Hedge Funds Play A Bigger Role in M&A: Deal-hungry buyers enjoy an expanding source of funding

With hedge funds playing an even bigger role in the M&A market, Mergers & Acquisitions assembled a group of experienced industry pros for its hedge fund roundtable in late September, covering everything from convergence with private equity to the sustainability of hedge funds as financiers to the increasing popularity of shareholder activism. An excerpted version of the discussion follows. Reinebach: How is the convergence of private equity and hedge funds – and real estate, for that matter – impacting M&A activity, especially as it adds more players to the landscape? Bodi: In the last 18 months or so it has been more complementary than competitive. Hedge funds have stepped in and provided financing in a number of different roles – mezzanine financing, second-lien financing, lead financing, even providing equity to deals. They’ve stepped up with the entire equity portion in some cases. Earlier on, it seemed as if there was a bit more competition between the two groups, but I think now they’re working well together. Talarico: I agree. We see hedge funds in three different ways. First, we see them as sources of financing; they’re able to get us additional leverage to help increase our returns. Second, we see them as a deal source. For example, we worked with Elliot Associates on Shopco, and if it weren’t for their approaching one of our real estate partners, we probably wouldn’t have given the deal a second look. But we ended up succeeding with that deal. Third, we’ve done at least one deal in which a hedge fund owned the debt of a company. The company was under water. They wanted to take over the company because they felt it could be revived, but they really didn’t want to operate it. We ended up buying their debt at a discount and then going in together to a 363 bankruptcy filing and buying the company. We have operating control, but we’re sharing the deal 50/50. Reinebach: On the financing side, are you seeing hedge funds encroaching on that space? Schwartz: Absolutely. With the liquidity in the marketplace, hedge funds have become, and continue to be, very aggressive in filling out the capital structure. We’ve also seen them playing in the equity tranches over the last six to nine months. They’re not getting the returns they’re looking for, so they’ve switched focus to taking equity positions versus debt. Reinebach: Steve, you said you’re seeing more of the hedge funds on the equity side, and certainly the guys in this room fall into that category. Are you seeing more cases where private equity firms are going head to head with hedge funds on deals? Schwartz: We haven’t seen that as much. In the cases where we’ve seen the hedge funds make an equity play, they’ve been the smaller, more unique deals and companies that wouldn’t necessarily get the attention of a private equity firm. Reinebach: Gary, have you seen cases where you’re up against a hedge fund? Talarico: The only situation where we’ve been up against a hedge fund is where the fund had a credit position, and in order to preserve its position it ended up competing with us. But we don’t see it too often in our space, which is distressed companies. Fifty percent of the companies we buy are losing money when we buy them, so we don’t see hedge funds that often. That could change, though. Brog: It seems like every conference I’ve gone to I hear about this fear from the private equity world that hedge funds are encroaching on their turf. I don’t know if that’s actually the case, though. There have been situations where speakers have talked about why hedge funds can’t do the same types of LBOs that a private equity firm can do because they don’t have the skill sets to accomplish them. So, I’m not sure whether hedge funds are taking deals away or if there’s just a lot of talk about it. Talarico: I think they’re taking some healthy-company deals. We don’t see it that often in the distressed space, but among the people that do traditional buyouts, I hear more talk about the hedge funds in their territory. Landaw: I agree. It’s happening, but the number of hedge funds getting into the space is a relatively small subset of the estimated 8,800 hedge funds that are out there. The convergence of private activity and hedge funds makes complete sense in that hedge funds are seeking to compel public companies to be run the same way that they would be if they were owned by a private equity fund. De Rose: We’re seeing hedge funds participating in smaller deals that we’re not as likely to see the private equity firms in. In larger deals, we’re actually seeing hedge funds partner as part of consortia. I can’t think of any instances where they’ve gone toe to toe over a property in an auction or a contested situation. Reinebach: What would you say is the most unfair knock against hedge funds when there is discussion about what hedge funds are qualified to do and what private equity funds are qualified to do? Brog: That’s a tough one. Everyone has different skill sets. People do things and approach things differently, but there’s probably some truth to the talk that the hedge funds don’t have the skill sets private equity firms have in taking control of companies and actually operating them. On the other hand, any relevant skills that hedge funds guys do have gets diminished by what the private equity world is saying. De Rose: Again, it’s also something that’s probably being differentiated in terms of size. I suspect there are large hedge funds that have the skills and experience that a decent-sized private equity firm has. Landaw: To be successful, hedge funds need to have a number of capabilities. A lot of hedge funds may consider themselves capable, value investors, but what really sets them apart is operational expertise, just as in the case of private equity funds. Reinebach: Many people think about hedge funds as short-term investors that are looking to take advantage of rate changes and stock prices. One of the big knocks against hedge funds, when you talk to private equity firms, is that these guys aren’t long-term investors. Brog: There’s clearly a difference in holding periods for regular, typical hedge funds and activist hedge funds. Activist hedge funds’ holding periods are significantly longer than your typical hedge fund’s holding period because it takes time to create change. It could mean one or two proxy cycles. Landaw: I agree. Activist hedge funds are prepared to make investments in a company for one to five years, and the criticism stems from people not separating activist hedge funds, which play in the private equity space, from traditional hedge funds. The question really isn’t one of short-term versus long-term. It’s a question of who will provide better value by putting out alternatives to a company’s current course of action that shareholders in a company might not otherwise consider. Reinebach: Despite the distinction of somebody being an activist versus non-activist, you do see folks suddenly emerging and calling themselves activist funds. Brog: It’s a flavor de jour in a market environment where it’s relatively difficult to generate returns. One of the ways you’re able to generate returns is by getting more involved in the situation, and, by definition, that’s an activist. Activism will grow in popularity over the next five years. More and more people will try to generate returns by being activists. Reinebach: Is there a proliferation of hedge funds taking root overseas? De Rose: It’s expanding globally in places like Germany. In places like London and France, you’re starting to see resistance, but activism is definitely taking root in Europe. Bodi: Even in the Far East it’s taking root. Activist activity at Korea’s biggest tobacco company isn’t just a one-time phenomenon. Reinebach: On the fundraising side, when you’re going out to investors, are you seeing hedge funds take money from private equity funds? Talarico: What I’m hearing is that it’s kind of a barbell right now and people with good returns have absolutely no trouble raising money but that people delivering mediocre returns have a lot of trouble raising money. Are hedge funds soaking up some of that? Probably, but the hedge funds’ return target is lower than private equity’s, so I don’t see them really competing for private equity money. Hedge funds and private equity are getting their money from the same people, but it’s from a different allocation. Reinebach: Five or 10 years ago there wasn’t much of a reason for private equity firms and hedge funds to commiserate, but now I would say there probably is a motivation to do that. Brog: Absolutely, especially when the end result that you’re looking for is the sale of a target company. Talarico: Even as recently as maybe three years ago, we didn’t really call hedge funds to market who we were and what we did. Now, our dialogue is much more frequent, and we make sure that the hedge funds know who we are, what we do, and what deals might be appropriate for us. Reinebach: With Sarbanes-Oxley, being a public company is more costly by default, so some of these smaller guys almost have to go private. Outside of that, is there anything about SOX that plays a role here? De Rose: In this environment, where deal scrutiny is at a level you haven’t seen before, it’s an atmosphere that’s probably very helpful to hedge fund activities. Talarico: There are underperforming public companies that need to make dramatic changes in their businesses, but they may be very difficult to make because they would require some short-term paying that would disrupt earnings for maybe two years. Occasionally, going private is a solution. The cost savings are terrific, and you’re also not under the microscope. You can take a little bit more of a long-term view. Reinebach: Are there certain sectors that are hot right now? Do you see the HCA deal having a big impact on health care activity, which is one of the bigger sectors in recent months? Or do you think there’s just so much money flying around, that it doesn’t matter what sector you’re in? Bodi: Health care has been undergoing consolidation for a while, and it’s going to continue with the HCA deal. The clubbing aspects of that deal are just a reflection of the consolidation that’s ongoing in the industry. Brog: Everyone is talking about club deals, and I always find that from a legal perspective, it’s peculiar how club deals happen. When you’re looking at a target company, you typically sign a confidentiality agreement that doesn’t allow you to talk about the deal. How do those people go out and work with other potential buyers? Obviously, if the deal is large enough you might need to club to get the deal done. But even when it’s not necessary, clubbing is still going on. Talarico: We recently were looking at a company and competing with others. We got a call from somebody else that was looking at it, and the way our competitor looked at it was, if they didn’t partner with us, they wouldn’t have done the deal at all. The reason wasn’t the size, but the risk. It actually forced us to make our decision earlier than we would have. I would rather sell down some of the risk and reduce our equity checks. Brog: But Gary, if you were the seller, how would you feel about clubbing? Talarico: I think it’s problematic, but it’s a fact of life. In the case I was talking about, we ended up reducing the field dramatically. We both said we probably wouldn’t bid alone, so you either lose both of us or you get us as a team. De Rose: Lots of times it’s better to have two dedicated buyers going toe to toe and bidding competitively than a weak auction with more players. So it’s a question of managing the process most effectively. Reinebach: On the financing side, is there a certain group that you see is committed to financing these deals, or is it kind of a flighty situation? Talarico: Foothill is one of our favorite lenders. We know what they’ll do. We call them up and we absolutely win, plus or minus 5%. We know where they’re going to be. It’s much more difficult to read a hedge fund. Banks will lend into almost any sector, but not a hedge fund. You have to call many more hedge funds if you want that to be your financing source. Banks are fairly predictable in terms of what they’ll do. Schwartz: We’re absolutely seeing that. We partner with so many different hedge funds that we get a sense of what hedge funds are and aren’t willing to do. A lot of times we’ll get the call and help arrange for the entire debt side. Reinebach: Looking into the future, there’s a theory that we’re not going to have private equity funds or hedge funds. Everyone’s going to be an alternative investment fund. Do you buy into that? Talarico: No. De Rose: What you probably will see are fund complexes that will have multiple strategies. Bodi: The jury’s out. Hedge funds will compete more and more for side pockets of capital, either in the distressed market or in private equity. It’s interesting to see the kind of pressure all of this money floating around has created. Someone quoted $1.3 trillion in hedge funds today and estimated that hedge fund money will reach as high as $10 trillion in 2010. What impact will this have on the whole financial landscape in general? What’s going to happen to banks? Who will be the real lending sources? Reinebach: In the case of a downturn, how do you think activist hedge funds would fare against other investors? Brog: They’ll grow in popularity, and the money will go there because in a flat to down market, hedge funds generate returns not by being passive shareholders but by asserting their rights as the owners of the company and making changes. Reinebach: How do you see that impacting your business? Talarico: It causes change, and change is good for us. The performance of a company could be suffering, and maybe going private is the right solution. It could be that the company has underperforming divisions it should exit and instead put its capital into better-performing divisions, which is good for us. De Rose: In the next downturn, I think [the private equity] business will be helped by the changes to the bankruptcy laws that took effect last year. It will make it a lot more expensive for companies to consider Chapter 11 as an alternative. There would be more impetus to do deals in distressed situations before bankruptcy or shortly thereafter, which would be an opportunity for hedge funds as well as your business. Reinebach: For the hedge funds, are you seeing any trends that point to a need for more corporate governance? And are you seeing a lot of a certain kind of mismanagement? Landaw: Over the past year, there’s been a dramatic increase in shareholder proposals to implement majority-voting guidelines. In general, shareholders like independent directors to be selected based on their experience and expertise, and they like to see the board of directors acting as a checks and balances system overseeing management. For years directors of public companies were accustomed to receiving wide latitude, sort of benign neglect from their institutional shareholders. That’s changed. Corporate and accounting scandals have changed the status quo. There’s no longer a presumption that directors have shareholders’ interests in the mind and that they can be trusted to do the right thing for shareholders. With the rise of shareholder activism, there’s suddenly an investor base with the economic incentive and resources to make it worthwhile for companies to improve their operations and performance. Brog: With that being said, there’s clearly a bias that goes on with institutions. There are institutions out there that will say, “Activist hedge funds, you’re doing a great job, we agree with you, but we’re still not going to vote with you.” The reason, they say, is they don’t want to be perceived as not management friendly. This is such a small position for them and they want to keep things going, but they’re not going to vote for you. I was advising a hedge fund on a proxy fight that it’s considering, and in addition to the company being completely mismanaged, it announced that it missed its numbers and, by the way, it has had some spring loading in its options. All they were concerned about was whether they were going to get shareholder support. This is a poster child. Landaw: I understand that there are 90 companies announcing that there’s some form of internal investigation regarding their stock option practices. There’s a historic bias with institutional investors to support company management. But in light of the scandals and frauds, we’ve seen a number of public companies making changes, including increased recognition of institutional investors and taking on more fiduciary responsibility to their own investors. This requires them to roll up their sleeves, answer the phone, listen to activists, and carefully consider what the proper course of action is. 1- Attila Bodi, Partner, McDermott Will & Emery 2- Stephen Schwartz, Executive Vice President, Wells Fargo Foothill 3- Richard De Rose, Managing Director, Houlihan Lokey Howard & Zukin 4- Timothy Brog, Principal and Manager, Pembridge Capital Management 5- Gary Talarico, Partner, Sun Capital Partners 6- Jared Landaw, Vice President and General Counsel, Barington Capital Group 7- Adam Reinebach, Publisher, Mergers & Acquisitions (c) 2006 Mergers and Acquisitions Journal and SourceMedia, Inc. All Rights Reserved. http://www.majournal.com http://www.sourcemedia.com