Hedge Fund Activists Press Smaller-Cap Public Firms While campaigns at big companies draw heavy coverage, some funds go down market with bids at underperformers

Some hedge fund managers have started to ask why colleagues like Carl Icahn and William Ackman of Pershing Square Capital Management should have all the fun in pressuring managements at companies they consider underperformers. So while the higher-profile activists have invaded the big-company space – Icahn at Time Warner Inc. and Ackman at McDonald’s Corp. – their emulators are taking the strategy down market while attempting to expand returns on their investments in mid-market firms. “These guys see what Icahn is doing at the high end and they’re trying to do it at smaller companies,” says T. Patrick Hurley, Managing Director of MidMarket Capital Advisors. He notes that companies as small as $150 million to $200 million are probably as low in the market-cap rankings as hedge fund shareholder activists should focus on. “Below that level, the tactic is more of a crap shoot,” he says. Crap shoot or not, Steel Partners II, an activist hedge fund, currently is running a campaign against Stratos International Inc., whose market cap is just under $90 million. In June, the fund offered to acquire the 85% of the optical and electronic components maker it doesn’t already own. Steel Partners II also is trying to buy Bairnco Corp., an engineered materials and components manufacturer with a market cap of about $88 million. In this case, the activists want to buy the company outright. While most campaigns are non-binding, Steel Partners II has started a tender offer for Bairnco. Another small target, software developer Phoenix Technologies Ltd., with a market cap of $129 million, is in the crosshairs of activist fund Ramius Capital Group, which wants to acquire the company. Deal information about these three campaigns came from SharkRepellent.net, a web site that tracks shareholder activist bids. High activist success rates Attacks on smaller companies may require a slightly different skill set, but a recent report that underlines the success of shareholder activist campaigns at companies of all sizes may cause more hedge funds with shareholder activist philosophies to target smaller companies. Morgan Joseph & Co. analyzed 94 campaigns by 29 activist hedge fund managers and found that the would-be change agents did quite well. In a report titled “Management in an Era of Shareholder Activism,” the firm states that between January 2004 and March 2006, shareholder activists who demanded a change in management got their way 75% of the time. The report also indicated that activists reported a 70% success rate in gaining a board seat; a 63% success rate at getting management to drop poison pills; a 55% success rate in trying to force the sale of a company; and a 50% win record when the goal was to force a special stock dividend. Activists also forced stock buybacks in 47% of their campaigns and logged a 44% success rate when trying to block a merger or acquisition. A pathway for more attacks Randy Lampert, a Managing Director at Morgan Joseph and one of the authors of the study, says he expects that activism could affect hundreds of companies over the next several years. Speaking specifically about the issue of campaigns against mid-market companies, he notes that the SEC has passed a number of rules that make it easier and cheaper for activists to target smaller-cap companies. Against the backdrop of corporate governance reforms in the last few years, Lampert says it has become easier for hedge funds to communicate their ideas to target companies. On the receiving end of these saber rattlings, boards are under more pressure to take those approaches seriously. Boards have to focus on activist motions and they frequently will form special committees, often manned by independent directors, to evaluate their proposals, Hurley notes. Setting the process in motion Lampert says that one aspect of the process is that the approach by shareholder activists need not be a “zero-sum” game. For the hedge fund shareholder activist, it’s often enough to set the process in motion. Even if they don’t succeed in achieving their structural goals at the company, activists often can profit just by giving the stock a nudge by pressuring the company. “If management doesn’t like the activist’s plan, they’ll have to come up with their own,” Hurley says. Often this is enough to bump up the stock a bit so that activists get at least a 5% to 7% boost to their holdings. If they can wield greater influence, their payoffs can be richer. Of course, much of this dynamic applies to any size company under siege from activists. Experts say there are disadvantages that must be evaluated when deciding to go after smaller companies. For starters, smaller firms should have fewer inefficiencies for activists to target. Also, they are likely to have shareholder blocs that are more insulated from public and fund pressures. Insider interests may be held by management or by family relations of the company’s founders. While not all LBOs are done hand in hand with existing management, Benjamin Bornstein, President and portfolio manager of Prospero Capital, which isn’t a shareholder activist firm, speculated that managements at smaller companies may be less willing to throw their lot in with shareholder activists. Out of the spotlight And while the Icahns and Ackmans of the world can use press coverage to help them wage campaigns against companies with market caps in the billions, there will be less press coverage of smaller campaigns. Lampert points out, though, that even if the press isn’t covering a certain activist’s approach to a company, there are SEC filings that either the stalker or prey would have to submit, and those would show up on some investors’ radar screens. Lampert says that mid-market firms should be proactive in dealing with the threat of shareholder activism. In the end, the best defense for small or large public companies is to keep their stock prices up. But that’s easier said than done for some potential targets of shareholder activists. (c) 2006 Mergers and Acquisitions Journal and SourceMedia, Inc. All Rights Reserved. http://www.majournal.com http://www.sourcemedia.com