Dangerous Waters for Dealmakers: Shareholder sharks are using their clout to influence deals

Flush with money and aggressive in the way they use it, 21st Century corporate activists are moving beyond traditional approaches to take aim at M&A itself. Although still pushing public companies with sagging stock prices to either sell themselves or restructure, the new breed, exemplified by often-impatient hedge fund managers, will fight hard against acquisitions they don’t like by companies in which they invest. That’s a warning to strategic buyers that their deals may have to be increasingly structured to please major shareholders that won’t hesitate to go public with their disapproval of deal price, fit, or other characteristics. The log of deals aborted under the pressure of opposition from hedge funds and other institutions is growing. Over the last two years, activist insiders derailed VNU NV’s plan to acquire IMS Health Inc. and killed the proposed combination of drug makers Mylan Laboratories Inc. and King Pharmaceuticals Inc. “The movement transcends M&A, but that’s where it started,” says Pat McGurn, a Managing Director at Institutional Shareholder Services. The effect of the new shareholder sharks, he adds, will be wide-ranging. “There’s not going to be any such thing as a friendly deal. Somebody’s going to jump in on every one.” Robert Kindler, head of M&A at J.P. Morgan Chase, says that dealmakers should get used to a sea change in the deals arena. “Historically, for a lot of deals, shareholder approval was automatic, but now many more deals are going to be at risk,” he notes. What has happened to put this new breed into such powerful positions? Commentators point out that the loudest and most aggressive aren’t your father’s generation of shareholder activists; they’re wedded to enhancing their own investments as opposed to being benevolently interested in corporate governance reforms. “Often they’re using an event-driven strategy in drag. They’re creating their own event-driven activity,” says Kurt Schacht, Executive Director of the CFA Centre for Financial Market Integrity. Benjamin Bornstein, President of Prospero Funds, says the tactics used by hedge fund shareholder activists amount to “mini-takeovers” and likens the new hedge fund shareholder activism to an updating of the Warren Buffet model of value investing. “In the older model of investing, you wait for the value to get unlocked. These activists are intervening directly to shorten the timeline,” he notes. In another twist of the M&A business, defenses from other eras, such as the “just say no” stance, poison pills, and staggered boards, are often ineffective in fending off the new breed of corporate raider. “Traditional defenses are the things that attract them,” McGurn says. “The more protective measures a board puts into place, the more they look to be entrenching themselves.” The sharks’ attacks take a number of forms. Sometimes they jump in because they want to kill a deal outright. In other cases, they want to manipulate the outcome. Other times, they lock on a company with an obvious vulnerability, like excess cash, and try to start a bidding process. Whether they call themselves shareholder activists, change agents, or corporate raiders, these insurgents are here to stay and it behooves dealmakers to adapt their strategies to a waterfront increasingly dotted with prowling fins. For today’s sharks, blood in the water translates to cash on a company’s books. In 2005, cash as a percentage of stock market value at the Standard & Poor’s 500 companies was higher than at any time since the early 1980s. Cash as a percentage of long-term debt stands at just below 40%, which is close to a record. Another reason for the prominence of the sharks, according to Schacht, is the increased acceptance of a heightened role for corporate governance in the wake of the Enron, WorldCom, and Tyco scandals. Hedge funds also have an additional motivation to adopt activist strategies because there are more pressures on them to keep delivering double-digit returns despite a rapid increase in the number of funds looking for opportunities. McGurn says he sees a shorthand equation featuring two main numbers to explain the outburst of hedge fund shareholder activism. The first number is $1 trillion, which is an estimate of the amount of capital hedge funds have available. The second is the ability to raise huge sums in real time, such as the $1 billion that Edward Lambert was able to raise to put Kmart Corp. and Sears, Roebuck & Co. together. But there will be limits to the sharks’ activity. Bornstein says he doesn’t expect the activists to target small and mid-size firms. And he notes that even while shareholder activists now seem to have momentum on their side, the downside of their strategy is that it takes a long time to analyze and run their campaigns. It might be an exaggeration to say no company is safe, but a look at recent targets of hedge fund shareholder activists shows a broad span of companies and industries. Size is certainly not enough protection in itself. “No company is too large to be immune to attack from these new activists, ” Kindler says. The list of activists targeting managements is a long mix of new hedge funds and veterans, such as Carl Icahn with recent campaigns aimed at Time Warner Inc., Fairmont Hotels & Resorts Inc., Kerr-McGee Corp., and Temple-Inland Inc. Icahn has called for the breakup of Time Warner into four entities and an increase in share buybacks. He is also attempting to install a slate of outside directors to change course at the South Korean tobacco and ginseng company KT&G. Other activists on the prowl include Pershing Square Capital Management, which has called for major divestitures at Wendy’s International Inc. and McDonald’s Corp. Then there is Relational Advisors, a firm seeking to halt the acquisition of Brooklyn-based Independence Community Bank Corp. by Pennsylvania-based Sovereign Bancorp Inc. in an unusual deal. The transaction includes Sovereign’s sale of a 20 % stake to Banco Santander Central Hispano SA. Sovereign beat back Relational’s objections in an action heard by the New York Stock Exchange and got the Pennsylvania legislature to support the sale of un-issued treasury shares without triggering a shareholder vote. The bill has not yet been signed by Pennsylvania Governor Ed Rendell. Longtime investor Kirk Kerkorian recently increased his stake in General Motors Corp. to 9.9% from 7.8%. Under his urging, the company moved in early February to halve its common stock dividend, reduce benefits for salaried workers, and cut pay for its top five executives. In the case of Deutsche Borse, hedge fund objections killed the exchange’s hostile bid for the London Stock Exchange and got the CEO fired. Another European win for hedge fund shareholder activists occurred when VNU had to scrap its proposed acquisition of IMS Health and the management team was sent packing. Knight Vinke Asset Management played a big role in shooting down that transaction. While a number of private equity firms are contemplating bids for the Dutch media company, Knight Vinke could emerge as a spoiler in any eventual sale. The 2004 battle over King Pharmaceuticals and Mylan Laboratories was a particularly interesting case study because Icahn opposed the deal and because the SEC cried foul over the activities of hedge fund Perry Capital in support of Mylan’s acquisition. Perry used a complex hedging technique that allowed it to buy a voting stake in the company without having any of its funds at risk. Apparently, the regulators don’t want hedge funds influencing mergers if they don’t risk losing any money on their positions. Perry’s move could have ensured that Mylan would get enough shareholder votes to support the bid for King. An eleventh-hour earnings restatement by King eventually killed the deal. A strategy like Perry’s is an example of what experts say will be a number of novel techniques dreamed up by shareholder activists that may manipulate corporate law to enable them to pressure their targets. In late 2005, Icahn announced that he had retained investment banker Lazard to assist him in his run at shaking up Time Warner. Some bankers, such as Kindler, question the wisdom of signing on with a raider since it could cost Lazard some clients. Lazard chief executive Bruce Wasserstein replied during a television interview that representing Icahn is consistent with his firm’s activities in different situations to enhance shareholder value. Kindler says that he doesn’t expect to see a full-service investment bank take work on behalf of hedge fund shareholder activists any time soon, but adds that representing activists could become a marketing advantage for boutique banks. Schacht anticipates a transformation in the ranks of the professional service providers. While in the past they wouldn’t have represented activists, they are now willing to work for them. He notes that the legal and banking fees created by the activists amount to a profitable piece of business for many would-be advisers. Another type of alliance the hedge funds have fostered is with pension funds, mutual funds, and other traditionally staid institutional investors. Some institutional holders have admitted that the activists are able to say and do things they can’t. If, as McGurn says, dealmakers can expect the sharks to jump their deals, Mergers & Acquisitions magazine has compiled a list of tactics that might serve as a shark net to enable principals to finish their deals despite the sight of fins cruising on the horizon. First is not to rely on a company’s poison pill. These devices, as useful as they might have been in the past, have a few problems in fighting off 21st Century raiders. For starters, they seem archaic in an age of increased awareness about corporate governance. Plus they tend to attract attention from the activists whose efforts they are often used to stymie. Additionally, pills appear to be vulnerable to a group assault by a number of activists combining their firepower. The typical pill triggers a sale of shares to all investors at sharply discounted prices if any unwanted buyer accumulates a certain amount of stock, 10% for example. But if a number of hedge funds work together, they can control more than 10% without triggering the flood of new shares. Paul Lapides, Director of the Corporate Governance Center at Kennesaw State University in Georgia, says that one way to fend off activists opposed to an acquisition is to start with a knock-out bid. He says a fully priced first offer that wins approval quickly could keep activists out. Dr. Saikat Chaudhuri, Assistant Professor of Management at the University of Pennsylvania’s Wharton School of Business, suggests that parties work on their deals’ cost structure and cost basis more aggressively in order to make sure the deal doesn’t get jumped. By doing this, the parties should be able to make sure the transaction’s cost synergies are quickly achievable and prominently displayed. He says if companies do this, the activists “won’t be able to touch their deals.” Bornstein recommends partially accommodating the activists’ demands. Arguably, this strategy was followed by Time Warner when it increased a share buyback under pressure from Icahn and by McDonald’s when it enacted decided to sell off some company-owned restaurants. William Ackman, a Principal at Pershing Square Capital, had wanted all company-owned stores sold or spun off. Kindler says that his firm has a unit dedicated to helping companies fight off raiders. He says this team meets with firms to show them how shareholder activists would look at the company and makes recommendations on things the company might do proactively to make it less vulnerable to raiders. Garth Girvan, a senior partner and M&A attorney in the Canadian law firm of McCarthy Tetrault, says that a way to fight hostile bids is take management’s case to the target’s largest shareholders. This technique worked, he notes, when Canada’s largest winemaker, Vincor Inc., fought off a hostile bid from Constellation Brands Inc. Schacht says that companies need to create a skilled communication program in order to deal with shareholder activists’ assaults. A “just say no” defense without appeals to shareholders and the public at large is not likely to work, he says. Dealmakers and other observers should also keep in mind that many commentators believe that the hedge fund shareholder activism movement has its good points. “A lot of the actions the activists are calling for can be healthy for the markets,” Kindler says. Indeed, Kindler says pressure from activists is leading principals to do smarter deals. While some bankers say the threat to boards and deals from the new breed of shareholder activist is exaggerated, most observers say the trend is significant and is here to stay. Pointing to an estimated 200 to 300 activist interventions in a variety of situations, Kindler says the threat of what an activist group might do is something that has to be evaluated in every boardroom in America. Other managements under attack from the activists might take heart in the report by consultant Hedge Fund Research. For the first time in 10 years, hedge funds experienced a quarterly decline in net assets. So if hedge funds themselves are seeing slower growth, it could cut some support for the activists. Long-Term Damage? An assessment of the activist wave includes both pros and cons and a look at some of the likely long-term effects of the movement contains some cautionary notes. McGurn says that a potential downside to shark activities is the damage they could do to a company’s long-range planning, saying, “Other holders have been saying attaboy’ and congratulating them for filling a vacuum and shaking up complacent management. But now you’re starting to see people questioning whether this is a good trend overall.” He adds that some participants are questioning how long they can push before the health of the targeted companies is endangered. If the economic cycle turns down, companies that have been raked by activists may wish they still had some cash reserves to cushion the shocks. Bornstein says that even if the early rounds of activist activity turn out to be winners, such as the way Icahn’s investment helped push Fairmont Hotels to sell, there might be fewer such victories as more funds employ activist techniques. And Schacht wonders, how much, in the final analysis, the new breed of shark actually represents the average shareholder? “Whose judgment matters to most shareholders – a management that’s been running the company for years or an activist that’s only interested in the company for the short term?” he asks. Underlying most, if not all, of these concerns is a simpler response to the prospect of a activist fund getting involved in a company’s business strategy: Post strong enough results and there won’t be any basis for an attack. Failing that, the stage seems to be set for what one expert says he expects to see from hedge fund activists going forward. “Creative shareholder activists are going to look for new ways to twist and bend corporate law to achieve their objectives in coming years,” he says. (c) 2006 Mergers and Acquisitions Journal and SourceMedia, Inc. All Rights Reserved. http://www.majournal.com http://www.sourcemedia.com