David Einhorn doesn't make many bad bets. Last summer the 38-year-old hedge fund manager walked away with $650,000 in the World Series of Poker, cash he promptly donated to charity. He has proven just as adroit at running his $3 billion Greenlight Capital Inc., which engages in so-called activist investing. Over the years Einhorn has generated fat returns by taking positions in companies and then badgering management into making drastic changes to boost the stock price. Last year his firm booked a heady 25% gain.
The high-stakes brawler isn't immune to losses, however. Consider his disastrous experience with New Century Financial Corp. (NEW), an Irvine (Calif.) lender that specializes in mortgages for people with shaky credit. Last year, after accumulating a 6.3% stake, Einhorn threatened management with a proxy battle, relenting only after clawing his way onto the company's board in March. So far all he has to show for the saber rattling is red ink. On Feb. 8 the stock plunged 36%, to a four-year low, after New Century warned that it would report a fourth-quarter loss and restate some of its 2006 results. The stock fell more on Feb. 21 after subprime mortgage lender NovaStar Financial Inc. (NFI) reported even worse earnings news. Shares of New Century, trading around 17.50, have been cut in half since Einhorn joined the board.
His experience underscores the risks of shareholder activism. Unlike other investors who might opt to minimize the pain by selling shares, Einhorn has his hands pretty much tied. His seat on the New Century board makes him a corporate insider, which restricts his ability to run for the exits when bad news hits. So Einhorn--along with Greenlight's investors--must stick around and hope New Century, which is now being hit with a wave of shareholder suits, turns things around.
To be sure, hedge funds are showing a knack for boosting stock prices by hectoring corporate managers for bigger dividends, share buybacks, or asset sales. A recent academic study found that, over the past five years, hedge fund agitators have outperformed the market. To wit: Atticus Capital, a $14 billion hedge fund, is credited for forcing copper miner Phelps Dodge (PD) to sell itself to Freeport-McMoRan Copper & Gold (FCX) in a $26 billion deal that will deliver a 33% premium to Phelps shareholders.
But the risks for agitators increase the minute they land on a company's board. Most hedge funds are short-term players that relish their ability to jump into and out of investments. Board relationships are sticky, says Damien Park, president and chief executive of Hedge Fund Solutions, a consultancy that advises companies on how to work with activist funds. "Investors who join boards should be long-term-oriented," he says. "This includes the good, the bad, and the ugly times."
Perhaps the best-known instance of an activist getting burned was the proxy battle waged by Warren G. Lichtenstein for a seat on the board of BKF Capital Group, an investment management firm. In 2005, Lichtenstein, the manager of $4 billion hedge fund Steel Partners, won a board seat with the support of Carl Icahn and other activist hedge fund managers. Lichtenstein planned to use his seat to wage a campaign to cut costs at the struggling investment firm, but the share price collapsed before that could happen. Trading around 20 when Lichtenstein joined the board, the stock was delisted from the New York Stock Exchange (NYX) last year and now fetches about 3 on the unregulated Pink Sheets. A Lichtenstein spokesman declined to comment.
It's hard to know whether Einhorn regrets the New Century deal. A Greenlight spokeswoman says he won't comment on the matter. He is being equally uncommunicative with his own investors. Those familiar with Greenlight say Einhorn can't discuss the fund's investment in New Century without running the risk of turning his fund investors into corporate insiders. New Century is keeping mum, too.
By Matthew Goldstein