It's no secret that hedge fund activism is on the rise—stalwarts like McDonald’s, Time Warner and Circuit City have been targeted by activist funds in recent months. Now, for the first time, a report describes the types of companies most likely to be targeted by funds, and outlines steps for preempting the wrath of highly vocal and impatient investors.
The Citigroup report, “Hedge Funds at the Gate,” offers a timely guide to help executives understand the implications of these new active investors. “As their initial activists efforts have proved profitable,” notes the report, “we expect the trend of hedge fund activism to continue and even grow in the coming months.”
Citigroup analyzed 31 companies that were involved in hedge fund activism campaigns over the last year to devise a generic profile of target companies. Below is an outline of Citigroup’s analysis:
Small Company Size
Despite the few attention-grabbing names, taking stakes in smaller companies is less expensive and easier than in larger ones. As a result, the median market capitalization of targeted companies is about $780 million. This compares with the $2 billion median market capitalization for companies in the S&P 1500.
Goldstein
According to Phillip Goldstein, the founder of Bulldog investors—which operates the activist Opportunity Partners fund—small companies have two qualities that make them undervalued and hence good targets. “They are under the radar screen of analysts and do not appeal to institutional investors,” Goldstein told Compliance Week.
Warren Lichtenstein of Steel Partners II, one of the most active hedge funds, recently told Compliance Week that, “there are tons of inefficiencies in microcaps. No analyst coverage and a lot of value.”
Jeff Ubben, founder of ValueAct Partners, adds that the very fact that “passive mutual funds are the owners of larger companies is what presents the need for active investors.”
The small target size maybe deceiving, though, as the report appears to have left out some of the largest hedge funds—such as such as D.E. Shaw and Cerberus Capital Management—which typically have assets under management exceeding $10 billion. These largest “mega” firms, which are involved in multiple hedging strategies, have bought control of a number of large companies recently, and are increasingly acting like their private equity fund cousins (see related article below, right).
With over 8,000 hedge funds existing today, the report notes that the barriers to entry in the business are relatively low. This means that new players can launch and become activist investors quickly, and—with relatively little capital—these startups will tend to target smaller size firms. Indeed, in the late 1970s, Carl Icahn made his grand entrance by targeting a slumping real estate investment trust with less than $100 million in assets.
Excess Cash
The report found that target companies have about twice the level of cash held by the median S&P 1500 company, and more than 120 percent more cash than the median company in their industry.
Surplus cash, “does not necessarily reduce the firm’s risk profile or improve its credit ratings, but it clearly reduces the firm’s return on invested capital,” notes the study. And a low ROI is a red flag.
Unutilized Debt Capacity
While having too much cash on the balance sheet is one red flag, not taking advantage of a firm’s debt capacity may be another. If doesn’t increase financial distress, swapping expensive equity for inexpensive debt can lower a firm’s cost of capital. And taking on additional debt to buy back stock can create immediate value for shareholders.
Stock Price Or Earnings Underperformance
Compared to the S&P 1500, which has a median market-to-book value of 2.4, Citigroup says the ratio for hedge fund targets is 1.7. Relative to their industry peers, target firms trade at an average valuation discount of about 30 percent relative to their peers.
This ratio highlights the fundamental premise of activist investing: that prodding the target company’s management and board to change financial or operating practices will raise the share price. As such hedge fund activists are ostensibly today’s “value investors.”
Discrepancies Between Asset Value And Market Value
Sectors such as retail, and exploration and production, have received significant hedge fund attention. Some funds and analysts believe that’s because the market miss-prices part of the value of these assets. The solution: capture “hidden value” by encouraging management to make certain strategic changes (e.g., spin off real estate).
Preempting Hedge Fund Activism
According to the Citigroup report, suggestions for keeping off of an activists’ radar screen include tackling issues that make companies targets—poor financial performance, too much idle cash, not enough debt on the balance sheet, and underperforming or undervalued businesses.
Another set of suggestions focus on investor relations and communications. As hedge funds can move rapidly in and out stocks, companies need to more actively monitor their investor base. To prevent surprises, not only should shareholders be tracked, but also debt and convertible securities holders.
The authors also recommend “maintaining a pro-active, vocal, and constant dialogue with investors.” Well-informed shareholders tend to have more trust and confidence in management, and thus, make for more passive, longer-term oriented investors.
Finally, in a suggestion that may irk corporate governance purists, the report recommends that companies should have “up-to-date structural defenses” to combat activists who are set to mount a proxy contest or hostile acquisition.
Interestingly, the report doesn’t identify the absence of any corporate governance practice as an attribute of targets. This is consistent with the view of Michael McConnell, the managing director of activist fund Shamrock Holdings, who recently told Compliance Week, "I don't think governance in or of itself will add cash to a company's coffers” (see related coverage above, right).
Still, for Goldstein of Bulldog Investors, to be successful, “hedge fund activism requires a value creation opportunity and the ability to unlock it.” An important attribute in his activist calculus is the shareholder base; companies such as Dow Jones and Cablevision, with super-voting stock held by families, close off opportunities for active investors to gain meaningful control.
What the report makes certain is that today’s business environment is highly conducive to hedge fund activists who “have more money and a shorter time horizon than the hostile raiders of the 1980s.”
How much money? According to Josh Rosenberg at Hedge Fund Research, “Total assets available to firms known to execute this brand of investing is close to $50 billion, or 5 percent of the roughly $1.08 trillion hedge fund industry.”
And that money, the Citigroup report asserts, may increasibly be deployed against the most vulnerable, small, underperforming public companies with excess cash on their balance sheets.
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