Suspect strategies: activism in the hedge fund sector

The financial crisis has thinned the ranks of activists that were beginning to crowd the hedge fund sector.

Many activist hedge funds started out as event-driven funds, designed to make good returns from events such as a bid. But then – perhaps unsurprisingly given the amount of money at stake – funds with heavy borrowing drifted into trying to influence and precipitate events. They set out to pick companies with sub-optimal strategies or boards, and then agitated for change.

The Children’s Investment Fund (TCI) was typical of the sector. Viewed as one of the more aggressive activist hedge funds, it had $15bn (£10bn, €12bn) under management at the height of the bull market. It made its name agitating for change at ABN Amro, the Dutch bank, which ended up precipitating an ill-fated consortium bid for ABN led by Royal Bank of Scotland.

However, during the financial crisis, overextension in Europe and Asia and vicious stock market falls caused the value of TCI’s flagship fund to drop by more than 40 per cent in 2008. Many other investors in activist funds also got their fingers burned during the financial crisis.

In 2008, activism was one of the worst-hit strategies in the hedge fund universe, according to Chicago-based consultancy Hedge Fund Research (HFR). Activist funds were down 30.8 per cent for the whole of that year. Assets under management in activist funds – a sub-sector of HFR’s index of event-driven funds – fell from more than $54bn in 2007 to $36bn in 2009, and more than $12bn was taken out of the sector that year.

A number of funds have closed following the market turmoil of 2008 and 2009. Atticus, a fund that described itself as “suggestionist” rather than activist or event driven, was a co-investor with TCI in Deutsche Börse, the German exchange group. In August 2009 it shut down its flagship funds, and the Atticus Global Fund returned about $4bn to clients. At its peak in 2007 the group had about $18bn in assets under management in its funds; by January 1 it was managing about $8bn.

Tim Barakett, founder of Atticus Global, told clients in a letter in August that “it is time to reassess my future”, adding that he was going to spend more time with his family.

The sector’s shrinkage has reinforced investors’ doubts about whether activism pays, and whether the benefits outweigh the costs. Academics have tried to come up with conclusive proof one way or another, but have largely failed.

Many investors say there is a world of difference between being activist – that is, setting out to shake up companies and push for change – and taking an interest in board decisions. The costs associated with activism – such as building a big enough stake to be listened to, calling meetings and doing research – may outweigh any uplift to returns. And the returns are volatile, too.

Against this backdrop, the California Public Employees’ Retirement System (Calpers), the single largest pension fund in the US, swears activism does pay. Every year, the fund picks a list of corporate sinners – companies that it thinks break the tenets of good governance – which has become known as Calpers’ Focus list.

The fund says that returns on the Focus list show that activism has been handsomely rewarded over the long term, and has more than justified the considerable resources Calpers devotes to activism.

Wilshire Associates, the investment consultancy, has analysed the returns on this portfolio. In July last year, it measured the performance of 139 companies targeted by Calpers between 1987 and 2007. Wilshire compared total returns five years before being identified by Calpers with five years of returns after Calpers took an interest.

In the five years before Calpers began to agitate for change, companies on its Focus list produced returns that averaged 84.2 per cent below their respective benchmarks, Wilshire reported. That was the equivalent to underperformance of 30.9 per cent a year.

But for five years after Calpers took an interest, the companies on the list produced returns of 15.4 per cent above their respective benchmarks. That was the equivalent of an average of about 3 per cent a year.

Wilshire says there is also evidence that the portfolio’s returns have spiked again in recent years as Calpers’ reputation as an activist fund has become more widely known. “Companies targeted in the last 10 years have, on average, produced cumulative excess returns of 37.4 per cent in the five years post initiative date,” noted Wilshire.

It also stated that the additional resources spent on compiling Calpers’ list since 2000 have demonstrably “paid dividends”.

Rivals remain sceptical, but many acknowledge that even if allocating time and money to activism may not substantially boost returns, investors need to be active. Doing nothing to force companies to abandon shareholder-destructive strategies, or tacitly acquiescing to poor standards of governance, can cost investors dearly.

The most obvious example in recent years was the €71bn (£59bn, $87bn) acquisition of ABN Amro by a consortium led by Royal Bank of Scotland, which investors voted through in spite of worries that the price was too high and would destroy shareholder value – which it did.

The deal brought home to regulators and investors that shareholders may balk at the additional costs of being activist, but they cannot afford to sit on their hands in the hope that companies and their managers know best.

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