By Martin Loinig
Historically speaking, the relationship between private equity funds and activist hedge funds has been shaped less by collaboration and more by confrontation. Activist investors, holding minority stakes in public companies, often opposed buyouts by private equity firms, consequently driving up acquisition prices. On the other hand, private equity firms also profited from activist investor engagement. Under activist pressure, target companies were often forced to sell off unprofitable divisions of their businesses to private equity firms.
These days, the established borders between shareholder activism and private equity are increasingly disappearing with activist funds employing private equity tactics and private equity firms investing like activist investors.
The convergence of private equity and shareholder activism
Minority positions divested by private equity investors accounted for an all-time high $69B in 2017 spanning over 1000+ deals.
This recent convergence into what is typically regarded as hedge fund territory is becoming increasingly prevalent. The observed trend is explainable by two factors: the competition in the private equity industry nowadays, and the similarity between private equity and shareholder activism.
Both activist hedge funds and private equity firms were able to raise, and now have at their disposal, considerable amounts of capital ready to be invested. Due to the high degree of competition in the private equity industry, private equity firms are increasingly faced with difficulties in sourcing attractive opportunities. The limited number of available targets together with high valuations make it no easy task to invest the funds available while still generating superior returns. Consequently, private equity firms are forced to innovate new strategies and alternative investment approaches to allocate capital.
It is relatively easy for both private equity firms and activist hedge funds to make use of the other’s respective investment approach because of the relative similarity between the asset classes. Oftentimes, firms from both industries target the same investment. This is because a firm that makes a desirable target for activist investors is often one that could be profitable for a private equity investor. Furthermore, the skillsets of both investors are closely aligned: a shrewdness for undervalued companies and the know-how to appropriately restructure and manage portfolio companies to drive value creation.
These resemblances become evident when observing more closely how activist hedge funds operate. Managers of these funds typically have a similar mindset to private equity firms. Usually they follow a longer-term plan for their investments based on operational improvements. Therefore, most activist investors enter a position only after having laid out an intricate plan detailing how to unleash additional shareholder value, increase operational efficiency and improve governance. They often also consider actions to improve the firms’ balance sheets such as the sale of non-core assets and unprofitable company divisions or modifying the board compensation structures. Recently, an increasing number of activist investors have focused on such cost-cutting strategies while some even began placing takeover bids themselves just like typical private equity firms. From an activist perspective, a full acquisition of the target company is an effective way to implement the desired operational changes.
Shareholder Activism Matrix
Source: The Hedge Fund Journal
As such changes, much like in private equity, require a relatively long time to materialize and realize returns, it is not uncommon to see investments with holding periods of up to three years. Consequently, activist funds are characterized by a low portfolio turnover, much different to most other equity-focused hedge funds.
Why do private equity firms engage in activist strategies?
First and foremost, by pursuing an activist style of investing, private equity firms gain access to a vast amount of new opportunities and potential investments. By gaining the ability to enter small minority positions in public companies, they can move faster and seize eventual dips in the market. In addition, minority investing enables them to take positions in companies that were initially not available for sale. This is usually done by acquiring a small stake in a public company of interest, (normally less than 5% of the shares outstanding) and therefore establish a “toehold” in the firm. This initial stake is used as a bargaining chip and a path to approach the company’s top management and initiate talks about a possible buyout. If the target’s management rejects the takeover bids, the private equity firm can attempt to create changes within the target company indirectly (for example by making changes at the board level) through its minority stake by following a typical shareholder activist approach. This sometimes occurs in cooperation with established activist funds.
Issues arising for private equity firms
When a private equity firm intends to employ activist hedge fund tactics, certain issues and challenges emerge. Some, if not most, limited partnership agreements of private equity funds entail provisions that clearly define the types of transaction in which the fund is authorized to engage. Oftentimes, these provisions do not allow funds to initiate hostile takeover attempts or proxy fights typical of activist investing,. Additionally, the time horizon for private equity firms is clearly defined in most cases. This limits the fund’s ability to take short-term positions and might only allow for investments for the purpose of gaining full control over a targeted company. Because of this, a surge in cooperation between activist funds and traditional private equity firms has been occurring in recent years. Another way around these provisions is to establish a separate activist fund for which such investment restrictions do not apply.
Another crucial aspect to consider is the private equity firm’s relationships with the management of the targeted firms. Working closely with management is an essential factor to success in private equity – quite contrary to shareholder activism. By behaving like an activist investor, private equity firms risk being perceived as an aggressor implementing change by force. Such a reputation can potentially limit a target management’s willingness to engage in takeover talks.
While the qualitative aspects of private equity minority investing are, at best, a trade-off between gains and disadvantages, the numbers should also be considered. A study designed to juxtapose minority investments and traditional private equity performance showed the mean absolute EBITDA improvement over the holding period was c44% for private equity backed minority investments while majority positions averaged c69%. The authors went on to confirm that minorities predominantly grew EBITDA through sales volumes as opposed to margin improvements. These results are somewhat unsurprising when you consider the limited control that a private equity fund manager has in a minority stake. Additionally, being in the co-pilot’s seat, the private equity firm does not have executive command over the target’s capital structure, which makes levering the firm increasingly difficult. Therefore, both EBITDA margin effects and deleverage effects are dampened when compared to those in majority stakes. Despite the fact that entering a minority position is normally discounted 20% to 40% relative to majority transactions – due to the absence of a control premium – this discount is also applied upon divestment and therefore offers no additional multiple arbitrage.
Source: Puche & Lotz, The Journal of Private Equity
This piece of research also established that overall IRR performance was more or less similar between both groups, yet money multiples, times money and public market equivalent metrics unanimously proved that minority stakes underperformed controlling positions. What does remain however, is that while absolute returns are less spectacular, risk adjusted returns are superior. GPs and LPs experience higher Sharpe ratios in minority divestments due to reduced overall risk stemming from smaller initial bets.
In light of the recent convergence of tactics and strategies employed by private equity firms and activist hedge funds, and despite the risks discussed, private equity will most likely continue to adopt and develop shareholder activism as a value creation tool. This, however, should be done on a case by case basis, depending on market conditions and the characteristics of the targeted firm. On the other hand, large activist investors such as Elliott Management will continue their recent push to take-over companies by acquiring majority stakes – sometimes in partnership with established private equity funds.
Editor: Eric Peghini
Author: Martin Loinig