Bachelor Thesis Hedge Fund Activism Value Creation or Destruction for the Target Firm? ANR: s893416 Name: M.W.S. Jansen Supervisor: J. Guo Study program: Business Administration Specialisation: Finance Words: 8169 Date: 20 June 2008 URL: http://homepage.uvt.nl/~s893416/scriptie.pdf.
Management Summary Hedge funds are a growing investment vehicle. Hedge funds pool investors money and invest those funds in financial instruments in an effort to make a positive return 1. Together with the increase in hedge funds over time, there has also been an increase in hedge fund activism by the funds managers. Hedge fund activism is defined as: A strategy in which a hedge fund purchases a 5 percent or greater stake in a publicly-traded firm with the stated intent of influencing the firm s policies. 2 Little knowledge exists about the efforts of hedge funds activists. This thesis will investigate how the actions of hedge fund activism influence the value of the target firm. First the characteristics of the target firm are investigated. According to Gillan and Starks (2007), only poor performance firms became target of traditional activists. Nowadays recent hedge fund activist are searching profitable companies to target. Klein and Zur (2006) indicated hedge fund activists target relatively small companies. After analysing the target firm, this thesis investigated whether hedge funds activism creates or destroys value of the firm. Brav et al. (2006) and Clifford (2007) find empirical evidence that the category of hedge fund activism in which hedge funds request the sale of the target firm, generates the highest abnormal return for the target firm. Brav et al. (2006) also indicates that hostile 3 targeting generates higher returns. Therefore evidence exists that hedge fund activism can increase value of the target firm while shareholder activism can not. Inconclusive evidence exist about whether hedge fund activism increase or decrease operational performance in terms of ROA and ROE. Most used papers in this research investigated the increase in value of the firm only in the short term. Limited evidence exists about long term value creation or destruction. Evidence of the impact of shareholder activism in the long run exists but is inconclusive. 4 Next, this thesis indicated whether the actions had been successful or not. Klein and Zur (2006) and Brav et al. (2006) interpret their results as evidence that hedge fund activists are extremely effective in making significant changes to their target firms. Contrary to this research, Bebchuck (2007) and Kahan and Rock (2006) argue that hedge fund activists are not powerful enough to be successful. This thesis can not conclude that hedge fund activism increase the value of the target firm. Therefore more research about the impact of hedge fund activism on the target firm in the long run is needed. Besides, more research into the successfulness of the actions is required to provide more insight in the value creation for the target firm. 1 Hedge funds. www.sec.gov. 2 Klein & Zur, 2006 3 Hostile: if hedge funds use at least one of the following: proxy contest, law suits, hostile takeover bid, threat to launch proxy fight or to sue, or public campaign to criticize or even to replace the management. 4 Karpoff, 2001 UvT Bachelor Thesis: Hedge fund activism by Marjolijn Jansen 2
Preface This is a research to the impact of hedge fund activism on the value of the target firm. With this research I will finish my bachelor Business Administration at Tilburg University. I enjoyed writing this thesis. I was fascinated by the subject hedge fund activism, and after finishing this thesis, I can conclude that my knowledge about hedge funds and activism has absolutely increased. In addition, my academic writing skills and my English vocabulary improved because of writing this thesis. First of all, I would like to thank my supervisor from Tilburg University, Jinqiang Guo, for his assistance. His comments were very helpful for me. Next, I would like to thank my friend Merel Poldervaart for correcting the English spelling and or grammatical errors and finally I would like thank my family for their comments and support. Marjolijn Jansen Tilburg, 20 June 2008 UvT Bachelor Thesis: Hedge fund activism by Marjolijn Jansen 3
Index Chapter 1 Introduction 5 1.1 Research motive 5 1.2 Problem statement 5 1.3 Research questions 6 1.4 Research design 6 Chapter 2 Brief explanation of used theory 7 2.1 Hedge funds 7 2.1.1 Hedge funds characteristics 8 2.1.2 Hedge funds vs. Mutual funds 8 2.1.3 Hedge funds strategies 9 2.1.4 Hedge funds performances and risks 10 2.2 Shareholder activism 11 2.3 Hedge fund activism 13 2.3.1 Approaches to launch activism 13 2.3.2 Motives for hedge fund activism 14 Chapter 3 Characteristics target firms 15 Chapter 4 Value creation or destruction? 17 4.1 Impact of shareholder activism 17 4.2. Value creation 18 4.2.1 Returns for different sorts of activism 18 4.2.2 General returns to the firm 18 4.3 Value destruction 20 Chapter 5 Successfulness of hedge fund activists 22 Chapter 6 Case study: Stork 24 6.1 Stork, the entire story 24 6.2 What kinds of hedge fund activism? 26 6.3 Value creation or destruction? 28 6.4 Successfulness 29 6.5 Conclusion case study 29 Chapter 7 Conclusion and recommendations 30 7.1 Conclusion 30 7.2 Discussion and recommendations 31 References 33 Appendices UvT Bachelor Thesis: Hedge fund activism by Marjolijn Jansen 4
Chapter 1 Introduction 1.1 Research motive Hedge funds are a growing investment vehicle. It is hard to find a definition of hedge funds because they have evolved into a multifaceted organizational structure. Hedge funds display several interesting characteristics that may influence performance, such as flexible investment strategies, strong managerial incentives, substantial managerial investment, sophisticated investors, and limited government oversight. 5 Alfred W. Jones has started the hedge fund in 1949. Up till 1990, approximately $50 billion was invested in hedge funds. Sixteen years later, in 2006, the amount invested in hedge funds contributes more than $1 trillion. 6 Together with the increase in hedge funds over time, there has also been an increase in hedge fund activism by the funds managers. Klein and Zur (2006) define hedge fund activism as follows: A strategy in which a hedge fund purchases a 5 percent or greater stake in a publicly-traded firm with the stated intent of influencing the firm s policies. Hedge fund activism has received a lot of media attention recently. An example is how the hedge funds Centaurus and Paulson & Co have tried to influence the firm s policy of Stork (a Dutch industrial firm). Nowadays shareholder activism by pension funds and mutual funds has been widely studied, but little knowledge exists about the efforts of hedge funds activist. This thesis will summarize the existing evidence about the efforts of hedge fund activism and will investigate what fields need more investigation. 1.2 Problem Statement The problem indication leads to the following problem statement: How do the actions of hedge fund activism influence the value of the target firm? The problem statement will investigate in which way the actions of hedge fund activism can influence a target firm. With actions, all kind of actions to influence the policy of the firm are meant, such as trying to replace the board, to change operating strategies, to split up the company, drop merger plans etcetera. To investigate in which way the actions influence the target firm, this thesis will summarize empirical evidence about to which extent the activism had been successfully. With successful, the extent to which the activist can implement their 5 Ackermann, McEnally & Ravenscraft, 1999 6 Stulz, 2007 UvT Bachelor Thesis: Hedge fund activism by Marjolijn Jansen 5
objectives to create more value for the shareholders, are meant. The purpose of this thesis is to find out whether hedge fund activism creates or destroys value of the target firm. The most evidence is from European and North-American firms, therefore this region will also be the area that this thesis will investigate. 1.3 Research Questions To solve this problem, it is necessary to split the problem statement up into the next three research questions: What kinds of companies are targeted by hedge fund activists? This research question will investigate the characteristics of firms that have been targeted by hedge fund activists. This section will investigate, whether or not common characteristics that attract activists, exist. Does hedge fund activism leads to value creation or destruction for the firm? This question will explore what actions will increase the value of the target firm and what actions will decrease the value of the target firm. Do hedge fund activists succeed in implementing their objectives? This last research question will compare empirical evidence about the effectiveness of the actions of hedge fund activist and will conclude to what extent the target firm complies with the demands of the activist. 1.4 Research Design This bachelor thesis will contain a literature review and a case study. Chapter 1 will explain the problem statement and the research questions. Then, to get more insight in this investment vehicle, chapter 2 will explain more about hedge funds, shareholder activism and hedge fund activism. Next, chapter 3 will explain what kinds of companies are targeted by hedge fund activism. Subsequently, in chapter 4 will be investigated whether hedge fund activism creates or destroys value for the target firm. Then chapter 5 will elaborate on the successfulness of the hedge fund activists in their demands. After this literature review, this thesis will continue with a case study in chapter 6. The case study is about the Dutch industrial firm Stork. This case will generate more insight into the situation of Stork, which has recently been attacked by the hedge funds Centaurus and Paulson & Co (C&P). Furthermore, the theory discussed until then will be used to analyse the change in the stock prices (value of Stork), during the attack of the hedge funds. In Chapter 7, the conclusions and recommendations for further research will be given. UvT Bachelor Thesis: Hedge fund activism by Marjolijn Jansen 6
Chapter 2 Brief explanation of used theories 2.1 Hedge funds As stated in the research motive, hedge funds are a growing investment vehicle. Figure 2.1 shows that by the year 2005 the total assets under management of the hedge funds industry totalled $1,130 billion. Compared the previous year, this shows an increase of 13%. Compared to the year 2002 this shows a doubling of the assets. Figure 2.1 also indicates that approximately 8000 hedge funds exist, with aggregate assets under management of over $1 trillion. This implies that the average hedge fund had assets of approximately $100 million. 7 The term hedge fund does not appear in the federal securities laws. Likewise, there is no clear definition of a hedge fund 8. R.M. Stulz (2003) defines hedge funds as: the use of financial instruments or of other tools to reduce exposure to a risk factor. The website of U.S. Securities and Exchange Commission explains that hedge funds pool investors money and invest those funds in financial instruments in an effort to make a positive return. To provide more insight about hedge funds, this thesis will first define the characteristics of hedge funds. After that, the main differences between hedge funds and mutual funds will be explained. Subsequently, the different hedge funds strategies will be illustrated. Finally, the performances and risks of hedge funds will be described. Figure 2.1 Number of global hedge funds 9 7 Kahan and Rock, 2006 8 Brav et al., 2006 9 International Financial Service London, 2006 UvT Bachelor Thesis: Hedge fund activism by Marjolijn Jansen 7
2.1.1 Hedge funds characteristics As stated by Brav, Jiang, Patroy and Thomas (2006), hedge funds have four characteristics. The first characteristic is that hedge funds are pooled, privately organized investment vehicles. The second is that they are administered by professional investment managers. The third characteristic is that hedge funds are not widely public available. The last characteristic is that hedge funds operate outside of securities regulation and registration requirements. For more hedge funds features according to Brav et al. (2006) see appendix 1. Ackermann, McEnally and Ravenscraft (1999) denote two additive features, the first is that hedge funds have flexible investment strategies and the second is that hedge funds have substantial managerial investment. 2.1.2 Hedge funds vs. Mutual funds A mutual fund is a company that pools money from many investors and invests the money in stocks, bonds, short-term money-market instruments, or other securities. 10 Therefore hedge funds and mutual funds perform exactly the same economic function but hedge funds can coexist with mutual funds as mutual funds do not deliver complex investment strategies. 11 One of the reasons why mutual funds do not deliver complex investment strategies and hedge funds do is because mutual funds are regulated and hedge funds are mostly unregulated. This implies that hedge funds have limited rules about how they can invest their funds, how their managers can be paid, how they are governed, how they can charge investors for their services and so on. Hedge funds can avoid the regulations by limiting the number of investors who can invest and by not making public offerings 12,13. Hedge funds can limit their investors because investing in hedge funds is not accessible for every investor. The investors of hedge funds need to be individuals or institutions who meet SEC (Securities and Exchange Commission) requirements, assuring that the investors are knowledgeable and able to bear a significant loss. Klein and Zur (2006) argue that because hedge funds are relatively unregulated, they differ from mutual funds in several ways that make them more suitable to be activists. First of all, hedge funds are exempt from the diversification requirements of the Internal Revenue Code and the 1940 Investment Company while mutual funds are subject to these requirements. This implies that hedge funds can make major investments in a wide variety of publicly-traded securities. Second, unlike mutual funds, hedge funds are not registered under the Investment 10 Mutual Funds www.sec.gov 11 Stulz, 2007 12 Brav et al., 2006 13 Stulz, 2007 UvT Bachelor Thesis: Hedge fund activism by Marjolijn Jansen 8
Company Act of 1940. Due to this fact, a hedge fund can build up voting rights in a target company to support a threat of a coming proxy fight. The third difference between mutual funds and hedge funds is that managers have higher personal incentives to use activist campaigns to earn abnormal stock returns. The managers compensation of hedge funds includes both a percentage of invested funds and a percentage of the funds profits. These performance-based fees are prohibited to mutual funds. Mutual fund performance-based fee must satisfy the fulcrum rule 14. 15 The last difference according to Klein and Zur is that hedge funds investors have the financial resources to bear large financial losses. Further, they argue that because of tax rules, hedge funds are not required to make distributions to shareholders. Therefore, hedge funds can use all their after-tax resources to engage the target firm in an activist campaign. 16 The main differences between hedge funds and mutual funds are summarized in table 2.1. Table 2.1 Main differences between hedge funds and mutual funds Hedge funds Mutual funds Regulations Relatively unregulated Regulated Strategies Complex investment strategies No complex investment strategies Accessible for every No Yes investor? Easy to launch activism Yes No 2.1.3 Hedge funds strategies Hedge fund investment strategies differ in their strategies from traditional money managers. Moreover every fund follows its own strategy. Hedge funds can generally be divided into three main groups. First, there are the global funds, which concentrate on economic changes in the world and sometimes make extensive use of leverage en derivatives. These funds invest in non-us stocks and bonds, including emerging market securities with no specific strategy reference. Secondly, there are event-driven funds which trade the securities of companies in 14 fulcrum rule: that is, gains and losses must have a symmetric effect, in the sense that the same amount of over- and under-performance relative to a benchmark must result in the same amount of positive and negative incentive fees for a mutual fund manager. 15 Fung & Hsieh, 1999 16 Klein & Zur, 2006. UvT Bachelor Thesis: Hedge fund activism by Marjolijn Jansen 9
extraordinary situations like mergers. 17 Thirdly, the largest group of funds are the market neutral funds. These funds enter simultaneously into long 18 as well as short 19 position. Besides, a separate class of funds exist, which are the funds of funds. Stulz (2007) defines these funds of funds as: funds that invest in individual hedge funds and monitors these investments, thereby providing investors a diversified portfolio of hedge funds, risk management services, and a way to share the due diligence costs with other investors. These funds of funds make it possible for more normal investors to invest in hedge funds. The funds of funds are a growing investment vehicle. According to research of Fung, Hsieh, Naik, and Ramadorai (2006) the funds have grown from assets under management of $18 billion in 1995 to assets under management of $190 billion in 2004. For a more detailed overview of the different strategies see appendix 2. 2.1.4 Hedge funds performances and risks Ackermann, McEnally and Ravenscraft (1999) find that hedge funds consistently outperform mutual funds, but not standard market indices. Hedge funds can be valuable in financial markets. They seek inefficiencies in the capital markets and attempt to correct them by bringing security prices closer to fundamental values. Mutual funds are not able to make financial markets more efficient. 20 According to the research of Ackermann et al. (1999) hedge funds earn mean annualized returns of between 9.2 and 16.1 percent. However substantial variation exists across funds classification. Market neutral, short sales, and funds of funds earn lower than average returns. However these hedge funds also have the lowest standard deviation (risk). This is in congruous with the fact that these funds are designed to reduce risk. The highest risk in returns is displayed by global, global macro, and U.S. opportunistic hedge funds. The event driven hedge funds are the only category that shows above-average returns and below-average variance. 21 17 Fung & Hsieh, 1999 18 Long: a position in a security or derivative that benefits from an increase in the price of the security or derivative (Stulz, 2003) 19 Short: a position in a security or derivative that benefits from a decrease in the price of the security or derivative. (Stulz, 2003) 20 Stulz, 2007 21 Ackermann et al., 1999 UvT Bachelor Thesis: Hedge fund activism by Marjolijn Jansen 10
Table 2.1 Relative performance and risk 22 Correlations coefficients Mean Std. Dev. HF CTA S&P 500 (return) (risk) Hedge funds (HF) 15.1 5.5 1 0.75 0.37 CTA funds (CTA) 14.7 9.9 1-0.01 S&P 500 16.2 12.3 1 Fung and Hsieh (1999) show in table 2.1 the performance and risk of hedge funds relative to the CTA funds and the S&P 500. CTAs are investment pools that are often structured in similar way as hedge fund partnerships but are typically operated by commodity trading advisors (CTAs). CTAs are firms or individuals who handle customer funds or provide advice for trading futures contracts or options on futures contracts. 23 Hedge funds have slightly less return than the S&P 500. However, the table also indicates that hedge funds are approximately half as risky as the S&P 500. Besides, hedge funds have low correlation with the S&P 500. 2.2 Shareholder activism Before this thesis will explain the definition of hedge fund activism the more general term shareholder activism will be explained. For the study of Smith (1996), shareholder activism is defined as: monitoring and attempting to bring about changes in the organizational control structure of firms (targets) not perceived to be pursuing shareholder-wealth-maximizing goals. Gillan and Starks (2007) argue that there are two ways to describe shareholder activists. Their first definition is: investors who, dissatisfied with some aspect of a company s management or operations, try to bring about change within the company without a change in control. The other way to describe shareholder activism is to think of it more broadly as encompassing a continuum of possible responses to corporate performance and activities. This continuum includes shareholders who simply trade company s shares at the one end, at the other extreme are the shareholders that initiate takeovers and leveraged buyout with the objective to fundamentally change the corporation. Of course, there are also shareholders in between of these extremes for example, blockholders with a minority stakes, who have the intention of influencing managerial decision-making. 24 22 Fung and Hsieh, 1999 23 Fung and Hsieh, 1999 24 Gillan and Starks, 2007 UvT Bachelor Thesis: Hedge fund activism by Marjolijn Jansen 11
Different forms of shareholder activism exist. Not only hedge funds investors but also institutional investors, religious organizations, labour unions, individuals, and other groups can engage in shareholder activism. 25 During the past few years hedge funds and private equity funds have become increasingly important players in financial markets, particular in their capacity as monitors of corporate performance. 26 Figure 2.2 Percentage ownership of institutional investors in U.S. stock markets 27 With the suspension of hostile takeovers at the end of the 1980s, and the steady growth in their ownership of U.S. companies, U.S. institutional investors were forced to play a more active role in corporate governance. As can be seen in figure 2.2, institutional investors held only about 10% of U.S. equities in 1953. By the end of 2005 their percentage ownership jumped to over 60%. 28 Public pension funds and other activist investors began engaging in shareholder activism using Rule 14a-8. This rule permits shareholder proposals on a variety of topics. Several studies have shown that the type of activism by non-hedge fund investors had little effect on firm value or performances. They caused no measurable effects on stock prices or earnings but just small changes to the firm s corporate governance structure. Institutional investor monitoring had seemed particularly promising, because as a group these investors often held a majority of many publicly traded firms equity securities. However, various 25 Brav et al., 2006 26 Gillan and Stark, 2007 27 Gillan and Stark, 2007 28 Gillian & Starks, 2007 UvT Bachelor Thesis: Hedge fund activism by Marjolijn Jansen 12
regulatory and structural barriers have overwhelmed their efforts. For hedge funds investors this is different. 29 That will be illustrated in the next paragraph. 2.3 Hedge fund activism As stated in the research Klein and Zur (2006) define hedge fund activism as: A strategy in which a hedge fund purchases a five percent or greater stake in a publicly-traded firm with the stated intent of influencing the firm s policies. The recent literature shows that there exist differences between traditional shareholder activism and hedge fund activism. Partnoy and Thomas (2006) argue that hedge fund activists have more radical objectives than traditional activists (for example board changes). 30 Kahan and Rock (2006) argue that hedge fund activism differs from traditional shareholder activism in several ways. First of all, hedge fund activism is directed at significant changes in individual companies while traditional activism is directed at small, systemic changes. Secondly, hedge fund activism entails higher costs. Thirdly hedge fund activism is strategic and ex ante while traditional activism is intermittent and ex post. Hedge fund activists are very promising activists because they can avoid legislation, face fewer political constraints and conflicts of interest than traditional investors. 2.3.1 Approaches to launch activism The research of Brav et al. (2006) sorts a sample of 888 events by the approach that hedge funds adopt to launch activism (see appendix 3). The least aggressive approach: stating that it intends to communicate with the board/management on a regular basis with the goal of enhancing shareholder value is the most common approach because more than halve of the sample used this approach. Brav et al. (2006) subcategorize these activism events by classifying the hostile cases. The hostile cases include hedge funds which seek board representation without a proxy contest or confrontation with the existing management/board (stated hostile intention involved), hedge funds which launch a proxy contest in order to replace the board, hedge funds which sue the company, hedge funds which threaten to wage a proxy fight in order to gain board representation or to sue the company, and hedge funds which intend to take control of the company, e.g., with a take-over bid. In total there seem to be 214 hostile cases, which is 24.1% of the total sample. 29 Brav et al., 2006 30 Becht, Franks, Mayer and Rossi, 2006 UvT Bachelor Thesis: Hedge fund activism by Marjolijn Jansen 13
2.3.2. Motives for hedge fund activism The motives for hedge fund activism can be divided into seven categories (see appendix 4). 31 Type 1 category includes hedge funds which believe that the company is undervalued and/or that the fund can help the managers maximize shareholder value. This is a rather friendly approach because no further activism is launched. Type 2 includes activism targeting operational efficiency. Type 3 includes activism targeting firm s payout policy and capital structure (reduction of excess cash, increase in firm leverage, higher payouts to shareholders by dividends or stock repurchases, equity issuance, recapitalization, restructuring debt). Type 4 includes activism targeting business strategy: proposing to strengthen business focus or refocusing the business strategy. Type 5 includes activism urging the sale of the target (hedge funds forcing a sale of the target company or attempt to takeover or to take it private). Type 6 includes activism targeting firm governance (efforts to overrule takeover defences, chase away the CEO or chairman, challenge board independence, demand more information disclosure and question potential fraud and to challenge the level or the pay-for-performance sensitivity of executive compensation). Type 7 includes activism in the form of providing finance. In this category, the hedge funds are financing either business or corporate restructuring arising out of bankruptcy or financial distress. In most of these cases, hedge funds also seek friendly board representation and are accommodated by the firm. 32 31 Brav et al., 2006 32 Brav et al., 2006 UvT Bachelor Thesis: Hedge fund activism by Marjolijn Jansen 14
Chapter 3 Characteristics target firms Gillan and Starks (2007) argue that until recently, the main criterion for activists to target a firm has been poor performance. The targets have also often been characterized by large shareholdings of other institutional investors, low inside ownership, and poor governance structure. In some cases poor performance and poor governance still trigger activist campaigns, however recent hedge fund activist are searching profitable companies to target. Klein and Zur (2006) compared the differences between hedge funds targeted firms, a control sample and firms that are targeted by others activists (non-hedge fund activist). It is striking in their study that non-hedge fund activists are more likely to target one firm at a time 33 and hedge fund activists have multiple targets 34 over the same period of time. Klein and Zur (2006) even found evidence of a hedge fund activist who had targeted 10 firms in the same period. Klein and Zur (2006) also did research on the exchange or market where the target firm trades at the time of initial investment. It turned out that non-hedge fund activists target firms in similar markets as hedge fund activist (predominantly firms trading on the NYSE 35 or NNM 36 ). It seems that hedge fund activists target firms in other industries than non-hedge fund activists. Non-hedge fund activists are more likely to invest in restaurants, hotels, motels, banking, and communication firms than hedge fund activists. Hedge fund activists are more likely to invest in pharmaceuticals, retail firms and business services. Differences exist between the stated reasons of activists about the purpose of transactions. Hedge fund activists are more concerned with mergers, stock buybacks and receiving cash dividends, while non-hedge fund activists are more interested in buying the target firm themselves, becoming an active investor, and steering the firm towards alternative strategic goals. Both types of activists frequently demand changes in the board of directors. 37 The research of Klein and Zur (2006) indicates that hedge funds target relatively profitable, healthy firms in terms of earnings per share, return on equity, BHARS 38, and Altman s Z- score 39 Other activists (non-hedge fund) target lower performing companies with a high 33 126 out of 141 activist 34 64 out of 102 activist 35 New York Stock Exchange 36 Nasdaq National Market 37 Klein & Zur, 2006 38 BAHR: Buy Hold abnormal return for the full year previous to filing of the initial schedule 13D. 39 A predictor of bankruptcy (Klein & Zur, 2006) UvT Bachelor Thesis: Hedge fund activism by Marjolijn Jansen 15
probability of bankruptcy (low z-score) and negative earnings per share. It is also shown that hedge fund targets have more cash on their balance sheets than non-hedge fund targets. The study of Klein and Zur (2006) indicates that compared to the control sample, hedge fund activists target relatively small companies. It makes sense that large firms are less likely to be targeted because a hedge fund would need a larger amount of capital to invest in order to amass a meaningful stake. Brav et al. (2006) used a database of 888 events launched by 131 activist hedge funds from the beginning of 2001 through the end of 2005 for their research. Just like the research of Klein and Zur (2006), their research also indicates that target firms are significantly more profitable than comparable firms in their sample. Profitability is measured both in terms of return on assets and cash flows generated. Brav et al. (2006) investigated more aspects of target firms than Klein and Zur (2006). Brav et al. (2006) found that target firms have a little more debt and that target firms dividend payout is slightly lower relative to the comparison firms used in their sample. According to Brav et al. (2006) activist hedge funds are seeking to identify undervalued companies where the potential for improvement is high. Hedge funds identify potential problems at targeted firms that are general issues, rather than firm specific issues (like operational difficulty and sales slump). The potential problems are related to the agency problem, relatively low payout ratio and diversifying investments that might not be in the best interest of shareholders. Little is know about the activist efforts of hedge funds to these target firms. The next sections will examine the efforts. UvT Bachelor Thesis: Hedge fund activism by Marjolijn Jansen 16
Chapter 4 Value creation or destruction? In the previous chapters, the theory about hedge fund activism has been explained. Now, this thesis will investigate whether hedge fund activism increases the value of the target firm or decreases the value. In the first paragraph, the impact of shareholder activism will be discussed. In the second paragraph, the ways to create value for the target firm by hedge fund activism will be discussed. Finally, in the third paragraph the ways to destroy value of the target firm by hedge fund activism will be discussed. 4.1 Impact of shareholder activism Inconclusive evidence exists about to which extent shareholder activism facilitates improvements in target firms values, earnings, operations and governance structures. Karpoff (2001) summarized recent empirical research of 20 studies about two sorts of activism: shareholder proxy resolutions and informal negotiations with target firm manager. He concludes that disagreement among researchers is more apparent than real. An overview of the inconclusive evidence about the impact of shareholder activism on the target firm is given in table 4.1. Table 4.1 Overview impact shareholder activism on the target firm 40 Shareholder activism increases the value of the target firm Shareholder activism does not increase the value of the target firm Smith (1996) Sunil Wahal (1996) Strickland, Wiles, and Zenner (1996) Karpoff, Malatesta, and Walkling (1996) Bizjak and Marquette (1998) Gillan and Starks (2000) Carleton, Nelson, and Weisbach (1998) Johnson and Schackell (1997) Del Guercio and Hwakins (1999) Wagster and Prevost (1996) Opler and Sokobin (1997) Woods (1996) Most evidence indicates that shareholder activism can prompt small changes in target firms governance structures but has negligible impacts on share values and earnings. 41 In the next two paragraphs, whether or not this is also the case with hedge fund activism, will be discussed. 40 Karpoff, 2001 41 Karpoff, 2001 UvT Bachelor Thesis: Hedge fund activism by Marjolijn Jansen 17
4.2 Value creation 4.2.1. Returns for different sorts of hedge fund activism Empirical evidence of Brav et al. (2006) shows how event-window abnormal returns vary with the stated objectives of the hedge funds. They divided the stated goals into seven categories. The sale category (category number 5 of chapter 2), in which hedge funds request the sale of the target firm, generates the highest abnormal return, with average abnormal return of 10.94%. Clifford (2007) divided the activism filings in six sub categories. One of these categories was: Sell Assets or Firm, an aggressive activism where the hedge fund requests the firm to sell off part of its assets or the entire firm. This category resembles to the sale category of Brav et al. (2006), empirical evidence of Clifford (2007) also indicates that this category generates the highest returns for the target company. Moreover, financing related activism generates large returns, on average 6.11%. The effect, however, is not significant. 42 Surprisingly, according to the results of Brav et al. (2006) activism targeting capital structure and governance issues show near zero abnormal return. Next, the research of Brav et al. (2006) indicates that hostile 43 targeting generates higher returns (11.8%) than relatively friendly ones (5.3%). However hostile activism is more costly, therefore hedge funds should only resort to it when the perceived benefits are higher. 44 4.2.2 General returns to the firm Firms targeted by both passive and active block holders experience positive and significant excess returns surrounding the filing date 45 on the short run. 46 This does not imply that the market views shareholder activism as providing additional value to the target firm, otherwise one would expect to see larger excess returns to firms targeted by activists block holders than firms targeted by passivist block holders. Brav et al. (2006) investigated the targeted companies operational performance, from three years before the activism to one year after. The results show that the Return on Equity (ROE) significantly improves while the Return on Assets (ROA) improves moderately. This could be a result of higher leverage or reduction in capital expenditure. On the contrary, Clifford (2007) finds a median increase in ROA of 1.17% in firms targeted by activist block holders, 42 Brav et al., 2006 43 Hostile: if hedge funds use at least one of the following: proxy contest, law suits, hostile takeover bid, threat to launch proxy fight or to sue, or public campaign to criticize or even to replace the management. 44 Brav et al., 2006 45 The filing date is the moment that the market receives a signal that an activist hedge fund is interested in the company and will most likely use its influence in an attempt to increase shareholder value. (Klein and Zur, 2006) 46 Clifford, 2007 UvT Bachelor Thesis: Hedge fund activism by Marjolijn Jansen 18
compared to firms targeted by passivists. Klein and Zur (2006) conclude that hedge fund activism does not result in an increase in accounting profitability. They found evidence that EPS 47, ROA and ROE decline in the year after the activism. Therefore, inconclusive evidence exist about whether hedge fund activism increase or decrease operational performance in terms of ROA and ROE. The results of Brav et al. (2006) indicate that the total payout ratio becomes larger and statistically different one year after activism (1.66%). Klein and Zur (2006), find evidence that cash on hand declines for target firms and part of this decline can be explained by robust increases in dividends paid to common shareholders. The leverage ratio decreases one year prior to activism (from 3.24% to 2.34%), and increases one year afterwards to 3.55%. 48 Klein and Zur (2006) also find that target firms increase the relative amount of debt in their capital structure. In contrast to these results, Clifford (2007) does not find evidence that payout ratios and leverage are statistically distinguishable from firms targeted by passivists. Below in table 4.1 the research windows of the used papers in this chapter are shown. Most used papers investigated the increase in value of the firm only in the short term. Limited evidence exists about long term value creation or destruction. Table 4.1 Overview used papers Paper Research data before filing date Research data after filing date Brav et al. (2006) -3 year + 1 year Klein & Zur (2006) -1 0 (filing date) Clifford (2007) -2 day +2 day -1 year +1 year Previous research on activist campaigns by pension funds and shareholder groups finds little systematic wealth creation as a result of the activist campaign. How can it be that hedge funds can increase value and pension funds and mutual funds cannot? Clifford (2007) argues that the organizational characteristics of a hedge fund, including its compensation incentives, ability to lock-up investor capital, and ability to ultimately acquire the target, increase its 47 EPS= Earnings per Share 48 Brav et al., 2006 UvT Bachelor Thesis: Hedge fund activism by Marjolijn Jansen 19
incentives and relative bargaining power with the target firm s management. This increase in power may help to explain why the gains to activism by hedge funds are more obvious than activist efforts by pension funds and mutual funds. 4.2 Value destruction The main problem regarding hedge fund activism is that activism is designed to achieve a short-term payoff at the expense of long-term profitability. Kahan and Rock (2006) investigated the dark side of hedge fund activism. They found that hedge funds could cause managers not to make crucial long-term investments. This is only possible when the stock market suffer from myopia. Myopia is when the market undervalues long-term investments relative to short-term investments. However, as stated by Kahan and Rock (2006), the existence of a short-termism problem is least proven. Clifford (2007) investigated the long-run stock performance of the target firm, because previous literature showed that hedge fund activists gain at the expense of the long-term firm value. Therefore, Clifford (2007) compared the average monthly excess returns of firms targeted by activists to those of firms targeted by passivists. He used a portfolio where he invested long in firms targeted by activists and shorts in the firms targeted by passivists. In the 1-year period after the block, activism yields annual excess return of 4.68%. However, in the long term, (2 year and 3 year after the block) Clifford (2007) was unable to distinguish activism yields with larger monthly excess returns than passivists returns. Nonetheless, Clifford (2007) provides evidence that these returns are not smaller than the returns of target firms targeted by passivists. Little evidence exists about whether hedge fund activism creates or destroys value of the firm in the long term. Moreover, Karpoff (2001), who summarized the evidence on the impact of shareholder activism on the target firm, was also not able to find much empirical evidence in the long run. The evidence that is available about the impact of shareholder activism in the long run is inconclusive. Opler and Sokobin (1995) find evidence that activism creates abnormal stock returns in stocks of targeted companies for periods up to four years after the announcement of the activism. Therefore their conclusion is that activism creates shareholders wealth. In addition, two studies of CalPERS 49 activism by Nesbitt (1994) and Smith (1995) find small but significant long term share price improvements afterwards. 50 In contrast to this positive evidence in the long run, Wahal (1996), Del Guercio and Hawkins (1999) and 49 CalPERS= California Public Employees Retirement System (leader in activism) 50 Opler & Sokobin, 1995 UvT Bachelor Thesis: Hedge fund activism by Marjolijn Jansen 20
Prevost and Rao (2000) conclude that the long-run average stock return is negative and in some cases statistically significant. 51 51 Karpoff, 2001 UvT Bachelor Thesis: Hedge fund activism by Marjolijn Jansen 21
Chapter 5 Successfulness of hedge fund activists Klein and Zur (2006) interpret their results as evidence that hedge fund activists are extremely effective in making significant changes to their target firms. They investigated per purpose of transaction the success rates of achieving the stated goals by the hedge funds. In 60 percent of the cases the hedge fund activists are successful in their demands. Hedge fund activists have a success rate of 73 percent in the change of composition in the board of directors and 100 percent success rate in buyback its own stock, in replacing the CEO, and initiating a cash dividend. Other stated purposes such as oppose a merger, sell the firm, and pursue strategic alternatives have a success rate of 50 percent. Brav et al. (2006) also found evidence that hedge fund activism is successful. In their research about 41 percent of the stated goals obtained success and 26 percent obtained partial success (hedge funds gain significant concessions from the target). According to Brav et al. (2006), the highest success rate (91.7%) is when a hedge fund acquires a stake in the potential target of a merger and acquisition (which has not completed yet) in order to facilitate the acquisition. The lowest success rate is when an activist tries to revoke takeover defences (20.4%). See appendix 4 for a more detailed overview of the success rates. Klein and Zur (2006) also investigated the relation between proxy fights and success of activists in achieving their goal and obtaining at least one seat of the target firm s board of directors. The proxy fights are divided into real proxy fights, public threatens (but never an actual proxy fights), and non-public threaten (no proxy fights). With a proxy fight the hedge fund activist achieves the most goals (72%) and has the highest chance of gaining at least one seat on target s board (73%). However, according to the χ²-test 52, Klein and Zur (2006) found no evidence of a relationship between proxy fights and the rate of success. Their conclusion is that the perceived threat of knowing that a proxy fight can occur is a weapon that hedge fund activists use against standing management. A threat of proxy fight is sufficient to elicit change in the board s composition. Contrary to this research, Bebchuck (2007) argues that: shareholders do not have the power to replace the directors of public companies. Electoral challenges are rare and the risk of replacement via a proxy contest is extremely low. 52 χ²-test is used to measure the relation between the variables. UvT Bachelor Thesis: Hedge fund activism by Marjolijn Jansen 22
Kahan and Rock (2006) also investigated the successfulness in affecting the corporate policy. They argue that hedge funds can not become powerful enough to exercise control over the targets. Hedge fund activist often buy 5% to 10% of the stake. This amount does not give them the power to exercise control over target firms. Therefore, in order to be successful, hedge funds need the support of others: corporate management, independent directors, traditional institutional investors with large stakes and other large shareholders. 53 53 Kahan & Rock, 2006 UvT Bachelor Thesis: Hedge fund activism by Marjolijn Jansen 23
Chapter 6 Case Study: Stork 6.1 Stork, the entire story The year 2006 for Stork was dominated by the investigation into a possible Public-to-Private transaction and the situation that arose as a result of the change in strategy desired by the shareholders Centaurus Capital Limited and Paulson & Co Inc. (The abbreviation of these hedge funds used in this chapter is: C&P). The entire story will be described in detail below. On February 1 st 2006 Stork announced its strategic choices for the next phase of value creation: Stork Prints and Stork WorkSphere would be divested and Stork would continue in the following phase with three groups: Aerospace, Food Systems and Technical Services. The big hedge funds C&P (joint shareholding of approximately 20%) were dissatisfied and wrote a letter to Stork with the options for Stork on February 6 th 2006. The options are: 1. Stork divests all its divisions with the exception of Stork Aerospace. or 2. Stork becomes a conglomerate with three divisions (as the management of Stork intended), but in the form of a privately held company instead of a listed company. On February 14 th 2006, a press release of Stork announced that Stork would reaffirm the strategy and that they would investigate the possibility of a public-to-private transaction. At March 10 th 2006 Stork gave an explanation in the Annual General Meeting of Shareholders (AGM) of the strategic decisions that it took in February 2006. At this AGM a representative of C&P indicated that C&P supported the initiative of a Public-to-Private investigation. On July 4 th 2006 a press release and a letter to the shareholders of Stork announced that a successful execution of public-to-private transaction was not feasible. During the Extraordinary General Meeting of Shareholders (EGM) on September 5 th 2006, Stork explained why they had decided to stop the investigation on the possibility of going private. On September 7 th 2006 Centaurus and Paulson sent another letter to request to call an EGM before October 19 th, 2006 to vote on whether or not Stork should fully concentrate on the aerospace division in order to create a Dutch aerospace champion and to divest all other businesses, including Stork Prints, Stork Technical Services and Stork Food Systems. EGM on October 12 th 2006, C&P handed out a presentation explaining their proposal. The proposal was adopted. On October 19 th 2006, C&P proposed by letter to the Supervisory Board to hold a discussion to investigate whether any common ground could be found between the strategic visions of Stork on the one hand and C&P on the other hand. On November 11 th, 2006 a discussion took place between Stork and C&P. However this did not UvT Bachelor Thesis: Hedge fund activism by Marjolijn Jansen 24
lead to a rapprochement. November 14 th 2006, Stork announced that implementation of the proposal of C&P would be irresponsible and that they, taking into account their responsibilities under Dutch corporate governance, were unable to accept the outcome of the vote at the EGM on 12 October 2006. On November 23 rd 2006, C&P requested Stork to hold a third EGM to vote of no confidence in the Supervisory Board and to propose the introduction of a statutory right of approval by the general meeting of shareholders for mergers and/or acquisitions or divestments with a value of more than 100 million dollar. On December 14 th 2006, Stork announced that it would comply with the request of C&P and call an EGM on 18 January 2007. On December 19 th 2006, the executive committee of the Stork Foundation (Stichting Stork) exercised its option right to acquire cumulative preferred shares in Stork. Preferred means that the holder of the preferred share must receive a dividend before holders of common shares receive dividend, and cumulative means that if dividends are not paid in a particular year, they will be carried forward. 54 The Foundation acquired 30,233,170 cumulative preference shares, slightly less than 50% of the issued share capital of Stork. The reason why the Foundation took this action was because it feared that there was a serious threat to the development, independence and continuity of Stork. The Foundation also stated that it intended to vote against the proposals of Centaurus and Paulson at the meeting. On January 5 th 2007, C&P requested the Enterprise Chamber of the Amsterdam Court of Appeal to hold an investigation into the policy and affairs of Stork. They also requested the Enterprise Chamber to take provisional measures, including cancellation of the voting rights of the 30,233,170 cumulative preference shares B held by the Stork Foundation. On January 17 th 2007 the Enterprise Chamber decided to hold an investigation into the policy and affairs of Stork which have led to the current situation. For the duration of the investigation, the Enterprise Chamber further ordered the following measures with immediate effect: Prohibition of voting on the items, proposed by Centaurus and Paulson, on the agenda of the EGM on January 18 th 2007. The appointment of three extra Supervisory Board members in addition to the current members. These new members will have the exclusive right to determine the agenda of ordinary and extraordinary general meetings of shareholders. They will also have a deciding vote on matters relating to the strategy of Stork and on those matters on which Stork and Centaurus and Paulson are divided, to be determined at the discretion of these Supervisory Board members. 54 Ross, Westerfield & Jaffe (2005) UvT Bachelor Thesis: Hedge fund activism by Marjolijn Jansen 25