Ackman, Icahn and Their Pals Are Keepers
It’s a fun time to be an activist hedge-fund manager. Bill Ackman’s Pershing Square International topped Bloomberg Markets’ list of the top-performing hedge funds in 2014. Carl Icahn hasn’t come in below seventh place in the last five Forbes annual rankings of the highest-paid hedge-fund managers (his average income over that stretch: $1.6 billion a year). Nelson Peltz is making headlines with his high-profile campaign to break up DuPont, a corporate giant with a 213-year history.
It isn't just these few big names, either. Activist hedge funds have outperformed their peers over just about every recent time frame, and study after study after study has shown that companies targeted by activist funds lead their non-targeted peers both in stock-price gains and operating performance, at least for a few years. There are a lot of questions after that about whether the gains can last, do they come at the expense of bondholders and employees, and whether the overall economic effect is positive. But let’s leave those aside here and ask a simpler question: Is the great activist run about to end?
I’ve got two answers:
- Yes, depending on how you define “about to” and “end.” Sometime in the next, say, three years the activists will fall behind the rest of the hedge-fund world in performance. A prominent activist (or two or three or four) will have a really terrible year. The number of activist funds will stop growing.
- After that, though, they’re not going to just go away. Icahn and Peltz have been doing this, in one form or another, since the late 1970s. And while they and their 1980s leveraged-buyout brethren are often cited as the originators of the practice, it actually goes back much further than that. The legendary Benjamin Graham mounted a years-long campaign in the 1920s (which he described in his memoirs) to get the Northern Pipeline Co., a Standard Oil descendant, to sell off some of its bond portfolio and give the proceeds to shareholders. Historians have documented other attempts at activism by outside shareholders going back at least to the 17th century Netherlands.
The paradoxical secret of shareholder activism is that it works because it’s hard. Corporate managers have all sorts of tools and resources at their disposal that can make it difficult and painful for an investor to take them on. Activism obviously can't work if it’s impossible -- when corporate management is so firmly entrenched that nothing an outside shareholder does can possibly make a difference. And it wouldn’t work in a world where corporate directors were up for re-election every day and shareholders voted on every investment decision. It’s when the activists are a small minority facing real obstacles, but are on occasion able to force changes at the companies they target, that the approach seems to make the most sense.
It makes sense not because the ideas the activists have are so brilliant. They tend to fall into three main categories -- hand over cash, break up or sell to another company. These all happen to be things that corporate executives don’t like to do. The people who run large corporations want to build things, not take them apart. And while the shift to paying executives mostly with stock has altered attitudes somewhat, the reluctance remains.
In a lot of cases that reluctance is appropriate. Corporations aren’t just collections of assets to be bought and sold, they’re collections of people trying to get interesting and profitable stuff done. Still, at companies that have underperformed the market for years on end, are deeply undervalued relative to their peers, have huge piles of cash that they don’t seem to know what to do with, there’s a better than 50-50 chance that the activist game plan is better than what the executives have in mind.
Over the past few years, though, activism has gotten easier, and the list of targets has grown. Unlike pension funds and most mutual funds, hedge funds are able, as New York University finance professor David Yermack described it in a 2010 paper, to “concentrate assets in a few target companies” and “build large voting positions by using leverage and empty voting strategies such as stock borrowing and equity swaps.” Securities and Exchange Commission rules and corporate charters have also gotten friendlier to outside rabble-rousers, and the Internet has made it much easier to organize and publicize a shareholder uprising. There also seems to have been a cultural shift in which other institutional investors and the media have become more willing to hear out the activists.
All that explains the recent rise in hedge-fund activism. It also delineates the potential limits. It isn't that the activists know how to run corporate America (or corporate Europe or corporate Canada or corporate anywhere) better than the executives do, it’s that they know how to run the worst-performing parts of it better.
As the list of activist targets grows and the performance profile of those targets inevitably improves, the chances that the activist recipe is the right one will have to decline. Diminishing returns will set in.
Will that cause the hedge-fund activists to implode? Activist managers are still a tiny part of the investment landscape; their percentage of hedge-fund assets under management appears to be in the single digits, and their share of the overall equity market is minuscule. Yeah, their ranks will shrink from time to time. Those ranks aren't all that big to begin with, though, and as long as the activists stay a small minority they will keep finding ways to make money.
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