Highfields Capital Management makes an unsolicited $3 billion offer for Circuit City. TCI Fund Management sparks a shareholder revolt that scuttles the Deutsche Börse’s bid for the London Stock Exchange. Lawndale Capital Management intervenes with the SEC to suggest that Sparton Corp. may have improperly held open the polls until the contract electronics manufacturer got the vote it wanted from shareholders.

Highfields? TCI? Lawndale? Corporate executives could be pardoned for stealing a line from Butch Cassidy and The Sundance Kid: “Who are these guys?”

Welcome to the Age of The Hedge Fund, a unique era in corporate influence in which new and largely misunderstood market forces have already demonstrated an uncanny ability to grab the attention of boards of directors. And while we’re still in the era’s early “Jurassic” period, it’s likely that the Age of The Hedge Fund will create interesting challenges and opportunities for public companies.

Watching Like A Hawk

Despite the incredible depth of passion surrounding the very words “hedge fund,” the fact is that these funds are far from monolithic. But one thing is certain: Hedge funds are proving to be entirely different from more familiar “CalPERS-style” activist investors.

To begin, hedge funds are paid a variable success fee on a portion of their profits, which fundamentally changes—and should change—how they behave. Performance fees mean that hedge funds are paid to think like owners; they are motivated to maximize absolute returns. By contrast, most conventional fund managers aim for relative performance—that is, beating peers or a benchmark.

There are, of course, myriad ways hedge funds aim for absolute returns. But, one possible result of not being constrained by keeping an eye on an index like the S&P 500, is that hedge funds can take concentrated positions in fewer companies. In effect, instead of mitigating risk by not putting all their eggs in one basket, concentrated hedge funds put all their eggs in just a few baskets and watch them like a hawk. This means they are more likely to have deep knowledge of your company than a mutual fund manager. And that, in turn, means they may have opinions about how your company should be run, what its capital structure should look like, and who the CEO should be.

Moreover, the concentrated position means the market return of your company’s stock has a larger effect upon the hedge funds’ performance than it would in a diversified, benchmark-oriented portfolio. So, a hedge fund with a concentrated position in your company’s stock has both the knowledge and the motivation to get involved. Sometimes that involvement means patient shareholding and engagement—even to the extent of joining corporate boards. And sometimes it means “going hostile,” as in Highfields’ bid for Circuit City.

Interstitial Tissue

Of course, not all hedge funds take concentrated positions; indeed, hedge funds are nothing if not diverse in how they search for returns. Some are short-term and trading-oriented, while others offer extraordinarily long and stable shareholder capital. Some are specialists in short selling, while others are long-only players. Some stick to secondary trading, but others do direct deals and provide capital at terms and conditions—and with a speed—unavailable from traditional financing sources.

In fact, when it comes to hedge funds, only one fact is universally true: You ignore them at their own risk. They wield a jaw-dropping $1 trillion in equity assets (which they then leverage), while operating with fewer restrictions than commercial banks, investment banks, private equity funds, and asset management companies. Plus, they increasingly demonstrate an appetite to compete with all those institutions. In effect, hedge funds have become the interstitial tissue filling all the underserved niches in the capital markets.

For corporations, that means both danger and opportunity.

Companies in the midst of transaction have long had to consider the hedge fund effect, as the funds have been major players in the mergers and acquisition markets for years. Traditionally, that trade was simple: taking long positions in the target company and shorting the stock of the predator. Those merger arbitrageurs earned the spread between the stocks of the two companies as they converged. Recently, however, the low interest rate environment—combined with acquirers being more judicious in the premiums they offer—has downsized that premium, leading some merger arbitrageurs to agitate for “topping bids”; that is, they actively seek to better the announced terms. Sometimes, that agitation involves merely saying “no” to a perceived low-ball bid, but sometimes it means putting the company in broader play. It was no accident that the loudest early cry against the original MCI/Verizon deal was from Paulson & Co., a leading merger arbitrageur firm.

Another recent—and important—development is the increasing propensity of hedge funds to blur the lines between themselves, private equity funds, commercial banks and investment banks. This creates real opportunities for corporate executives, particularly CFO’s of smaller firms, who may be able to gain financing from hedge funds—financing that has been unavailable from traditional sources.

Consider the Laurus Funds. Laurus has popularized the use of asset-based convertible lending—asset-collateralized, shorter term, floating-rate instruments that are convertible into stock of publicly-listed, small-cap growth companies. Though organized as a hedge fund, it more resembles a merchant bank. Indeed, its Web site calls many of its employees “investment bankers/originators,” and describes the firm as “a financial institution that makes direct investments in US listed small and micro cap companies, ” rather than a hedge fund. Thus far, its financing strategy seems to be extraordinarily successful for both the firm and its clients; a number of companies have done multiple financings from the firm, and investors have been giddy with its double-digit gains.

Fastest Guns In Town

A word of warning, however: There is danger in every opportunity, including innovative financing. Just ask those unfortunate executives who arranged poorly designed first-generation PIPEs (private investment in public equity securities). Effectively, those companies sold equity to hedge funds in private transactions, and “guaranteed” the value of the equity with more equity, should the share price drop. Of course, if the price dropped enough, the structure created a “death spiral” of dilution. In some early situations gone bad, market rumors circulated that the buyers of the PIPEs had conspired with other hedge funds to short the stock of the companies, creating the death spiral, thereby enabling the PIPE buyer to control the assets of the company for very little capital.

Being forewarned, however, should enable corporate executives to use hedge funds’ abilities to their advantage. Reputable hedge funds have benefited companies by allowing them to access capital at terms and conditions unavailable from traditional sources. “Credit opportunity funds,” for example, have provided everything from privately-placed senior debt to equity. Indeed, hedge funds have done deals as diverse as financing the transfer of industrial looms from North Carolina to China, creating pre-packaged convertible bond offerings placed through investment banks in Canada, and syndicating a complete financing package to enable a food distribution company to restructure without going through bankruptcy.

So, corporate executives can be excused for asking, “Who are these guys?”—the variety of hedge funds is not simple to understand.

But it’s imperative to do so. Hedge funds exist—they’re not going away. They influence all the capital market players. They have as much ammunition as some of the biggest traditional institutions. They’re innovative. And they have fewer rules, so their “ammo” can be deployed quickly.

They can help you or hurt you; after all, as good as Butch Cassidy and the Sundance Kid were, we all know how that movie ended.

Getting hedge funds—the new fastest guns in town—on your side is one major step toward making sure you don’t end up the same way.

This column solely reflects the views of its authors, and should not be regarded as legal advice. It is for general information and discussion only, and is not a full analysis of the matters presented.

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