Extreme Value Hedging: How Activist Hedge Fund Managers are Taking on the World
Ronald D. Orol
In June 2006, Robert Chapman, the ‘We have no interest in being shackled by the membership rules of a Club Carreker “insider”’, wrote: ‘To be honest, I begin to retch at the image of my flying into Dallas to attend a board meeting as a minority director outweighed by the group-think-driven crew listed in the addressee section above. I have nightmares involving my choking down gourmet tuna sandwiches and uninformed “long term” business judgments, both being served in abundant quantity by you and your Texas “pardners”.’
Chapman is one of the more colourful activist hedge fund managers. He has a deft way with words, and his pithy, often inflammatory letters are widely publicised in the press — particularly the financial press, which rarely has anything more colourful than grey annual reports to write about.
Chapman calls his letter-writing part of his ‘social lever’ — shaming the company into making the changes he wants. What he wanted in this case was for Carreker to put itself up for sale. Companies in similar businesses had sold for high valuations and Carreker had ‘a broad product line and extremely strong customer list,’ he noted. It also had $40 million in cash. ‘Given your tainted history as a “corporate acquisitor”,’ Chapman wrote to the firm later that month, referring to the 2001 purchase by Carreker of Check Solutions Company (an acquisition that had gone somewhat awry), ‘we strongly advise that Carreker not utilise its $40 million in cash and marketable securities to flood its income statement, yet once again, with more intangible amortization and overall business risk.’
Shortly after that letter, Carreker took Chapman’s hint and asked its financial advisers to consider strategic options for the firm, including a sale. In January 2007, it was bought by a company called Checkfree Corporation for $206 million, or about $8 a share. By then, Chapman had lost interest. His original assessment of Carreker’s worth was $12 a share. When it became apparent his estimate was wildly optimistic, he unloaded his holding in the company.
He didn’t do too badly though. The investment in Carreker yielded a 30 per cent return, more or less. Chapman had purchased his stake for, on average, $5.50 a share; he sold it for between $6.75 and $7.75 a share. His actions (and those of other activist managers who piled into Carreker) had, it seemed, ‘enhanced shareholder value’.
This is the phrase that is always trotted out to justify and promote what activist managers do, though it’s sometimes tarted up in the even more respectable clothes of ‘improving corporate governance’. As a group, activist managers are the direct, linear descendents of the corporate raiders of the 1980s — and many of them actually worked for financial predators such as T Boone Pickens, famous for his dawn raids on US energy companies. In the days before the Feds stepped in with their pesky regulations, Pickens and his piratical ilk could secretly build up a large stake in a target company, then launch an opportunistic takeover bid. Various corporate and securities regulatory changes have made that much more difficult, as have restrictions on financing for hostile takeovers and corporate anti-takeover protection, known as poison pills.
The transformation of raiding into activism was a result of changed circumstances, as much as anything. Today’s activists, unlike yesterday’s raiders, are much more likely to work consensually with a target company’s management over time to improve value. Raiders were much more direct: often, their ultimate strategy was to break up the company and sell it off bit by bit. Both raiders and activists, however, have the same goal: to increase the value of their holding in a company by one means or the other.
Does it work? According to figures presented in this book, it has, at least in the past. Activist hedge funds, which in 2006 accounted for some $117 billion in assets — up from $48.6 billion in 2004 — have consistently out-performed the S&P 500 benchmark. In 2004, for instance, the S&P returned 10.86 per cent, while activists produced 23.16 per cent.
The next year, the S&P reported 4.91 per cent and activists returned 16.43 per cent. In 2006, the S&P managed 15.78 per cent and activist funds 16.72 per cent. The decline in the returns of activist hedge funds and the more than doubling of their assets is probably not accidental: as strategies become more popular, there is more competition to find opportunities and returns become thinner.
It’s at roughly that point, when the strategy is almost tapped out, that a book about it appears. This probably has something to do with the fact that the publishing industry moves much more slowly than the financial industry. Extreme Value Hedging seems to have been written in the latter half of 2006 and the early part of 2007, when hedge-fund activists were making the running and the fodder for their horses — cheap money — was plentiful. There is a whiff of a golden past in phrases such as ‘corporations have access to much more debt financing… than ever before, and the cost of all that debt is lower than it has ever been’ and ‘corporations seeking new debt funding can go to… institutions that offer collateralised debt obligations [CDOs], which are investment-grade securities backed by a pool of bonds and loans.’
That may well have been true only twelve months ago. But, as we all know, the era of easy financing came to an end in roughly the third quarter of 2007 and ‘investment-grade’ CDOs turned out to be the financial equivalent of rat poison. Probably, 2007 marked the end of the ‘activist era’ as well, at least for the time being. The smart money now is said to be moving into funds that have been set up to exploit the credit crisis, by buying cheaply those self-same CDOs and CMOs that caused it in the first place. Those managers who have the resources to unpick their complex structures and value their underlying assets will be the ones to make the running in the next year or two. Financial journalists wanting to get a book out about it should probably start writing now.
Review by Paul Mungo