The New Raiders
By Emily Thornton
Boston hedge fund Highfields Capital Management apparently had had enough. It watched in dismay as its investment in the nation's No. 3 electronics retailer, Circuit City Stores (CC ), floundered. Finally it took action. But Highfields didn't sell its 6.7% stake and then maybe try its luck at shorting the stock. Instead, it decided to buy the whole company, making a surprise $3.25 billion bid on Feb. 15. The stock soared 16% that day.
Highfields and its reclusive managers, Jonathon Jacobson and Richard Grubman, are on the leading edge of a new wave of corporate raiders. Flush with hundreds of billions of dollars in cash from investors and hard-pressed to maintain the double-digit returns they promise as competition stiffens, many hedge funds are reinventing themselves as private investment firms. They charge the high fees of a hedge fund but, no longer content with shorting shares or pursuing other hedging strategies, they're seizing control of companies.
In all, hedge funds and their affiliates have announced deals for at least 23 companies, valued at about $30 billion, in the past year. Already, New York-based Cerberus Capital Management, named for the three-headed dog that guards the gates of hell in classical mythology, controls companies worth at least $20 billion that employ tens of thousands of people.
The escalating battle over chunks of Corporate America is creating fear and outrage in many executive suites. Even if they're unable to buy companies outright, hedge funds are winning board seats, ousting chief executives, and forcing companies to shape up by making big stock and bond purchases.
They're butting heads with rival buyers for outfits that are for sale and launching hostile tender offers for those that aren't. And they're no respecters of size. A former Morgan Stanley managing director, Scott Sipprelle, the 42-year-old chairman of $1 billion Copper Arch Capital, has become so frustrated at his old firm's underperforming stock that he is publicly calling on the company with a $65 billion market cap to dump its credit-card and retail-brokerage operations. Morgan Stanley insiders believe he is trying to put the company in play.
Some of the raids threaten to be far bloodier than those launched a generation ago by Street-smart raiders such as T. Boone Pickens and Henry R. Kravis. For one, the new raiders don't need any help financing their deals, as the 1980s crowd did. A few have $10 billion or more in their war chests. Dozens have more than $1 billion, a far cry from the select group that dominated the takeover game back then.
What's more, the new raiders can be more aggressive than their predecessors because the times allow them to be. In the wake of Enron and other scandals, companies have never been as vulnerable to shareholder demands as now. Businesses must disclose more information than ever, their poison pills are gone, and their spats with shareholders on earnings calls are widely broadcast. Hedge funds can exploit this changed climate because, unlike traditional buyout funds, they don't have conservative pension funds that loathe public controversy stopping them from making hostile moves.
It's not just CEOs who are suffering sleepless nights. Traditional buyout firms are getting the jitters, too. Some, such as Texas Pacific Group, are setting up partnerships with hedge funds to compete for investor dollars. Some bankers expect that, as more hedge funds turn hostile, the more nurturing private-equity firms will present themselves as white knights ready to ride to the rescue of the hedgers' targets. "I would not be surprised if private-equity firms tried to top Highfields' bid for Circuit City," says Alan Jones, a senior banker at Morgan Stanley.
THE RIGHT STUFF?
Still, hedge funds are rewriting the rules for Corporate America. They are supplying jet fuel for mergers and acquisitions. And their leaders are emerging as a new managing class. Some are forcing managers to admit that assets, such as real estate, are worth more than entire businesses. They are taking the idea that CEOs work for shareholders to an entirely new level, speeding up the revolving door to head honchos' offices.
"We're not going to see the Jack Welches any more who are allowed their periods of ups and downs," says John Challenger, CEO of executive recruiting firm Challenger, Gray & Christmas.
Private equity firms charge that these often young, impatient numbers guys who run hedge funds and sit for hours in front of computer screens are ill-equipped to run companies. Veteran buyout specialist Kravis warns that hedge funds do not know how to create value. "Companies are not pieces of paper," echoes Michael G. Psaros, founding partner of private equity firm KPS Special Situations Funds.
Hedgers maintain that they are better qualified to run businesses than are most chief executives. "I've invested in hundreds of companies," brags 39-year-old Thomas R. Hudson Jr., founder of nearly three-year-old Pirate Capital, which has raised almost $400 million and had a 29% return after fees last year. "Most CEOs have come up through the ranks. Maybe they've worked at four or five places." Plus, some hedge funds have former CEOs and CFOs on their payrolls, ready to be parachuted in at a moment's notice.
The new raiders often hunt in packs. In August, several, including Och-Ziff Capital Management Group, teamed up with Berkshire Hathaway (BRK-A ) and White Mountains Insurance Group to buy insurer Symetra Financial, formerly owned by Safeco (SAFC ), for $1.35 billion.
Some funds buy just enough stock to bark out orders to management. Call them the Attack Dogs. Others, the Midas Men, straighten out struggling companies. Then there are the Crackerjacks, who use cutting-edge maneuvers to outsmart other bidders. Here's how they work:
When 39-year-old Warren G. Lichtenstein made a hostile bid for rocket-motor-maker GenCorp (GY ) in November, he stunned Wall Street vets who never imagined a hedge fund buying such a company. But for Lichtenstein, founder and principal of the $3 billion New York-based Steel Partners, it was all in a day's work. From his perspective, he "owns" 25 companies, bought with downpayments of less than 15% of their stock -- as though they were houses. "We're called a hedge fund because of our fee structure, but we're just a partnership that can invest in public and private companies. We hedge by buying cheap," he says.
Distinction without a difference? Perhaps. As a major shareholder, Lichtenstein is chairman of aerospace technology company United Industrial Corp. (UIC ). There's little hint that just two years ago Lichtenstein was an outsider waging war against the company's management. Since he became chairman, the company's stock has doubled, to $33. That contributed to the roughly 35% return after fees that Lichtenstein's fund racked up in the past year, making it one of the hottest around. What does Lichtenstein bring to companies that managers can't? "Discipline," he says. "Empower the people. And then hold them accountable."
Now Lichtenstein is setting his sights on bigger trophies. He used to invest in $100 million companies. These days he hunts mostly for bargains in the $2 billion range, believing he'll fare better because there's less risk in bigger companies. They employ higher-quality people and ultimately have more suitors willing to pay top dollar for them, yet they are riddled with inefficiencies and excessive costs. By Emily Thornton
Another top raider prefers a more swashbuckling image. Surrounded by buccaneer memorabilia in Pirate Capital's office in Norwalk, Conn., Hudson and his crew fire off lawsuits and testy letters to companies that they consider poorly run. They helped to oust the chairman and CEO of educational services provider Cornell Cos. (CRN ) and to attract offers for John Q. Hammons Hotels (JQH ). James A. Mitarotonda, a co-founder and principal of Barington Capital Group, has created waves, too. From his office opposite Carnegie Hall in New York City, he spurred changes that led to the Feb. 7 resignation of the CEO of Register.com (RCOM ).
At the other end of the spectrum, most deals pursued by Midas men aren't hostile. But these alchemists who spin distressed companies into gold increasingly find themselves facing off against private equity and corporate buyers for bargains. Stephen A. Feinberg, founder of Cerberus, which manages more than $14 billion, backed out of a deal last year for Clayton Homes that was also pursued by Warren Buffett.
But Feinberg has outmaneuvered other buyers to pick up old-line companies such as Anchor Glass Container (AGCC ) and MeadWestvaco'S (MWV ) paper unit along with its 900,000 acres of forest land. In December he took public BlueLinx Holdings (BXC ), a building-products distributor bought from Georgia-Pacific (GP ) last May.
PLAYING FOR KEEPS.
Iconic companies aren't out of the hedge funds' reach. D.E. Shaw & Co., with $12 billion in capital and populated by PhDs, bought toy emporium FAO Schwarz out of bankruptcy last year. Founder David E. Shaw, himself a PhD in computer science, personally promised Frederick August Otto (F.A.O.) Schwarz, Jr., the founder's great-grandson, to make the retailer the world's greatest toy store. "Our feeling was that the brand was strong and the things FAO used to do were important and worth something," says Shaw, whose mother viewed toys as works of art. "If we brought [FAO] back to its original mission, [the company] should be profitable."
If Shaw pulls off the revival, it will indicate that hedge funds can be better managers than critics give them credit for. There are positive signs. People beg to be let in to FAO Schwarz's flagship New York store on Fifth Avenue before its doors open at 10 a.m. Once it's time, three salespeople, dressed as toy soldiers, roll out a red carpet and blast a trumpet to greet shoppers. Shaw says the catalog and online businesses have "exceeded expectations." The company says it is profitable.
Hedge funds are adept at finding new wrinkles in traditional dealmaking. Like many financiers, Edward Lampert's ESL Investments started buying shares of his target, Sears (S ), before making a bid for the company. But there was a twist: He already owned and ran the company's rival, Kmart (KMRT ), and it was Kmart that actually made the bid.
Consider, too, Richard Perry's battle with Carl Icahn, the legendary financier. Icahn -- who is trying to raise about $3 billion to start his own hedge fund -- is suing Perry Capital for $1 billion for allegedly meddling in a proposed acquisition of generic-drug producer King Pharmaceuticals (KG ) by a larger rival, Mylan Laboratories (MYL ). Icahn charges that Perry used complex hedging techniques to obtain shareholder voting rights without holding an economic interest in the shares. Perry declines to comment.
The reinvention of hedge funds marks a new era for the industry -- and for Wall Street. During the 1990s fund managers took their cue from George Soros, morphing into multistrategy types and taking advantage of inefficiencies between the world's stock, bond, and currency markets. In a similar metamorphosis, hedge funds now are buying whole companies.
Some of the new raiders simply want to make changes, rake in the rewards, and move on. Others plan to hold on to companies and rebuild them over the long haul. Either way, they're not long on tolerance. If CEOs slip up, these guys will take their companies from them. Consider yourself warned.
Thornton is Finance & Banking editor for BusinessWeek in New York
with Susan Zegel in New York