Shareholder activism

Activist hedge funds found wanting in essential tasks

US hedge funds not fulfilling function of making profits and helping wider investor community

[march 29, 2016] by: Stephen Foley in New York and Miles Johnson in London

US lawmakers including Elizabeth Warren and Bernie Sanders are supporting a new bill that aims to curb activist hedge funds, but it seems that financial markets are already taking the wind out of activists’ sails without them.

While concern about whether activists exacerbate corporate short-termism has now reached Capitol Hill, it has been building for some time among the wider shareholder community.

Activist hedge funds have been on site at an accumulating number of corporate disasters, of which the plunging share price of Valeant Pharmaceuticals is just the latest.

By urging companies to improve their returns to shareholders, these activists are supposed to benefit the wider investor community at the same time as making fat profits for their own funds — but on both counts they have often been found wanting.

“Activism is a credibility game,” says Alper Ince, an investor in hedge funds at fund of funds group Paamco. “You have to have credibility with management and a good reputation. At the end of the day this is also a stock picking strategy, so if your batting average goes down with bad picks then it will become more difficult to convince the market of your view.”

Last week, Valeant, a company effectively built by the activist fund ValueAct, repudiated its entire corporate culture as one where “the tone at the top of the organisation and the performance-based environment … may have been contributing factors resulting in the company’s improper revenue recognition”.

It is not the first time that activists have been blamed for pushing companies to enhance short-term shareholder value at the expense of the long term. Between 2012 and 2014, ADT, the alarms business, bought back more than $2bn in stock, partly at the behest of activist fund Corvex; the buybacks were followed by a profit warning that the company blamed on its failure to match rivals’ investment in marketing.

Corvex got $44 per share selling back the bulk of its stake to the company before the profit warning, a share price the company has never seen since.

More recently, LPL Financial, a stockbroking business, went on a debt-funded buyback spree under pressure from Marcato Capital, which is run by Mick McGuire, a protégé of Bill Ackman, only to see its shares crash 40 per cent this year as faltering earnings prompted concerns about its debt load.

The debacles risk robbing activists of one of the things that gives them their edge: their reputation for adding shareholder value.

Activist funds lost 9 per cent, after fees, in the year to February 29, according to HFR, and have returned just 2.8 per cent a year over the past three years, a period when the broader stock market returned an annualised 10.8 per cent. The industry’s biggest stars dimmed: Daniel Loeb’s activist portfolio lost 3 per cent in 2015; Carl Icahn lost 18 per cent; and Mr Ackman suffered a 20 per cent meltdown last year that has only worsened in the opening months of this year.

The reaction has been swift. For the first time since the financial crisis, investors pulled money out of activist funds in the fourth quarter of 2015, a net $1.5bn, about 1 per cent of their total assets, and there is an expectation that this year’s first-quarter figure could be even worse.

Anthony Scaramucci, founder of the fund of hedge funds company SkyBridge Capital, reduced his company’s investments with several high-profile funds late last year when it became clear that profits were no longer rolling in, despite an apparently benign environment for activism.

“The activists over the past 24 months have had only tailwinds,” Mr Scaramucci said. “There has been tons of cash on S&P 500 balance sheets, near-zero interest rates and all the positive rules in the Dodd-Frank act that improved minority shareholder rights and allowed activists to exert more power over companies. They had these huge tailwinds and yet they did not do well.”

The so-called Brokaw Bill introduced on Capitol Hill earlier this month is designed to add some headwinds. It is named after the little Wisconsin town where locals blame the closure of a paper mill by Wausau Paper on pressure from activist fund Starboard Value.

“We cannot allow our economy to be hijacked by a small group of investors who seek only to enrich themselves at the expense of workers, taxpayers and communities,” said Tammy Baldwin, the Democratic representative who has co-authored the proposed legislation.

The bill aims to make life harder for activist hedge funds by forcing them to disclose their stakebuilding and derivatives positions more quickly — within two days of hitting a 5 per cent stake, rather than the current 10 days — and limiting their ability to work with other funds.

For the time being, the bill has received little traction beyond the core group of liberals who signed up earlier this month, but that might not matter. The skies are getting darker for activists regardless.

“This is an unforgiving industry,” says Paamco’s Mr Ince. “Making mistakes can lead to massive outflows.”