Activists leading hedge funds warm up for tough season ahead

Stephen Foley

Increase in showdowns likely but profit expectations are scaled back

This is the pre-season for the hedge fund world’s activist investors; the Loebs and the Icahns, and the Ackmans and scores more of lesser fame but no less ambition.

Think of Carl Icahn’s recent admonishment to Apple to buy back more stock as a friendly fixture, one for the crowds, as the old activist limbers up for more competitive matches ahead.

All the activists are deep in training for the coming season. Although most of the showdowns with target companies come in the spring, around the time of the annual shareholder meetings, the groundwork is being laid in many cases this month.

There is money still to be made, they believe, in targeting an underperforming company and aggressively pushing for a change of strategy or a change of management, or both. Investors believe the same. They have poured $14bn into activist hedge funds this year, according to eVestment.

However, there are reasons to suspect the high-water mark for returns from this strategy may already have passed.

The money that has flowed in has to be put to work, regardless of the doubts, and all the signals are that 2015 could be the most active activist season yet.

Proxy solicitors, who help companies and hedge funds solicit shareholder support during hostile battles, report a flood of incoming calls. Dan Loeb was one of the first out on the pitch, revealing a stake in Amgen last month and suggesting that the drugmaker break itself up. Other activists are likely to make their cases to management in private, with the threat of going public in the new year, if they do not get co-operation.

A Mergermarket survey last week showed both corporate executives and investors expect another increase in showdowns with activists in the 2015 season. It was an overwhelming poll result: 50 per cent said they expected activity to “somewhat increase” and another 48 per cent said they expected it to “substantially increase”. Only 2 per cent thought it would stay about the same, and no one thought it was going away.

There is also a big red flag in that survey for investors tempted to put their money with the activists. It seems profit expectations are already being scaled back.

Only one in five hedge funds are targeting returns of more than 20 per cent from their efforts to overhaul companies, Mergermarket found. The rest are expecting something between 10 and 20 per cent. This compares with two years ago, the last time the survey was done, when almost half the funds thought they could make more than 20 per cent.

In part, this is an obvious effect of higher equity prices, a rising tide that has lifted all boats, even the leaky tubs that usually attract the attention of activists. It is also the result of activism’s popularity. With more money hunting for undervalued and mismanaged companies, activists are forced to pick less certain targets.

“Many activists believe that the popularity of the strategy will lead to lower returns,” says Marc Weingarten, partner at the law firm Schulte Roth & Zabel. “The previous year’s results may be hard to duplicate.”

The sheer size of the biggest activist funds means they are now targeting corporate megaliths including the likes of PepsiCo and Air Products and, yes, even Apple. While no one would pretend corporate governance is all it should be at the top of the corporate food chain, this is a far cry from activism’s origins drubbing the egregious, entrenched managers of staid mid-caps, where a shake-up can be a game changer for the shares.

The need for large-cap activism may be diminishing since long-term institutional shareholders are increasingly willing to challenge management and the companies themselves have adopted much of the activists’ playbook, with share buybacks and now mergers and acquisitions all at the top of executives’ agendas. It seems fair to assume bigger targets mean smaller profits for activists.

Investors are chasing historic returns, as they so often do. Activist hedge funds led the industry last year with returns of 19.2 per cent, according to HFR data, and they led it again in the first three quarters of 2014, with 4.2 per cent more, before October’s wobble.

It is clear the coming season will be busy, brutal and bruising for the companies that come under attack. As for investment returns, the final score is not so certain.

stephen.foley@ft.com

Twitter: @stephenfoley