Activist funds. A new take on a tested strategy.

February 14, 2014

Progressing from “Corporate Raiders” to “Activist Funds,” the strategy of acquiring a sizable amount of shares in a company to gain control of a company is not a new fad. Names among the likes of Carl Icahn and Elliot Associates are headlining major news stations, more recently with Icahn’s acquirement of a large stake in Apple, causing mass curiosity about the intentions of these billionaire investors. The curiosity, however, is not misguided. The California Public Employees Retirement System (CalPERS) and various other pension funds have recently invested a fair amount in Activist Funds, perhaps signaling that there may be more to Activist Funds than meets the eyes.

So what is an Activist fund? In short, it is normally a hedge fund whose dominant strategy is to figure out which companies are undervalued and to turn that market imperfection into a return for the fund. This return is generated in two ways: either a complete “executive position restructuring” or a creation of added value to the company (M&A or taking a company private). The general consensus, though controversial, is that these Activist Funds will go with the corporate restructuring and sell the company acquired within a short period. However, it is our opinion that the current states and trends of Activist Funds will globally cause the business infrastructures to drastically improve and shift the actions of Activist Funds to take a more honest (value additive) approach, and also increase M&A activity.

Why? With the media today spreading news of Activist Funds initiating large share buys, combined with industries across the board seeing companies being revamped, there is an air of insecurity and fear. Companies in reaction will preemptively enact defense policies and try to prevent any “take overs” from occurring. The three lines of defense that can be created are a staggered election for the board (making it hard for funds to gain a seat), the poison pill defense, and flat out lawsuits. There is no doubt that companies will take some of these actions, but the most beneficial and strategic move is to simply improve their OWN infrastructure. When you are being targeted by one of these Activist Funds, it isn’t random but through careful analysis; meaning that there lays inefficiency in your company.

How will activist funds react to this? Following the implementation of defense policies as well as improving company inefficiencies, Activist firms will no longer be able to exploit company mismanagement in the short run and will have pursue the more long term value additive strategy. In other words, Activist Funds will seek still seek positions of power and influence in a company, BUT with the intent of either acquiring or selling companies to create value. Essentially, every major Activist Fund spokesperson is already preaching this ideology, but the matter of the fact is that they will always seek profit maximization. Adding to the payoff of increased M&A activity is the fact that the long-term strategy for Activist Funds has a high payout (exit premium).

Skeptics of this theory may question why Activist Funds will completely cease their short-term strategy, but there are three reasons why they will. First, before selling shares over 5% of the market cap, you must re-amend the 13D filing with the SEC that you had originally filed for. This will be public news and create decreased confidence and expectations, leading to a decrease in the stock price. Second, in the short term “corporate take over” you are running the risk of walk-outs from important employees which may also affect shareholder confidence. Lastly, the most dangerous effect of gaining control of a large company is the susceptibility to short term effects in the marketplace.

In the end, the existence of Activists Funds is beneficial to the business climate in many ways. This is a perfect example of a free market “correcting” itself and excluding companies with inefficiency and weakness. The standard of companies as a whole will improve and continue that way as long as Activist Funds exist.