Hedge Fund Activist Basics
Shareholder activism in the UK is when minority shareholders (often hedge funds) exercise and enforce their rights with the aim of increasing shareholder value over the long term.
What is shareholder activism?
Hedge-fund activists aren’t the first hard-nosed investors to kick up a stink about the way under-valued, mismanaged companies are run but they have become enormously effective. Market statistics paint a powerful picture of their activism, with a huge wave of hedge funds now engaged in a day-to-day struggle with the corporate elite.
Between 1994 and 2006, the number of public firms that hedge funds targeted for poor performance grew more than 10-fold (from less than 12 to over 120).
Hedge funds don’t engage in activism because they’re good guys – far from it! Hedge-fund activists want to buy the shares of a company because they think those shares are cheap. If all goes well, and the judicious application of lobbying, legal threats, PR campaigns and the occasional whiff of mental intimidation(!) pays off, the firm’s shares increase in value substantially.
Hedge-fund shareholder activists typically rely on the so-called value approach when identifying their targets, forming in effect a subset of hedge funds that invests in equities in a manner akin to classic, value-orientated investors; that is, they look to increase the intrinsic value of the company’s shares. This value-investing approach usually means that investors buy a company with a decent balance sheet, sound cash flow and a cheap share price.
Evolving shareholder activism over time
In the 1970s and 1980s, a whole generation of corporate raiders thrilled the US media, publicly duelling with a star-studded list of the top corporate names in the US business scene. These raiders would buy large numbers of undervalued shares in companies, thus securing significant voting rights that enabled them to force a company to change leadership, management or structure in order to increase the share values.
But this confrontational activism alienated many investors and thereafter a subtler form of activism began to emerge. In particular, many big institutional funds noticed that, when a corporate raider turned up on the scene, frequently the raider pocketed most of the gains from shaking up a company and not the fund!
This anxiety spawned a more consensual activism that consisted of encouraging the management of a company to change direction, cut costs, scale back expansion plans and return money to the long-suffering shareholder base through share buy-back offers or increased dividend payments.
Leading US pension funds (such as the Californian state scheme Calpers) also muscled in on this game, sometimes working on their own to change companies, sometimes partnering up with other funds including private equity houses.
Although similar in some ways, private equity firms typically invest in companies over longer time periods – three to seven years, for example – with the intent of increasing the value of the company’s assets and, therefore, the profit made by the firm’s investment.
Hedge funds, on the other hand, generally invest in securities solely to make money from the change in the asset’s price, without any major intent to change the structure or profitability of the company itself, and therefore hold the assets for much shorter periods of time, sometimes for seconds or fractions of seconds.
This pension-fund activism popped up in the more conservative City of London as well. The pension fund for what used to be called British Telecom (BT) was and is self-managed by a company called Hermes, and over the last 30 years its UK-focused fund has been especially active, cajoling and jostling company CEOs to do the right thing and change the direction of their company.
That approach certainly paid off for BT pensioners and the UK fund has produced an annual return of 8.2 per cent for the last 20 years – a good 4 per cent per year more than you’d expect from investing in the FTSE All Shares index.
As a guide to what activists look for in a target company, the BT Hermes UK fund has three selection criteria for picking the companies in which it invests. It asks:
Is the firm underperforming?
Does the fund believe it can engage with the company’s management successfully?
Does the fund expect to obtain at least 20 per cent more value over the current share price?