Variance Capital Newsletter

Activist investors have been touting new funds of late to benefit from what they claim is an enhanced opportunity set in big cap equities. The new launches come as activists experience a tough few months. Hurt by the collapse of many private equity buy-outs and their exposure to a weakening equity market, it also feels fairly intuitive that activists’ effectiveness is limited in a bear market. Managements already know what to do in a recessionary environment: cut costs and protect cash flows. No one really needs to tell them what to do when their company’s survival is at stake.

Others aren’t giving up on the sources of return offered by activists. Large pension funds and fiduciaries (with billions to allocate to PE and faced with the compressed expected returns), are looking for activist hedge funds to fill the void, extracting value from underperforming companies. Their argument is that lead times to react are that much shorter in a bear market and activists can therefore attract more concessions from normally complacent management teams and boards.

Big Cap private equity is dead. Long live private equity.

It is undeniably true that with the economy sputtering and banks pulling back on lending, the noose is starting to tighten around the returns promised in the latest private equity vintages.

The strength of the latest stages of the LBO market is very well illustrated in the chart above. LBO activity has been steadily growing since 2001 and has leapt forward dramatically in 2006/2007. The coincidence of strong liquidity in the PE arena and the credit markets and a strong global economy has been the key factor in the record setting number of LBOs. It is instructive to observe the increase in the amount of leverage on the companies and the amount of equity being contributed by the private equity firms. 15 years ago, 25% of internal rates of return (IRRs) were driven by leverage. Up until last summer it had inverted to 75%.

The PE bubble has burst, deals were too levered and they took the credit crunch right on the chin. Banks aren’t lending and the global deleveraging process should be underway well into 2009. And that's just part of the deal hangover. In addition to a dearth of new deals, Standard & Poor's estimates that there is more than $140 billion worth of bad leverage buyout loans in the pipeline - loans that now sit on the books of the very same big money center banks that are weighed down by rotten mortgage debt.

It unfortunately takes away an important source of decorrelated returns for fiduciaries that need to match their liabilities with their assets. Activist hedge funds could therefore act as an alternative.

It may be sensible to distinguish between the various types of activists. There are the noisemakers which are inherently traders who take a position and shake the tree by alerting the media. This method has had varied degrees of success but it mainly worked when PE firms acted as a natural bid in the market and could come in and buy the ailing company. Then there’s what we can call the true activists who have a private equity mindset and are long term, deep value players. They approach investments with detailed shareholder value enhancement plans and the expertise to advise managements on how to execute them. They use public activism tools like proxy fights only as a last resort. The value of deep value can vary but it usually means the company is trading at 50 to 100% discount to where it could be. Carl Icahn, Nelson Peltz, Chris Hohn (The Children’s Investment Fund), Bill Ackman (Pershing Square), and Christer Gardell and Lars Förberg at Cevian are all very good examples of the latter.

Some activist managers can short in down markets or at least expose themselves to make money in some of the ailing sectors of the economy.
It’s not absolutely necessary for these companies to go private to put in place a plan that works.
Activist hedge funds can offer a lot more transparency. Since their book is marked to market investors can always get a snapshot of how their efforts are adding value.
Lock ups are much lower for hedge funds than for PE GPs. Although a stable investor base is always useful for a hedge fund, their liquidity terms are a lot more favourable in times where liquidity is an asset. Some funds ask for 3 year lock ups but never as high as the 9 top 12 year cycles warranted for private equity.
Private equity funds also buy the company at a 30 to 40% premium to its market price whilst activists discreetly purchase a stake at market prices.
Activists can sell their positions as discreetly as when they came in without having to wait for the IPO of the company.
The stock market is very adaptive, and it has taken on board some of these large activists’ growing reputation. Like TCI, the appearance of Cevian Capital on a stock register provokes a positive reaction. Over the last seven deals, stocks have appreciated an average of 23% over Cevian’s in-price after its holding was made public.
Minority shareholders are irate when they get bought out and then see the company go public again at multiples of its last purchase price. Activists add value to all shareholders without risking any battles.
There is now obviously a lot less capital chasing after these large deals. Most bulls on the strategy would argue that the demise in PE taking away some competition that could ultimately level off returns.

It’s important to distinguish between P&L and effectiveness when looking at activists.

It’s not obvious to me that activist hedge fund returns are ultimately going to rise simply because they offer a current advantage over PE. If less PE players are around to chase after the same finite amount of deals, the argument goes; it should effectively enhance returns for the activist. It’s unfortunately not that simple. A bear market will have an automatic and negative impact on returns regardless of how crowded the field is. Furthermore, PE deals acted as a “natural” bid in the market helping equity valuations for all.

PE returns are usually broken down into S&P returns (beta) plus 5 or 10% (alpha), a bit like hedge fund returns. There’s also a liquidity premium found in both. Cost of capital also appears to be pretty much the same for both entities. It’s actually the same person, or the same group, within the investor base that invests in hedge funds and private equity funds. This has the automatic effect of levelling the playing field and aligning costs for both firms. Admittedly, most PE deals were highly leveraged but this was done using the same competitive debt providers on similar terms. Furthermore, hedge funds use leverage and margin accounts and their returns are also very driven by the cost of debt. The cost of equity doesn’t change significantly as the LPs behind the hedge funds are looking for a similar yield from hedge funds and PE GPs. PE and hedge fund IRR requirements are pretty standard at around 15 to 20% a year and may be very hard to achieve in the years to come.

Not only are some activists running very concentrated portfolios, carrying both systemic and idiosyncratic risk, but very few actually know how to short. Most don’t come from trading background and aren’t comfortable with a short book. Their first line of defence in difficult times is to raise cash. Cash is clearly king but by the time market environment warrants a move into cash, it is often too late. Nelson Peltz, who’s firm Trian Capital specializes in food, beverage and hamburger chain deals is a long only vehicle that bound to suffer in the midst of a correction. Eric Knight, founder of the Monaco-based hedge fund Knight Vinke, and who was involved in a very well publicised attack on HSBC, also doesn’t short. On the other hand, Bill Ackman at Pershing Square buys CDS and was always quite vocal about his short positions on the monolines. He managed to generate close to 7% performance in January.

There is only so much alpha generation can do for your returns, if most of your positions are getting killed by the markets. Investors in this sector need to understand that activist effectiveness will have very little impact on the fund’s P&L in an environment where the only winning positions are a fund’s shorts. There are several sources of return that activists focus on with each manager bringing his/her own set of tools to the table. Some are more growth stock orientated (see Carl Icahn’s last comments with Motorola, Biogen and JC Penney) whilst others are value driven or focus on more cyclical names. Essentially, if value stocks outperform, activist managers who focus on growth will find it difficult to generate positive returns. Take Bill Ackman for instance who is quite focused on retail chains like Borders, Barnes & Noble. So as the consumer falters in the US, consumer cyclical stocks should be in the front lines of the corrections (see Lowe’s this week for instance) and there’s very little activism can do to prevent a negative P&L on long positions on these names.

As for the argument that managers will be more responsive to activism if their stock is down with the markets, it remains to be seen. Ahead of the credit crisis, the Cadbury boars had endorsed firstly Ackman’s then Peltz’s desires to see the confectionary business spun off from the soft drinks business. It now appears to be postponed indefinitely.