness of various
EXECUTIVE TAKEAWAY
financial strategies, the firms competitive
Senior decision-makers should adopt a
positioning, and the firms likelihood of
being the target of hedge fund activism.
pro-active strategy against hedge fund
activism. Management teams and Boards of
Directors should regularly assess the type of
value enhancing financial policies that hedge
funds tend to propose. Effective
communication to shareholders about these
decisions is also paramount to creating
long-term shareholder value.

HEDGE FUND ACTIVISTS 2.0

NOTES:

11

12

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NOTES:

We would like to thank Akhil Bansal, Ben Berinstein,

Cassio Calil, Lowell Caulder, Andy Chi, John Clark,
Kelly Coffey, Evan Junek, James Rothschild, and
Chris Ventresca for their invaluable comments and
suggestions. We would like to thank Anthony Balbona,
Jennifer Chan, and the IB Marketing Group for their
help with the editorial process and, in particular, we
are very grateful to Carlo Padovano for his invaluable
contributions with the analytics in this report and his
many insights.

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