Hedge funds should not be the only activist investors

Last updated: February 26, 2014 7:08 pm

Hedge funds should not be the only activist investors

By John Gapper

The danger is that directors talk to the loudest voices but spurn contact with anyone else

At 78, Carl Icahn shows little sign of retiring, or of becoming more polite. After finally prodding Forest Labs into a $25bn takeover by Actavis, he renewed his attack on eBay this week, accusing John Donahoe, its chief executive, of being “completely asleep or, even worse, either naive or wilfully blind”.

This is becoming a fruitful decade for Mr Icahn and fellow hedge fund agitators, such as Dan Loeb of Third Point. From being reviled in the past as corporate raiders and “greenmailers”, they have rebranded themselves effectively as activist investors, willing to fight and defeat entrenched and complacent boards of directors and executives while pension funds slumber.

But larger institutions should beware of outsourcing their activism to packs of hedge funds that may, or may not, have their interests at heart. It makes for an easier life, and it can bring rewards for little effort or outlay. It also means taking a great deal on trust.

Activist investors are steadily overturning the US tradition of shareholders deferring to executives save for cases of blatant misconduct or mismanagement, when everyone calls in the lawyers. They have won the argument that investors have a right to express their views, overturning the assumption that insiders know best.

The danger is that directors end up talking to the loudest voices in the room – the funds who publicly call them idiots – while spurning contacts with anyone else. By the time it comes to a showdown with an agitator such as Mr Icahn, they have little hope of getting others on their side. That is, as some are coming to realise, stupid.

In other words, directors and investment institutions have a mutual interest in talking to each other routinely, rather than waiting to battle in a Delaware courtroom or accepting Mr Icahn’s lead. Two-way communication does not sound like a very radical notion but it has come slowly to the US.

The tradition of arm’s length antagonism between boards and unhappy investors goes back to the late 1970s, when Mr Icahn rose to fame. Martin Lipton, a founding partner of the corporate law firm Wachtell, Lipton, Rosen & Katz invented the poison pill defence in 1982 as a way for boards under siege to block raiders.

The poison pill endures – it was, for example, deployed by Netflix against Mr Icahn in 2012 – and Mr Lipton is still hard at work. But the intellectual tide has gradually turned against him. Mary Jo White, chair of the Securities and Exchange Commission, argued in a speech in December that “there is widespread acceptance of many of the policy changes that so-called activists seek”.

Carl Icahn insists that he does not buy securities with the intention of getting a quick pop

Indeed, Mr Lipton seems to have lost a recent argument that he really should have won. Wachtell Lipton petitioned the SEC two years ago to tighten up lax US disclosure rules that have allowed hedge funds to build up stakes in target companies without having to show their hands promptly, as they do in the UK, Australia and elsewhere.

Lucian Bebchuk, a Harvard professor who has tussled constantly with Mr Lipton in the cause of shareholder rights, promptly swung into action, arguing that the existing rules are strict enough. So far, the SEC has not acted – Mr Lipton has been poisoned by his own pill.

The temptation now is for giant institutions such as Fidelity and BlackRock to freeride with activists. The latter can build stakes of up to 5 per cent (often more if they act together or use derivatives to mask their activities) before declaring an interest and waging war. If they force the company into a deal, or into distributing cash to investors, everyone gets a payout.

That works fine if the interests of activists and the bigger institutions are similar. In some cases they are – Mr Icahn insists that “we do not buy securities with the intention of agitating for a quick ‘pop’ and then ‘flipping’ them for a speedy profit”, and Mr Bebchuk’s research indicates that hedge fund activism tends to improve the operating performance of target companies.

But this is not inevitable – activist investors are biased towards events, such as a merger, rather than steady improvement that increases long-term returns. “Activists are good at presenting their views as long-term and mainstream investors have to chip away at that and reassure themselves it is genuine,” says Michelle Edkins, BlackRock’s head of corporate governance.

There is not much time if a company has remained aloof from investors until it becomes a target. “The dialogue must start on a sunny day because by the time [a company’s directors] get out there on a rainy day, the game is over,” says Jim Woolery, deputy chairman of the New York law firm Cadwalader, Wickersham & Taft.

In the past, a board could deploy a poison pill and dismiss any critical investor as a greenmailer. There is less chance of that being sufficient now activism is respectable. Activist funds have $80bn under management and succeeded in 70 per cent of campaigns last year to block or alter the terms of agreed corporate deals, according to the law firm Simpson Thacher.

The formation this month of the Shareholder-Director Exchange, a body intended to facilitate direct conversation between institutional investors and board directors, is one sign of attitudes changing. Both sides realise that, if they leave it to others to seize the initiative, they may not like the result.

US capital markets have moved on from equating investor activism with asset-stripping. They have yet to reach the point where activism does not always mean a fight.