As Activist Hedge Funds Boom, 'Hushmail' Takes Hold

Jun 26 2014 | 12:13pm ET

Activist hedge funds have been around for about a decade and their modis operandi has not changed dramatically in that time: buy a significant stake in a company, agitate for change, realize profits, repeat.

What has changed is the number of such investors: according to data provider Preqin, there are now over 400 activist hedge funds worldwide. Moreover, 2013 saw the launch of 28 new activist funds, the highest number of launches since 2007.

And the ranks of activist hedge fund managers are unlikely to shrink anytime soon—their assets are $100 billion and growing, according to Hedge Fund Research, and of the $6.5 billion investors poured into event-driven funds in May of this year, eVestment said a full $4 billion went to activist strategies. Better still, institutional investors are beginning to look at activist funds—at least in North America, which Preqin says accounts for 90% of all institutional interest in activists.

Driving this increased attention is performance: activist hedge funds have been outperforming the broader hedge fund industry, generating average cumulative returns of 11.82% for the 12-month period ending April 30 compared to 7.88% for the average fund. They have also outperformed the broader industry on an annualized basis over two, three and five years, according to Preqin.

Mind you, on a risk-adjusted basis, that picture is less rosy: the three-year Sharpe ratio for activist hedge funds was 0.52 as of April 30 compared to 0.77 for hedge funds overall, according to Preqin.

But the outsized results of some of the better-known activist managers and the aforementioned interest from institutions will ensure the field remains a lively one.

Botox

This past year has certainly been lively, marked by interesting developments involving some of the biggest names in hedge fund activism—think Pershing Square's Bill Ackman, think Third Point's Daniel Loeb.

Ackman's headline-generating campaign against Botox-maker Allergan, for instance, is interesting in part because he has teamed with a corporation, Valeant, to achieve his goal. That's something new in the activist universe, according to Spencer Klein, M&A practice co-chair at Morrison & Foerster.

“It's a bit surprising,” he told FINalternatives in a recent phone interview, although not necessarily indicative of a trend:

“I think it's a bit of a unique circumstance to some degree. Valeant has been a relatively aggressive corporate acquirer and a lot of the companies that it has looked at are perceived by Valeant to be mismanaged with cost structures that are not justifiable. In some ways, that's a very sympathetic perspective relative to a hedge fund activist. You would hear Ackman saying exactly the same thing about a lot of the companies that he invests in. So I think there's a common perspective that Valeant shared with Pershing that won't often repeat itself.”

Pat McHugh is a senior managing director at Okapi Partners, a proxy solicitor that works with both activist managers and target corporations. He told FINalternatives that while “a lot of people are watching this one to see if it works out and if it is going to be a viable option going forward...I think it's important that you have comfort with your partner and feel you can work with them because it would almost seem at a certain point there's a potential for a divergence of interests in that situation.”

Or, as Klein put it, “there's a little bit of a fox-in-the-hen-house concern and I think it would drive most companies away from affirmatively partnering with an activist investor.”

Two-Tiered Shareholder Rights

Another recent high-profile activist campaign with a twist was that of Daniel Loeb's Third Point against  Sotheby's auction house.

To head off what it perceived as a threat from Loeb, Sotheby's introduced a special two-tiered poison pill that triggered at 20% for passive investors and 10% for activists. Sotheby's, said Klein, was not the first company to try such a defense—perhaps a dozen or more companies have employed it—but Loeb was the first activist to challenge it.

“Historically, poison pills have not discriminated between and among shareholders based upon their purpose or their type of investment,” said Klein. “This poison pill that was adopted by Sotheby's is part of a trend in which companies have adopted similar poison pills that discriminate based upon who the shareholder is...”

Loeb applied for a preliminary injunction against Sotheby's.

“The core of the Third Point argument was that either a 10% holding is a threat or a 20% holding is a threat and it's not reasonable for you to take these kind of actions against one group at 10% and another group at 20%,” said Klein. “It wasn't a winning argument.”

The court said that were the case to proceed to trial, it would likely rule that Sotheby's defensive measure satisfied what is known as the Unocal test for Delaware companies. The Unocal test, which dates to a 1985 court case and is “the seminal case on defensive actions,” according to Klein, has two prongs:

“There has to be a legally recognizable threat to the company and the response, the defensive action, has to be proportional or reasonable in relation to that threat. So the question that was being dealt with in this case was whether or not there was a threat that was being posed by Third Point, and whether this two-tiered poison pill was a reasonable response to that threat. And the court...said that they would likely conclude if it were on trial...that the board satisfied Unocal.”

Hushmail

Another interesting development on the activist front is the rise of “hushmail”—the term given to the phenomenon of activist investors seeking to sell their stakes back to target companies.

In a recent client alert, law firm Latham & Watkins likened hushmail to the “greenmail” phenomenon of 30 years ago:

“During the heyday of takeovers in the 1980s, so-called corporate raiders would often amass a sizable stock position in a target company, and then threaten or commence a hostile offer for the company. In some cases, the bidder would then approach the target and offer to drop the hostile bid if the target bought back its stock at a significant premium to current market prices.”

Hushmail, the 2014 version of greenmail, owes its name to Texas businessman (and failed presidential candidate) H. Ross Perot, who coined the term to describe General Motors' offer to buy his GM stock at a premium if he agreed to stop badmouthing GM management.

An activist hedge fund may be tempted to resort to hushmail if its agenda has failed and it wants out of an investment but doesn't want to risk damaging share price by dumping its entire holding all at once.

Exiting is even trickier for activists who have won seats on the target company's board, writes Latham & Watkins, “because insider trading policies and SEC rules may significantly restrict their ability to dispose of shares quickly.”

So to exit rapidly (and at the highest possible price), the activist may try to get the target company to buy back its stock, usually at a discount to the current market price, but sometimes at a premium.

“As part of the purchase agreement, the activist may enter into a standstill and non-disparagement agreement with the target. If the activist has representatives on the board of the target, the representatives typically would resign their director positions after the repurchase, given the activist’s lack of ongoing economic interest,” says the report.

As one of what they describe as “numerous” examples of companies buying back stock from activist investors, the report's authors cite the case of KSA Capital. In April 2014, KSA sold a 9% block of shares back to AEP Industries at a 4.5% premium, after which KSA still owned 21% of AEP's outstanding stock.

As part of the deal, KSA “signed a two-year standstill and non-disparagement agreement with AEP, and agreed to vote its remaining block in favor of director nominees nominated by the AEP board at the next two annual meetings of stockholders.”

Such deals are entirely legal but, as  Latham & Watkins suggest, can do serious damage to an activist's reputation, given that an activist's entire raison d'etre is supposed to be safeguarding shareholder value.

“An activist investor who seeks a hushmail buyout can fairly be said to be putting the activist’s short-term interest in liquidity ahead of the interests of other stockholders, who are not offered the same deal,” write Latham & Watkins.

In doing so, activists risk “being painted as villains rather than heroes.”


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