Hedge funds, Wall Street's bastions of privacy, are finding it can pay to wear a public face.
In the space of a year, the world-beating success of Ed Lampert at Kmart and
has turned so-called "activist" investing into the style
for the fast-money crowd, with huge implications. Sleepy boardrooms have been jolted into action; Carl Icahn's image has been rehabilitated; and investors have found a new way to gamble on corporate turnarounds.
The tactics of hedge funds that fall into the activist category are too varied to pinpoint the amount of money they have received. Anecdotally, however, Wall Street senses a craze, with yield-starved institutions beating paths to an investment style that has scored triumphs at companies as diverse as
and, just Friday,
"More and more hedge funds are becoming activists," says Michael Hawthorne, a partner at Mellon HBV Alternative Strategies, a hedge fund that took a 9.9% position in
. "They are finding out that their investments tend to be more profitable than when they just are passive investors."
Distaste for passivity characterizes the activist funds, which, broadly speaking, are those willing to take and disclose big stakes in publicly traded companies while pressing for changes in corporate governance. Their demands, backed with the threat of a proxy war, are shareholder-centric, including board declassification, higher dividends, pricey buybacks and the removal of executives they think are failing.
"We're starting to see more of our clients contacting management and communicating concerns over the management of these companies or contemplating filing proxies," said Ron Geffner, a lawyer who represents hedge funds at the firm Sadis & Goldberg. "It's a way to enhance performance when the markets are tight, when people are having a difficult time generating results."
A case that illustrates the boom is the return of Bob Chapman, a vocal and colorful hedge fund activist known for his frank letters to corporate boards. After taking a sabbatical last year to recover from a surfing injury, Chapman is back and prepping a new activist fund for January. "The smell of napalm followed me around on my sabbatical and drove me back into the battle," he says.
Chapman's first fund was open only to rich individuals. The new one, however, will take institutional money, a sign that the market is maturing. "Institutional hedge fund investors are getting more and more enamored with activism than they were before," he says.
In an investment category that for decades has been identified with hulking private equity funds, the shift is significant. To be sure, private equity is stronger than ever, marshaling enormous sums of money into buyouts and all manner of exotic finance. According to Thomson Venture Economics, 38 buyout and mezzanine funds raised $22.1 billion in the second quarter, up 64% from the first quarter.
The rise of the activist hedge fund both parallels and augments private equity's renaissance.
Nowhere is that more evident than in the sector's most significant players, Lampert and Icahn. At Kmart and then Sears, Lampert -- who runs about $9 billion at ESL -- eschews a trader's philosophy, preferring to drive profitability through stingy capital allocation and stock buybacks. He pursues a strategy of business-building at his other major public holdings,
While Icahn is new to hedge funds, his strategies for forcing corporate change over the last two decades are like an activist's bible. After popularizing "greenmail" in the '80s, Icahn has recently adapted the strategy to public markets, using the threat of a buyout (and the help of hedge fund Jana Partners in one case) to convince Mylan and Kerr-McGee to do above-market buybacks with borrowed money.
Last May, Icahn disclosed a 4.5 million-share position in
Many smaller fish play a significant role, too, among them Pirate Capital, Steel Partners, Highfields Capital and Pershing Square Capital. The proliferation has created opportunity for smaller investors. Anyone who bought Wendy's when Pershing Square announced a stake in April was sitting on 26% gain on Friday after the restaurant chain raised its dividend, expanded a buyback program and announced the partial spinoff of its Tim Hortons unit. The moves were more or less forced by the activists' presence.
One reason for the growth of activist strategy is the decline of merchant banking on Wall Street. According to Charles Gradante, managing principal of advisory firm Hennessee Group, investment banks such as Goldman Sachs, Lehman and Lazard have been less inclined to take long-term stakes in public companies since going public themselves. And where investment houses once exerted influence as agents for mezzanine finance, that type of lending is now often handled by private equity funds.
Hedge funds have been able to join the fray as their cash piles have increased and investors grow more willing to tie up money for the long-term. Late last year, for example, Eric Mindich got $3 billion for his new hedge fund, a record start-up launch. The former Goldman Sachs star was able to impose investor lockup provisions and early withdrawal penalties that were previously unheard of in the hedge fund world. About one-third of the Mindich fund's strategy is supposed to be straight-up private equity, further blurring the line between trader and owner.
Still, most activist hedge funds remain oriented to short-term gains simply because they face the time pressure of their peers, a problem that private equity shops are immune from, says McConnell. Because they are generally disinclined to acquire companies outright (even Lampert shies away from buyouts), hedge fund activists have sometimes been forced into tactics that can smack of
Barbarians at the Gate
ruthlessness. More problematically, they are subject to the same entrenched disadvantages faced by any investor who wants to change a company without controlling it.
At Blockbuster, for instance, Icahn tried desperately to get the company to acquire
before the battle was lost to
( MOVI). His famous bluster continued even after the setback as he won three seats on Blockbuster's board and remained a big holder of Movie Gallery. Still, the travails show that even the game's best players face daunting headwinds.
"There is a flurry of 13D filings, and the stock goes up. But over time, the management has the ability to say, 'I don't care, I don't agree,'" says the head of a large fund of funds. "It's very rare when you get a Kmart/Sears."
Still, when an activist succeeds, the payoff can be enormous, both in terms of money and influence on corporate governance everywhere. Investors who bought Kmart when it came out of bankruptcy in 2003 have seen the value of their investment rise by a factor of seven.
Activist triumphs create a "halo effect" in the market, says McConnell, as executives at other potential targets start to worry about their own performance. Add to the equation the success of Lampert in business-building, and yesterday's barbarians start to seem a lot less savage.