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Finance: Stirrers and shakers

22 August, 2012

Canadian Pacific Railway can claim, with some justification, to be the company that built Canada. It was only with the promise of the tracks it laid from the west coast to the east in the 1880s that the territories of Nova Scotia, New Brunswick and British Columbia agreed to join the budding nation.

Yet this national treasure no longer has a Canadian at its helm. In May, a board packed with the great and good of the country’s business elite was infiltrated by Bill Ackman, a brash activist hedge fund manager from New York, and his preferred candidates. Less than a year after Mr Ackman’s hedge fund became Canadian Pacific’s largest shareholder, Pershing Square Capital nominees fill eight of the 14 seats and his preferred candidate, the American E. Hunter Harrison, is chief executive.

The sweeping victory was just the latest sign that restless shareholders are frustrated with stagnant share prices and increasingly willing to challenge the executives supposed to serve their interests. During this year’s febrile annual meeting season in North America and the UK, which became known as a “shareholder spring”, management at companies such as Citigroup and Barclays were rebuked over executive pay. Even Apple – now the most valuable company in history – was forced to change the way it elects board members.

But it is activist hedge funds in particular that have set their sights high. Ralph Whitworth’s Relational Investors has disclosed a holding in PepsiCo, while Mr Ackman has moved on to Procter & Gamble, the 12th largest company in the US by market value. Today’s breed of savvy activists have honed their tactics. And they are giving boards – already under pressure from regulators and a public wary of excessive compensation – yet another threat to worry about.

“No company is safe because of the size of their market capitalisation,” says Chris Young, head of contested situations for Credit Suisse. “The activists feel they are well positioned to go after the P&Gs of the world.”

If an earlier generation of corporate leaders faced private equity “barbarians” storming the gates and carrying companies off for dismemberment, today’s confront insurgents appearing in their midst to wrest away power.

As the spectre of further activism looms, boards and bankers say this is not a flash in the pan, but rather reflects a fundamental shift in investor power, based on several trends that have increased the clout of the agitators.

Foremost among them is lacklustre stock market performance since the financial crash of 2007. With stock prices largely flat, institutional investors, and even management, are more likely to listen to informed activists with credible ideas. Indeed, when it is revealed that an activist has built up a position in a company’s stock, the price often goes up on expectations that change is afoot. After Mr Ackman disclosed even a relatively small 1 per cent stake in P&G last month, its shares jumped 5 per cent.

At the same time, economic recovery since 2009, however faint, has given companies time to pay down debt and build cash piles that activists would like to see returned through dividends or share buybacks. Paul Parker, head of global corporate finance and mergers and acquisitions at Barclays, says: “The percussive theme song is unmistakable: use it or lose it. Excess capital must be used or returned to shareholders.”

Eager for higher capital returns, activists are approaching companies with plans on how to achieve them. Clinton Group, a small New York fund, recently sent a PowerPoint presentation to Wet Seal, a clothing retailer in which it owns a 4 per cent stake, detailing the benefits of a stock buyback programme that it forecast would include a near doubling of the share price.

But with growth in revenues typically slow, shareholders are also open to more radical ideas. One approach is to agitate for management changes; the most severe involves pushing for a sale of the company.

That is exactly what Relational Investors achieved this year after buying 10 per cent of Par Pharmaceuticals and holding talks with management of the New Jersey-based generic drugs group. That kicked off a sale process, which in July resulted in a bid of almost $2bn for the group from the private equity firm TPG Capital.

Another approach is to shake up a company through spin-offs and break-ups in order to “unlock value” hidden in languishing obscure divisions or beneath suffocating corporate structures. For example, McGraw-Hill last year announced the education and data company would split itself in two, bowing to pressure from Jana Partners, an activist hedge fund, and the Ontario Teachers Pension.

In this instance, the presence of an institution working hand-in-hand with an activist fund also pointed to a shift in respectability. A decade ago, they were gadflies irrelevant to be swatted or raiders to be vilified and blocked. Barry Rosenstein, head of Jana, says that when he first started taking activist stakes, “companies would throw every obstacle they could in our path”.

In time, however, investors at mutual and pension funds that hold shares passively began to see activists as a positive influence. In 2005 Jana teamed up with the veteran corporate raider Carl Icahn to take on Kerr-McGee, a US energy company in which they had between them built up a 7 per cent stake.

Though the initial response was a raising of the drawbridge, says Mr Rosenstein, Kerr-McGee’s management hit the road to see its biggest investors. “We were the last ones they got to, and when they arrived they said, ‘OK, you win, we get it.’” The next year the company accepted a bid from Anadarko Petroleum of the US.

Today, even if direct involvement such as that of Ontario is rare, unprecedented levels of co-operation between activists and institutional investors heightens the threat to companies. “The activists are having discussions with major shareholders beforehand,” Mr Parker says. “They can go in and say, ‘Most of your shareholders feel this way.’ They go in quite confidently.”

Because funds can now achieve influence without building up large stakes on their own, the number of activist 13D filings – which investors are required to submit to regulators when they acquire a stake of more than 5 per cent – understates the true extent of their influence. This year’s activist 13D filings are broadly in line with those of the past two years. However, many activists refrain from crossing the threshold – which means their stake, and their discussions with the board, need never become public. “Their strategy is to buy under 5 per cent, approach a company and say what they need to do,” Mr Young says. “If they don’t, then they’ll cross 5 per cent.”

At Hewlett-Packard, for example, Mr Whitworth’s fund took a 1 per cent stake, and he was swiftly invited to join the board of the US electronics group. His stake in PepsiCo is also less than 1 per cent. “Unlike pre-financial crisis, when there was a lot of bellicose rhetoric from activists, they’ve gotten a lot savvier,” says Mark Shafir, co-head of global M&A at Citigroup. “They’re trying to do more behind closed doors.”

For once activist stakes are public, the markets take hold. The arrival of Mr Ackman’s Pershing Square on P&G’s shareholder register has set off a flurry of trading, research and outright speculation as to what changes might result.

Mr Ackman says such activism enables shareholders to police the managements of companies immune to the threat of buyouts. “You can’t do private equity on big companies – you can’t take it private and fix it,” he says. “But you can get influence without piling on a bunch of leverage. I think its much healthier for the stock market.”

In many cases, however, there may be little that activists can propose that companies have not thought of themselves. When New York-based Starboard agitated for a sale of AOL’s patent portfolio this year, the technology company said it was already pursuing a such deal. Similarly, speculation is rife that P&G may seek to sell Duracell batteries and Iams pet food following Mr Ackman’s interest in the company – but people close to the group say it has long eyed those brands as possible divestitures.

“Companies are being more proactive,” Mr Young says. “They look at the company through the lens of an activist. What are the levers they could pull? Do any of them make sense? For the ones that don’t make sense, maybe we need to get out and talk to our shareholders and articulate the company strategy.”

In addition, public markets may not be the best place to attempt a more dramatic reshaping of a company. Another of Mr Ackman’s projects is JC Penney, a US department store chain undergoing an extreme makeover. With an 18 per cent stake in the group, Pershing has backed wholesale changes to the retailer’s structure, management, product and strategy that resulted in same-store sales dropping by a fifth during the second quarter compared with the same period the previous year.

“Things are going to look ugly during the transformation, and some shareholders have given up hope after a quarter or two of results, but management have our full support,” Mr Ackman says.

A high-profile failure on that scale would probably dent investor enthusiasm for activism – and even some activists cast doubt on their ability to influence the largest companies.

“At [a market capitalisation of] $100bn and above, where everyone has a very small ownership interest, I really question what input you can have,” says Mr Rosenstein, who prefers to target those in the $5bn to $20bn range. “We always confirm from the start that we’ll have the votes if we need them, and with companies that big it’s harder to do that.”

But regardless of what happens at P&G as a result of the agitation, Mr Ackman’s stake has raised the possibility that some of the biggest companies in the world could be targeted.

In a speech last year to the Council of Institutional Investors in Washington, Nelson Peltz of the activist Trian Fund Management said companies with market capitalisations of $50bn or greater, which he calls “untouchables”, were finally within reach. “We saw multiple opportunities in large-cap companies that could benefit from our constructivist approach [when the fund was formed],” he said. “Now we can target them more easily.”

Building up a stake of even 5 per cent in such companies is expensive, and there are few firms with the reputation, capital and resources to take it on. “Activism against very large-cap companies is still hard,” says Bruce Goldfarb of Okapi Partners, which advises investors pushing for change. “But good ideas from activists can be adopted by management, and activists can claim an outcome.”

Yet with such funds emboldened by recent successes, and a gloomy economic outlook suggesting share prices may remain stagnant for some time, companies of all sizes should be prepared to engage with restless investors.

“If your stock price has gone nowhere over four or five years and you’ve got a lot of cash on the balance sheet, that’s fertile ground for the activists,” Mr Shafir says. “Everybody should be concerned about it.”

Bill Ackman: Big game hunter

He has been one of the busiest activist investors in recent months. His Pershing Square Capital has $10bn under management, with stakes in Procter & Gamble and Canadian Pacific Railway, among others.

Carl Icahn: Original corporate raider

Among the original corporate raiders, taking big stakes in companies and finding ways to edge up share prices. Icahn Capital today holds stakes in 17 groups, including Chesapeake Energy, with a value of $10.5bn.

Ralph Whitworth: Stealthy stake-builder

Started out working under the Texan oil billionaire T. Boone Pickens before founding Relational Investors in 1996, which has $6bn under management and stakes in Hewlett-Packard and PepsiCo.

Barry Rosenstein: Break-up artist

Founded Jana Partners in 2001. Returns this decade have been varied, but successes, such as agitation for McGraw-Hill’s break-up and a $5.3bn sale of Coventry Health Care, should boost this year’s bottom line.

Dan Loeb: Coup leader

Highly feared since staging coup at Yahoo in 2008, after which he exposed chief executive for embellishing his CV. Known for colourful letters he writes about target companies. His Third Point has $9bn under management.

Nelson Peltz: Dropout turned billionaire

Dropped out of Wharton business school degree and went into industry before co-founding Trian Fund. With about $4bn under management, the fund pursues big targets such as the biotech group Genzyme and Home Depot.

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Finance: Stirrers and shakers

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