Defusing Hedge Fund Attacks: Directors and executives can play an active role in preempting activist hedge funds’ agendas and bolstering shareholder support

Activist hedge funds may represent the most significant threat to the ability of public companies to control their long-term strategies since the corporate raiders of the 1980s. Although defensive measures and case law developed during and since the 1980s provide boards of directors with ample means to reject and resist unsolicited acquisition proposals, they are not necessarily effective for responding to non-concerted exercises of stockholder voting power and the post-Sarbanes-Oxley shift in the fundamental corporate governance paradigm. Activist hedge funds try to exploit this vulnerability by demanding, often under the cloak of “shareholder democracy,” that boards take specific actions, underscoring those demands with an implicit or explicit threat to campaign for changes in the composition of the board. These tactics have proven to be effective for a number of reasons, including: * The agenda of a typical activist hedge fund is focused on creating near-term increases in stockholder wealth, and frequently advocates an immediate payout to stockholders by means of a special dividend, share repurchase, sale of the company, or divestiture of a unit; * The instigating fund typically acquires a significant amount of the target’s stock while staying below triggering thresholds set in short-swing profit forfeiture laws, shareholder rights plans, takeover statutes, and other defensive measures; * Other hedge funds frequently act in a parallel move with the instigating fund, effectively enhancing its voting power, although they claim they are not creating an investment “group” – which has to be reported to the SEC under the federal Williams Act – or aggregating an ownership position that would subject them to short-swing profit forfeiture laws and the company’s own defensive measures; * The prospect of a near-term liquidity event, such as a sale, may be attractive to some stockholders, including institutional investors with substantial holdings, further magnifying the influence of the instigating hedge fund; and * Thanks to market dynamics, a substantial portion of the target’s stock may accumulate rapidly in the hands of stockholders, supporting the instigating hedge fund’s agenda once it has been made public. It’s a mistake for boards of directors to consider hedge fund activism as a passing fancy that will disappear in time. In fact, it’s imperative that directors and management of public companies proactively assess their vulnerability to attack by activist hedge funds and take appropriate steps to manage that risk. Directors should be well informed on developments in the field and take the initiative in considering strategic, financial, and communication actions that can preempt activist demands in an orderly fashion. The alternative is being forced to act hastily when a fund’s sudden pressure takes the board by surprise. This article covers the nature of the hedge fund industry, the typical investment strategies employed by activist funds, the criteria that funds tend to use to identify targets, the common tactics of activist funds, and how companies may preempt or respond effectively to hedge fund activism. Hedge Fund Industry Hedge funds are lightly regulated, actively managed investment pools, generally available only to high-net-worth individuals and institutions. Their managers typically have significant discretion to pursue a broad array of investment strategies. Most hedge funds try to generate returns that equal or beat an established index, with less risk than more traditional investment vehicles, such as stock or bond mutual funds. Large amounts of leverage often are used to enhance returns. Hedge fund managers typically are compensated through a fixed management fee – typically 1% to 2% of assets under management – and a performance fee, such as 20% to 25% of portfolio gains. Performance fees are calculated and paid as frequently as every quarter and provide a powerful incentive for hedge fund managers to generate short-term price appreciation and income from distributions. Due to explosive growth in both the number of hedge funds and the amount of investment capital they control, hedge funds play a central role in U.S. and global capital markets. According to Bernstein Global Wealth Management, a unit of AllianceBernstein, the number of hedge funds grew from a few hundred to more than 8,000 worldwide between 1990 and 2005 and reached about 9,000 by the end of 2006. U.S. hedge funds alone now control about $1.3 trillion in net assets. In recent years, hedge funds generally have delivered attractive returns with lower-than-average risk. However, since most strategies are based on identifying and exploiting inefficiencies in relatively small markets, the proliferation of hedge funds and the enormous increases in their asset bases have made it more difficult for their managers to maintain historical rates of return without trying more innovative and aggressive strategies and tactics, including shareholder activism at public companies. According to estimates, more than 100 activist hedge funds controlling over $100 billion in net assets are currently in operation. Activist Investment Strategies While activist hedge fund managers may employ a variety of investment strategies, they typically pursue a strategic theme that can be characterized as “value investing plus.” In this regard, their investment criteria are similar to those of more traditional value-oriented investors who focus on companies that are undervalued by the public markets. The “plus” is that activist hedge funds generally are not content to wait for a target’s stock price to reflect this unrealized value. Instead, they try for near-term stock price appreciation by campaigning for corporate action that unlocks perceived values. Often, the activist hedge fund manager will press for near-term payouts to stockholders, such as special dividends or share repurchases funded from existing cash balances, borrowed funds, or cash proceeds from the sale of business units or even the entire company. Investment Criteria While activist hedge funds employ a multitude of investment criteria to identify companies, the principal targets usually are firms that: * Have significant holdings of cash or marketable securities; * Enjoy the ability to raise significant amounts of cash through borrowings and are underleveraged; * Own assets or businesses with values that are not fully reflected in the stock price; * Suffer from underperforming stock prices, especially if the company has strong fundamentals but has fallen out of favor with investors; or * Struggle with change or crises that have temporarily depressed stock prices. Because many companies, including those that are financially healthy and well-regarded, occasionally or chronically may exhibit one or more of the above characteristics, the universe of companies that may be targeted by activist hedge funds is quite large. Activist Hedge Fund Tactics Although they share the common goal of encouraging a target’s management to take specific action desired by the fund, activist hedge fund managers employ a wide range of tactics. Some funds prefer, at least initially, to start measured, private dialogues with management, while others seem to relish launching vitriolic attacks on management and board members in public. Still other funds take a more middle-of-the-road or graduated approach that may start with talks and advance to less friendly moves. In general, activist hedge funds employ one or more of these tactics: * Discussion and negotiation with company management; * Publicly disclosed or open letters to management that criticize performance and advocate change; * Aggressive 13D filings that reveal new or additional stock purchases and the fund’s goal of enhancing shareholder value; * Communication with other stockholders to garner support for the fund’s agenda and solicit assistance in putting pressure on management to act; * Proxy contests aimed at obtaining directorship or control of the board; and * Tender offers or other acquisition proposals. In order to broaden their appeal to other stockholders and proxy advisory firms, activist hedge funds frequently portray themselves as champions of corporate governance reform and stockholder rights. Despite relatively low levels of stock ownership, invariably less than 10% because of concerns about short-swing profit forfeiture, activist hedge funds can muster significant indirect support for their agendas. That arms them with substantial negotiating leverage and increases their likelihood of success at the ballot box even when targets resist. The voting power and influence of activist hedge funds are enhanced frequently and significantly by: * Parallel investing by other hedge funds, creating so-called wolf packs; * Support from sympathetic traditional investors, such as mutual funds and pension plans; and * Endorsement by proxy advisory firms, which frequently support activist agendas. Consequently, activist hedge funds have enjoyed considerable success in achieving their goals. Based on private research, there were 80 proxy contests during the nine months ended Sept. 30, 2006 and the insurgents prevailed in about two-thirds of them. Company Preparedness Because of the threat posed by activist hedge funds, prevention may be the best medicine and a good offense may be the best defense for public company boards and managers. In other words, directors and executives should try to preempt the typical activist hedge fund agenda and to bolster stockholder support by: * Developing and maintaining a comprehensive and credible strategic plan; * Communicating candidly and consistently to investors on how the strategic plan is being executed and what results are being achieved; * Proactively addressing any actual or perceived shortcomings in the plan’s execution or results, describing clearly the corrective actions being taken, and clearing up any misperceptions; * Taking the lead in explaining why substantial cash balances, the preservation of unused borrowing capacity, or the retention of particular business units is essential to, or at least consistent with, the strategic plan; * Periodically considering, without being prodded, whether typical activist hedge fund proposals may be appropriate for implementation; * Monitoring and proactively addressing the concerns of investors, including those raised in the media, in analyst reports, or in dialogue with substantial stockholders; * Cultivating productive, honest, and open relationships with major stockholders through regular discussions, including seeking their input regarding the company and its prospects; * Actively monitoring the composition of the company’s stockholder base and stock trading activity to facilitate the previously described initiatives and to look for early warning signs of hedge fund activism; and * Forming a team of financial, legal, and investor relations professionals to monitor the likelihood of an activist hedge fund campaign and to plan various responses. Courts have recognized that it’s the prerogative of boards of directors to establish corporate objectives, including the time frame for the realization of those objectives. In this regard, directors are not obligated to abandon a deliberately conceived and viable long-term strategy in order to maximize stockholder value in the near term. Courts also have held that directors have an affirmative obligation to protect the corporation from threats to corporate policy and effectiveness. Ultimately, directors are accountable to stockholders through the election process, and stockholders holding sufficient voting power to determine the outcome of the elections hold the real power in determining the company’s strategic direction. Some traditional defensive measures regulating stockholder voting rights and the election and removal of directors continue to be useful in the context of preparing for hedge fund activism. Accordingly, directors should carefully consider whether to retain existing charter provisions, such as classified boards and prohibitions against stockholder actions by written consent, even though there is significant antipathy by institutional investors toward such measures. Similarly, directors should exercise caution before jumping on “best practices” bandwagons, including election of directors by majority voting. Directors also should retain bylaw provisions that eliminate the ability of shareholders to call special meetings of stockholders and that require advance notice of stockholder nominations and stockholder proposals in connection with shareholder annual meetings. These provisions also should be updated when necessary. In combination, these requirements can limit an activist hedge fund’s window of opportunity to initiate director nominations or other business to be brought before a stockholder meeting to one 30-day period per year, except for proposals properly submitted under the Rule 14a-8 of the Securities Exchange Act. Shareholder rights plans also may be useful in some instances, particularly if legal concepts regarding concerted action are determined to be applicable to hedge funds acting in parallel moves or if circumstances justify significantly reducing the triggering stock ownership threshold. Impact on M&A Companies also should be aware that activist hedge funds frequently insert themselves into M&A deals. One example is an investment in one of the partners in a publicly announced transaction. An activist fund that considers the purchase price too low may invest in the target and try to force it to negotiate a higher price, exercise rights of dissent and appraisal, or retain an equity interest in the combined company after the deal, particularly if the acquirer is a private equity fund. Conversely, if the transaction is stock-for stock, a fund that considers the price too high may invest in the acquirer and campaign to have its stockholders reject the transaction. Activist hedge funds also have been known to push for more active auctions, to encourage private equity funds to enter bidding contests, and to form or join bidding consortia so they can maintain an ownership position in the target. Indeed, many large hedge funds are beginning to act like private equity funds, employing an activist strategy as a means to obtain a controlling interest in or completely acquire a target company. Company Responses A company confronted by an activist hedge fund should not panic. The keys to an effective response, in our experience, are a board that is well informed, understands the current hedge fund phenomenon, and enjoys a positive relationship with management. The company also should understand that ignoring the problem won’t make it go away. Thus, the company may be well advised to listen carefully to what the activist hedge fund manager has to say, while taking care not to react to any provocation or make any commitments. The company then should consider its alternatives on an informed basis and with the assistance of financial, legal, and investor relations advisers. Only then will the company be able to make an informed decision on the most desirable course of action. The ultimate decision must be guided by a good-faith belief that the selected course of action is the most beneficial action for stockholders, taking into account the practicalities of the selected course of action and other relevant circumstances. The most appropriate course of action will vary with the circumstances and generally cannot be determined in advance. “Possible” outcomes range from reaching an accommodation with the activist hedge fund to waging an intense public and investor relations battle in an effort to bolster support for staying the existing course or for pursuing alternatives. Regardless of the path that is chosen, however, responding to hedge fund activist campaigns is a challenging, fluid process. A company that has developed a thoughtful preparedness program will be in a better position to respond to and manage an activist campaign than one that lacks a plan. Activist hedge funds resemble the corporate raiders of the 1980s, and market forces in the early part of the 21st Century have provided a fertile ground for their rapid growth and significant influence. Directors and managers of public companies should be aware of the threats presented by hedge fund activism and should consider appropriate steps for anticipating and responding effectively to the pressures. Mark Betzen is a Partner and Co-Head of Texas Region M&A at Jones Day, and Stuart Chasanoff is Counsel in the firm’s Private Equity Practice in the Dallas office. (c) 2007 Mergers and Acquisitions Journal and SourceMedia, Inc. All Rights Reserved. http://www.majournal.com http://www.sourcemedia.com