ACTIVIST INVESTING

Trent Webster State Board of Administration of Florida

December 2007

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INTRODUCTION There is substantial evidence to suggest activist investing generates statistically significant excess returns greater than the market. Four major academic papers have been published within the past two years concluding that activist investing generates excess returns of 5% to 16%, and returns may be even higher over longer time periods. The six public pension funds contacted attested that, in aggregate, the hired activist managers produced returns in excess of their assigned benchmarks. A preliminary database was constructed with returns provided to the SBA by activist managers and by Mercer whereby activist managers generated significant outperformance in total over time. Though investors have engaged in activist strategies for many years, activist investing is not widespread in the public pension plan domain. Apart from specific high-profile funds such as CalPERS and the Virginia Retirement Fund, few public pension plans have a governance activist program where capital is committed to effect change at the corporate level. The lack of widespread participation in the strategy offers an opportunity to the SBA. Committing capital to an activist strategy also demonstrates a greater interest in improving governance at corporations, which is consistent with the SBAs expanding corporate governance program. The primary structure of an activist manager is a limited partnership. These structures offer several advantages over traditional fund managers. Managers are more incentivized and less conflicted. The cost of activism is lower since they operate with less regulatory scrutiny, and limited partnerships are more nimble. However, activism as an institutional strategy is still nascent, many activist fund managers are not used to the demands of institutions, activist returns can be very volatile, transparency can be lacking, and activists may engage in activities inconsistent with other shareholders and the social good. The strategy carries other risks. Investments can be illiquid as managers will take large positions in single companies. This can lead to large losses in individual stocks if the manager is wrong. Such large losses may bring headline risk. Headline risk may also be prevalent when a manager undertakes a high-profile, hostile action against a company. It is recommended that the SBA allocate capital to an activist governance investment program, potentially within the Strategic Investments asset class. Since the strategy is a hybrid between Domestic and International Equities investments are in public equities and Alternative Investments the legal structures are similar to private equity funds an activist program would best fit in Strategic Investments. A significant amount of capital should be allocated to affect the overall performance of the total fund. It is also recommended that several managers be hired over time by developing a forward calendar of potential activist funds, possibly with the assistance of outside consultants. Activist managers tend to run concentrated portfolios, sometimes holding as little as one name, and thus returns can be highly volatile. Hiring several managers would mitigate the volatility of activist returns.

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ACTIVIST FUNDS Definition The ownership of publicly traded securities is often widely dispersed amongst institutions and the public. Motivations and rationales for holding a publicly traded security differ materially between investors. The dispersion of ownership and different motivations create market structures which may impede the optimum return of an investment. Such market structures include the proliferation of passive indexing investment strategies, large institutions with a primary focus on short-term returns, institutional philosophies and resources which preclude meaningful active engagement with company management, investment consultants and their clients who expect limitations on the actions of institutional investors, widespread ownership amongst a well-meaning though ill-equipped public, agency problems inherent within investment institutions, liquidity constraints, and laws, amongst others. Time frames, resources, expectations and expertise may all contribute to market structures that generate sub-optimal investment returns. Most owners of securities wish to generate a reasonable rate of return. However, investors responses to the lack of a reasonable return may also contribute to sub-optimal returns. For example, a large institution with a significant stake in a company which has performed poorly is more likely to simply sell the security than to partake in a meaningful engagement with company management to fix the problem causing poor returns. With a critical mass of such institutional investors, problems specific to the corporation may remain unsolved for some time as there may be little incentive for management to fix the problem. Meaningful engagement of company management is expensive and costly for an institution, let alone an individual investor. Engagement of corporate management requires a skill set and special expertise often lacking within traditional investment institutions. Since large institutions usually have many different investment options, and specific problems within a portfolio of investments require a disproportionate amount of time and resources, there can be little motivation for a large institution to develop the expertise required to engage management. In a market where such neglect occurs, the price of a security may not reflect the intrinsic value of the business. Such mis-pricing may give rise to abnormal returns. However, it is not a corollary that a mis-priced security will give rise to abnormal returns. After all, if a security is chronically undervalued, there is usually a reason. Thus, arbitraging the abnormal return in a mis-priced security usually requires action to remove the impediments which have inhibited full valuation. Activist investing attempts to initiate change within the corporation to unlock the value inherent in the mis-priced security by actively engaging management. The activist investor may engage management in a friendly way by offering expertise and advice on

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business or financial matters, or the activist investor may engage management in a hostile way, threatening to remove board members and managers whom the activist investor view as impediments to unlocking value. Activist investing has, in recent times, been the purview of a few large pension funds. A particular type of activist investor, the corporate raider, evoked negative reactions amongst the public, politicians and, eventually, the investment community itself in the 1980s and early 1990s. Through changes in laws and attitudes, the influence of corporate raiders dissipated, leaving large institutional funds, particularly public pension plans, as the highest profile proponents of activist investing. It is not clear that the direct corporate governance efforts of pension funds have been effective. There is no statistical evidence confirming that activist programs of pension funds have generated excess returns (though there is some evidence of improvements in operations and corporate governance metrics).1

It may be that pension funds are subject to similar constraints faced by other institutions as well as constraints unique unto themselves.

The failure of pension funds to arbitrage differences between the prices of stocks and the intrinsic values of specific companies has lead to the formation of new activist-specific funds, particularly during this decade. The organization of activist funds is designed to overcome the structural impediments that may face traditional institutions. Issues of time frames, resources, expectations and expertise are solved by activist funds so that structural impediments towards unlocking value are diminished. Gillan and Starks (1998) state that the most common form of shareholder activism is an investor who attempts to change the status quo through voice, that is without a change in control of the firm. The voice reflected in the most common form of shareholder activism encompasses a broad range of activities a shareholder proposal to the proxy statement, direct negotiation with management, and public targeting of a corporation using the media to send information to other investors about the problems and needed changes at a firm.2

Schulte Roth & Zabel define activist investing as acquiring positions in public companies, and seeking to cause the companies to take steps to maximize shareholder value.3

Such steps include

A sale of the company A recapitalization of a companys balance sheet A spin-off of a division or a restructuring of a business unit

1 See Crutchley, Hudson and Jenson (1998); Karpoff (2001); Prevost and Rao; Romano (2000); Smith (1996); and Wahal (1996). 2 Gillan, Stuart and Laura Starks. Corporate Governance Proposals and Shareholder Activism: The Role of Institutional Investors. Journal of Financial Economics. 1998. 3 Schulte Roth & Zabel LLP. 15th Annual Private Investment Funds Seminar, Activist Investing. January 19, 2006.

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Higher or extra dividend payments Higher or more stock buybacks A management change, usually the CEO

Activist investors also acquire positions in public companies, and through their actions attempt to improve corporate governance. Such steps include

Majority voting for directors De-staggering board of directors Redeem poison pill Other governance issues

Types of Activist Managers Damien Park, president and chief executive of Hedge Fund Solutions LLC, identified four types of activist managers.4

Constructive Activists Constructive managers are managers who fly under the radar, send letters and call management, suggesting ways to improve value. They are deliberately non-confrontational and stay out of the media. Operational Activists Operational activists are managers who bring a team of experts to help improve a companys value, either by joining the board or working as consultants Reluctant Activists Reluctant managers are managers who have held the stock a long time and have not gained from the position. Reluctant managers become activists to effect change or create a liquidity event to get out of the stock. Private Capital Management in Domestic Equities is an example of a reluctant activist manger. Pure activists Pure activists are managers who make headlines taking a position in a company with the intention of enacting a sale, a big share buyback or some other event. A better moniker for pure activists may be noisy activists or confrontational activists. The motive of much shareholder activism is forcing CEOs away from the status quo and into a strategy that is not in the CEOs own self-interest. One activist manager stated that there is no better method to improve a poorly run company than full disclosure to shareholders who are ignorant about what is going on.5

4 Accredited Investor. Activist Managers Maturing, Maybe. p34. June 2007. 5 Accredited Investor. Activism Roundtable. pp16-19. June 2007.

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Activist Fund Structures Schulte Roth & Zabel identify three general structures of activist funds hedge funds, private equity funds and hybrid funds.6

Hedge fund structure Hedge funds are fully funded. The capital is funded at closing and invested as the manager sees fit. The funds are open-ended and additional investors can come in from time to time, buying in at marked-to-market prices. Investments recycled as liquidated positions are reinvested in other investments. The carry is taken on a marked-to-market basis, reflecting realized and unrealized gains and losses. The life of the fund is unlimited, and there is no limit on the number of investments that can be made. Withdrawals are subject to lockups, gates or other limitations, though investors usually can withdraw periodically. Liquidity varies enormously from fund to fund. There are usually no hurdle rates and there is usually no claw back. However, there are high water marks as a loss in one time period is carried over to the next and must be made up in the following periods before any carry is assigned. Brav, Jiang, Partnoy, and Thomas (2006) identified four characteristics of hedge funds they are pooled, privately organized investment vehicles; they are administered by professional investment managers; they are not widely available to the public; and they operate outside securities regulation and registration requirements.7

It is important to note that the term hedge fund is a nebulous term with wide connotations. An investment structure deemed a hedge fund may be anything but, and may have little in common with another hedge fund other than its legal structure and fees. Thus, definitions of hedge funds are broadly descriptive. In this paper, the term hedge fund is interchangeable with the terms activist fund and limited partnership. Private equity structure Unlike a typical hedge fund structure, capital is called from the investor as required, and investors usually enter into an agreement where the investor is committed for five to seven years. The funds are closed-ended. Additional investors may come in during some finite time period after the initial closing, often one year, but not thereafter. If a manager wishes to commit more capital, the manager opens another fund. Profits from the sale of an investment are distributed back to the investor and not re-invested, though if an opportunity for a quick flip arises, the manager may not return capital to the investor arising from the flip. Carry is taken on realized returns only. The funds have a finite life and there are no withdrawals from the fund. Managers must obtain a hurdle rate before the manager is able to take carry. Finally, the manager must give back carry to the extent that over the life of the fund, the manager receives more than the carry percentage of realized profits.

6 Schulte Roth & Zabel (2006). 7 Brav, Alon, Wei Jiang, Frank Partnoy, and Randall Thomas (2006). Hedge Fund Activism, Corporate Governance, and Firm Performance. Working paper presented at Vanderbilt University. October 13, 2006.

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Hybrid fund structure Due to high portfolio concentration and limited liquidity, many activist funds fall between hedge funds and private equity in style and structure. Often times, the convergence is driven by the client as the client is more familiar with private equity rather than public market structures. The funds have both trading and management expertise and capability. They can pressure the company to enhance shareholder value and can bid for and buy the company. Terms and structure of hybrid funds vary widely. Liquidity Liquidity conditions are more similar to private equity structures than public market funds. Nissenbaum and Bianchini (2005) highlight three liquidity issues regarding activist managers.8

Lockups Activist managers tend to have lockup periods longer than typical hedge fund managers. Lockup periods of 18 months or more are often considered. Lockups can be hard or soft. A soft lockup usually entails the ability to withdraw money during the lockup period at a cost of 1%-5% of the amount to be withdrawn. Many activist fund managers find that permitting quarterly or semi-annual withdrawals upon 60 days notice after an initial lockup to be manageable. Side Pockets Side pockets, or special investment accounts, have been gaining in popularity as hedge funds hold greater amounts of illiquid or hard to value assets such as distressed debt and private placements. It is a mechanism built into a funds documents which tracks an illiquid or hard-to-value investment in a memorandum account that is apart from the funds liquid assets. Typically, the manager must designate an investment as a special investment at the time the investment is made. Only the investors who were investors in the fund when the special investment was made participate in the special investment. The special investment is held at fair value usually at cost, unless a reliable mark-up or write down is possible and performance compensation is paid only after there is a realization of the special investment. The portion of an investors' capital held in special investment accounts cannot be withdrawn until each special investment is realized or deemed to be realized, i.e., a privately placed security becomes freely tradable. A manager may reserve the right to designate 10% to 20% of the value of the fund's assets as special investments. Activist funds invest in liquid securities, the opposite of the types of securities for which side pockets have traditionally been used. However, special investment accounts can be adapted to help deal with the liquidity needs of an activist fund. First, an activist fund can permit a position that the fund manager wishes to hold for a longer term be designated as 8 Nissenbaum, David and Maria Gabriela Bianchini. Activist Investing Developments. Activist Fund Structuring. Spring 2005.

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a special investment, i.e. the fund manger does not want to sell before a certain event occurs, such as a shareholder vote or merger. Second, the activist fund can permit a special investment be designated by the fund manager at any time, i.e. if a position eventually exceeds 10% of the company's stock and cannot be sold because of short-term trading liability or if the fund manager comes to possess inside information. Gates A gate provision is where the fund manager limits withdrawals on any withdrawal date to less than a stated percentage of a fund's net assets, often 10% to 25% depending on how frequently investors have a right to withdraw capital. Gates are a very common feature in hedge funds of almost all strategies. Imposing a gate slows a potential run on the fund by forcing investors to wait until the next regular withdrawal date. Imposing a gate can be viewed by investors as a negative event. Advantages and Limits of an Activist Program Advantages Robert Thompson (2006) outlined several advantages of an activist hedge fund program.9

He noted that hedge funds have several advantages over traditional investment managers that permit hedge funds to be more effective champions of shareholders.

Hedge fund compensation provides stronger performance incentives. The bulk of hedge fund compensation arises from the performance fee whereas traditional managers are generally paid a flat salary plus a bonus.

Traditional managers are often part of a larger organization that competes to win retirement account management from corporations. Conflicts arise for the traditional manager as the corporate objective in winning the retirement business is not in step with the need to unlock shareholder value at the same corporation.

Hedge funds incur lower costs for activism since they operate under less regulatory scrutiny. They can disclose less about holdings and trades, they can hedge and they can avoid diversification requirements.

Because hedge funds often have lock ups, they do not have to provide liquidity in the same manner as other funds such as mutual funds and pension funds, which must provide investors liquidity on demand.

Hedge funds generally are more nimble, flexible and aggressive than other forms of investment vehicles. Such characteristics make hedge funds better candidates for activism.

Klein and Zur also note the advantages of the hedge fund structure pertaining to activism compared to mutual funds, which they argue are at a disadvantage in activist

9 Thompson, Robert B. The Limits of Hedge Fund Activism. Working paper presented at Vanderbilt University. October 13, 2006.

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management.10

To qualify for tax benefits, mutual funds must be diversified, which means they cannot own more than 10% of the outstanding securities of any company, nor can 5% of the funds total assets be invested in any one security. Hedge funds are not subject to such tax rules and can hold large amounts of stock in their portfolios without penalty. Also, hedge fund managers are free from pay-for-performance restrictions imposed on mutual fund managers by the Investment Advisors Act of 1940. Finally, hedge funds do not have the conflicts mutual funds and investment managers who run corporate pension plans have.

Unlike the 1980s, when corporations developed poison pill defenses to fend off corporate raiders, no new innovative defenses have emerged to counter activism thus far, though that may be changing.11 However, targets of hostile activism are learning the tactics of activists and working preemptively to defend their position thereby potentially raising the cost, extending the duration and lowering the success rate of hostile activism.12

Limits to Hedge Fund Activism Thompson noted several limits to hedge fund activism.13

Hedge funds are generally motivated to produce above average returns and use governance to drive gains. However, more hedge funds and pension funds are employing corporate governance activist strategies and opportunities for above average returns may be limited. The same ease with which hedge funds were able to adapt to governance activism can be transferred to other strategies. Thus, hedge funds may not be long-term participants in activist strategies.

The gains from strategies promoted by activists can be achieved more by financial buyers rather than strategic buyers. Activists often do not bring economies of scale or value from vertical integration. They do not necessarily bring knowledge for a particular industry or complimentary skills. Rather, they instill a discipline that existing management could implement without the activist. In fact, the gain they plan to deliver does not necessarily come from displacing inefficient management. As a result, this discipline is more likely to show up in segments of the economy vulnerable to financial acquisitions. The inclination to push for cash payments or to monetize assets is most likely to occur at the point of the economic cycle where cash is most likely to accumulate. This could pose a problem for the SBA as the SBA may hold a target firm in an index fund, though it is unclear whether it would be detrimental at the total fund level. Activist behavior may be inconsistent with the social good. Activist managers may act in a manner that enrich themselves while leaving the rest of society poorer. Generally, there

10 Klein, April and Emanuel Zur. Hedge Fund Activism. Working Paper, New York University. October, 2006. 11 Thompson (2006). 12 Ben-Ur, David. Shareholder Activism. Corbin Capital Partners. January 2007. 13 Thompson (2006).

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is little evidence of such widespread abuse, though there are examples of activists acting in a manner which may be construed as not acting in the best interests of society. Activists may harm their own investors. Volatility and the size of some hedge funds could lead to a run on the bank or pose a threat to markets. Compensation schemes utilized by hedge funds may create perverse economic incentives and may induce market manipulation. Shareholder activism may threaten other constituencies, and may impose financial distress and costs on employees, creditors and communities. A worrisome aspect is the use of financial tools to separate the interests of ownership and control from economic interests. This strategy is known as empty voting, and the motivation is usually to enhance the value of another asset, for example, acquiring votes in a bidder to help ensure approval of the takeover of a target where the investor has a large stake. An example of empty voting was Mylan Laboratories attempted purchase of King Pharmaceuticals. Perry Capital had acquired a large block of Mylan and entered a derivatives contract to hedge away the economic interest but retain the voting rights.14

Perry used its position to pressure Mylan into purchasing King, in which Perry had a significant interest, at a hefty premium.

Shareholder interests may not be aligned. As Anabtawi and Stout (2006) note, minority shareholders can have private interests that are pitted against other shareholders common interests in enhancing value.15

Common and increasing sources of conflict between minority and other shareholders include

Empty voting, demonstrated in the Mylan example above. Significant and undiversified holdings in other components of a firms capital

structure such as stocks or bonds of the corporation or equity ownership in other companies whose value is affected by business decisions that also affect the value of the companys shares.

Economic interests, in particular business transactions with corporations such as greenmail repurchases, employment contracts, or collective bargaining agreements that are not shared by other equity holders.

A short-term interest in enhancing the value of the shares at the expense of long-term equity value.

14 Anabtawi, Iman and Lynn Stout. A General Theory of Shareholder Fiduciary Duty. Working paper presented at Vanderbilt University. October 13, 2006. 15 Anabtawi and Stout (2006).

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Risks as a Strategy As an Asset Manager There are several risks unique to activist investing. These risks include16

Time and money. It takes an enormous time commitment as activists are waging political and strategic offensives. Political offensives include the media, politicians and the courts. Strategic offensives include proxy fights and acquisition proposals. All the while, managers are researching and trading a balanced portfolio. Target management is fighting with the activists own money as the executives and the board defend their own honor and use shareholders resources to do so.

Obtaining a material position in the stock without alerting the market. Information leakage is common in financial markets, and it increases the price of the stock, boosting basis cost and diluting returns.

Finding companies where the shareholder base are people the manager can convince. Generally, the more diverse the shareholder base and the lower the percentage of stock held by institutions, the greater the difficulty in effecting change.

Returns are very sporadic. This was a common theme voiced by other institutions investing in an activist program. Returns of individual managers can be very volatile.

Illiquidity and the difficulty in reversing course. Once the investment occurs, it is expensive to liquidate the position.

For the SBA The SBA as an organization faces risks if it decides to implement an activist strategy. Such risks include

Illiquidity. If ever the need to access funds were to arise, it would be difficult to do so given the structure of activist funds.

Large loss of money in any one investment held within a relatively concentrated portfolio.

Relative organizational instability of activist managers. Activist managers may only have one product, the activist fund they are managing. Because underperformance is tolerated less willingly by many who invest in hedge funds, underperformance can lead to a run on assets and possibly a shuttering of the fund. For example, activist manager Pirate Capital saw its capital fall to an estimated $375 million on September 1, 2007, from an estimated $1.8 billion the year before.17

16 Accredited Investor. Activism Roundtable. pp16-19. June 2007.

17 Losses Force Pirate to Pull up the Plank. DealBook, http://dealbook.blogs.nytimes.com/2007/09/12/after-losses-pirate-pulls-up-the-plank/. September 12, 2007.

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Lack of institutional experience. The nascent nature of this strategy means asset managers in general have less experience dealing with large institutions such as the SBA.

Headline risk. Companies may use the media to portray the activist investor in a negative light.

Declining alpha. Alpha is positive within activist investing. However, more capital is being committed to the strategy, which may mean lower excess returns in the future.

Activists tend to invest in small cap value companies. Small cap value indices have been the best performing indices of all US public equities this decade.

Shareholder conflicts. Actions undertaken by activist managers to increase returns in the short-run may not be in the best interests of the company nor the industry in the long-run.

ACTIVIST MANAGER RETURNS There is no known comprehensive database of activist hedge funds. The few publicly available hedge fund databases that carry activist manager data are incomplete. Brav, Jiang, Partnoy and Thomas estimate that only 20-25% of their sample are represented in the public data providers.18

Databases of activist manager returns are scant. Hedge Fund Research of Chicago offered a database of hedge fund returns totaling 45 names at the time of this writing. The cost of obtaining the database was $4500. At $100 per return stream, it was not considered good value, especially when the vendor stated that many other activist funds and multi-strategy funds engaging in activism were not represented in the database. In Wilshires database of hedge fund returns, only seven of the 5500 funds were considered activist. Given the nature of the hedge fund industry, where it is common for funds to close a year or two after opening, the problem of survivorship bias in hedge fund databases is acute. According to one estimate, over 1000 hedge funds closed in 2005 and 2006.19

Also, many activist events are driven by multi-strategy hedge funds, or equity hedge funds that are initiating activist campaigns in which they had not intended to launch but felt compelled to do so to unlock the value in their investment. Such campaigns are not captured in return databases, potentially skewing the return distribution. A problem arises in the measurement of the effects of activist management. Much activism occurs behind the scenes through private negotiation where there is no external observation of the event.20

18 Brav, Jiang, Partnoy and Thomas (2006).

One study measured the size of this dynamic. The study

19 Despite Blue-Chip Gains, Hedge Funds are Faltering. Pittsburgh Post-Gazette. http://www.post-gazette.com/pg/06277/727312-28.stm. October 4, 2006. 20 Gillan and Starks (2003).

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found that of 45 firms contacted by TIAA-CREF regarding an issue brought forth by the fund, 71% reached a negotiated settlement prior to the vote on the shareholder proposal. The remaining 29% resisted TIAA-CREFs pressures and the shareholder proposals went to a vote.21

In the past, various activist money managers have submitted marketing material to the SBA. Often included in the marketing materials was a stream of returns representing the actual portfolio or a composite of a representative portfolio. Mercer also provided the SBA with a table of returns generated by activist managers hired by CalPERS. From this data, a preliminary comparative universe of activist managers was created. The funds were spread across geography, with data available from the United States, Europe, the UK and Japan. Within the United States, there were funds benchmarked against a broad market benchmark and others that were considered small-cap funds. Returns for 22 activist funds were compiled. Due to the differing time frames for which managers submitted data, only returns for full calendar years were included. For example, one manager submitted calendar year returns for 1994 through 2006 while returns for only one full calendar year could be constructed for other funds. The total number of full calendar year returns compiled was 98. The average number of calendar year returns for the managers was 4.5 years whereas the median number of years was 3.0. The average annual active return above the benchmark for the managers was 12.6%. The median annual active return was 10.5%. The standard deviation of active returns was 31.1%. The largest positive active return was +176%. The largest negative active return was -55%. Sixty-eight of the 98 calendar years were positive, or 69% of the time. Universe returns broken down by geography are in the Appendix. A hypothetical portfolio of activist managers was created from the returns provided, shown in Table 1. The hypothetical portfolio assumes the managers were hired on the first day of the year for when returns were available. Manager returns are equal-weighted as are benchmark returns.

21 Carleton, Willard T., James M. Nelson and Michael Weisbach. The Influence of Institutions on Corporate Governance through Private Negotiations: Evidence from TIAA-CREF. University of Arizona Working Paper. 1997.

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Table 1 Active Returns of an Equal-Weighted Activist Portfolio Managed Return Benchmark Return Active Managers 1994 1.4% 7.5% -6.1% 3 1995 56.3% 25.5% 30.8% 3 1996 21.6% 9.8% 11.8% 3 1997 40.2% 14.1% 26.1% 3 1998 -3.6% 19.8% -23.3% 3 1999 40.2% 28.2% 12.1% 5 2000 16.4% -6.6% 23.0% 7 2001 31.6% -15.4% 47.0% 7 2002 1.9% -18.4% 20.3% 8 2003 51.3% 29.7% 21.6% 11 2004 23.4% 16.4% 7.0% 17 2005 18.9% 12.4% 6.6% 13 2006 17.7% 20.3% -2.6% 14 Total 1390.2% 241.1% 1149.1% Annualized 23.1% 9.9% 13.2% The annualized return for the hypothetical portfolio is 23.1% versus 9.9% for the hypothetical aggregate benchmark. Because of the limits of the database, it should not be considered a definitive universe. Rather, it is best viewed as an incomplete representative sample. PEER PRACTICES California Public Employees Retirement System (CalPERS) CalPERS began investing in activist strategies in 1986.22 Recently, CalPERS announced their activist allocation will increase from $5.1 billion to $10 billion.23

The allocation had been 1%-5% of the total Global portfolio of more than $150 billion. The new allocation will be 2%-8%. Currently, external activist managers run $4.2 billion for CalPERS and $860 million is managed internally in a co-investment program.

CalPERS expanded their activist program in 2005 when several new managers were hired. CalPERS currently employs 11 external managers, six focused on the United States and five on Europe and Japan. Of the 11 managers, two focus exclusively on small-cap companies. CalPERS allocated approximately $200 million to each manager. The aggregate activist portfolio consisted of roughly 110 companies, with no managers holding the same stock. When CalPERS constructed the portfolio, the fund deliberately diversified across geographies and market capitalizations. The smallest company owned

22 Teleconference between Dennis Johnson of CalPERS and Scott Seery and Trent Webster of the SBA on October 2, 2006. 23 CalPERS press release. June 18, 2007.

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by market cap was $200 million while the largest was $30-$40 billion. Companies are typically owned for two to four years. The strategy is primarily deep value. Though governance is a focus, managers are not necessarily out to improve governance. Governance is a means to higher returns, not an end unto itself. Managers are not necessarily interested in long-term value creation. Managers are focused primarily on the more efficient allocation of capital by management and on board changes. Activist fund managers will take board seats but usually would rather not as board members are insiders and subject to insider trading laws. None of the managers short or use derivatives. Several managers are interested only in balance sheet restructuring. CalPERS deliberately avoids high profile managers. Most managers are low profile and do not pursue hostile strategies. The typical activist manager has a three year lock-up period. CalPERS sits on many of the funds advisory boards and uses ISS and Glass-Lewis as advisors. CalPERS has a co-investment program and runs an internal activist portfolio that, in late 2006, comprised of six companies four in the United States, one in Japan and one in Europe, with another name to be added. The co-investment portfolio has beaten the over-all portfolio by about 2% per year. Managers are compensated on a performance-based fee structure if one of their companies is in the co-investment portfolio. Four employees worked on the program, with no one dedicated full-time. However, CalPERS had intended to hire a portfolio manager who would be dedicated solely to the activist program. Risk adjusted returns for CalPERS have been strong. Up until mid-2005, the information ratio of the activist program was 1.23.24 As of the end of March 2007, the governance program had returned 14.4% versus a benchmark return of 6.4% since inception, while over the past five years, the program had gained 14.5% compared to the benchmark return of 10.9%.25

24 Anson, Mark. CIO CalPERS. Presentation entitled Building Investment Products for Institutional Portfolios. June 6, 2005. 25 CalPERS revision of global equity sub asset class allocation ranges policy recommendation to members of the policy committee, p6. June 18, 2007.

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The activist program had both the highest standard deviation and highest alpha of all investment strategies at CalPERS. There was no targeted alpha, nor was there a risk budget although CalPERS was working on one at the time. California State Teachers Retirement System (CalSTRS) CalSTRS began their activist investing program three years ago when they hired Relational Advisors.26

They are currently in the process of hiring seven new managers four in the US, one in Europe and two in Japan. Hermes had been hired as the European manager while Sparx and Taiyo Pacific had been hired as managers for Japan. Two managers in the United States will be large cap and two managers will be small/mid-cap. They tend to hire managers that avoid hostile engagements.

Currently, CalSTRS has $1.2 billion with Relational. The fund intends to increase the allocation to $2.5-$3.0 billion. Total fund assets under management at CalSTRS is currently $170 billion. CalSTRS conducted the search. They used a consultant but only in an advisory role. Managers not hired are part of a bench that may be hired in the future. A few managers in the search were new and did not have track records.

26 Conference call between Brian Rice, California State Teachers Retirement System, and Trent Webster. November 19, 2007.

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To date, the program has been successful. Relational had returns of 30% in the previous fiscal year, which was 8%-10% ahead of their benchmark. Since then, returns have fallen to 3%-4% for the year. Thus, though returns are attractive, they are also volatile. The activist program is considered a corporate governance portfolio and is part of the global equities asset class. Private equity is not part of global equities at CalSTRS. Lock-ups were for one to three years, and fees were generally 2% of assets and 20% of returns above a benchmark. Benchmarks are broad market benchmarks such as the Russell 1000, Russell 2000 and MSCI Europe. Managers were generally accommodative for reporting purposes. Canada Pension Plan (CPP) The activist program at the Canada Pension Plan began in January 2007.27

CPP describes their activist program as Relationship Investments. Relationship Investments include not only activist managers but all engagement of public companies, including proxies and governance.

Total assets under management at CPP are $120 billion. By 2022, CPP expects assets under management to grow to $450-$500 billion. Relationship Investing is domiciled within the public markets group, which currently has $105 billion in assets. CPP has hired two funds and will hire two more in the near future, totaling $1.2-$1.3 billion in assets. It is their intention to grow to $3-$5 billion over time and hire 15 to 20 external activist mangers. They intend to hire 2-3 US larger-cap activist managers, 2-3 US smaller-cap activist managers, 3-4 European managers and a few Japanese managers. They expect to hire a mix of friendly and more confrontational managers. As their expertise grows, internal staff will invest directly in target companies. They expect capital allocated to the internal program will eventually equal the external allocation. Thus, total assets under management in the relationship program is expected to be $5-$10 billion. CPP approaches benchmarking in a unique manner. All investments are benchmarked to a global passive portfolio. All active investments are expected to beat whatever portion of the benchmark from which capital was drawn. For example, if KKR draws on a commitment to buy Dollar General, the benchmark for the private equity investment in Dollar General is the returns from a passive index of US retail stocks. The relationship managers are benchmarked in the same manner. Internally, however, CPP expects the activist program to generate 300-400 basis points of return over the global passive equity benchmark. 27 Conference call between Nikhil Shah, Canada Pension Plan Investment Board, and Trent Webster. November 14, 2007.

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When asked about fees, they said that even large institutions have little or no leverage when negotiating. One manager agreed to a 1.5% management fee and a 20% incentive fee, locked in over three years. Another manager agreed to 2% and 20% over three years. Another agreed to 1% and 20% in excess of a large-cap benchmark. Yet another agreed to 1.5% and 20% relative to CPPs internal benchmarks, their preferred fee structure. Managers were hesitant to be judged against an equity benchmark. On disclosure, one current manager supplies CPP with anything requested. The other current manager is reluctant to do so. CPP conducted the search entirely on their own. They did not use a consultant. Los Angeles City Employees Retirement System (LACERS) LACERS has invested $150 million in an activist strategy, representing 1.6% of the total fund.28

They are expanding the program, perhaps by as much as 100%. LACERS has issued RFIs and will determine the commitment after the selection process.

The activist program began in 2005. Half the capital committed was with funds focusing on domestic companies and half with funds focusing on international companies. LACERS hired Relational for the US strategy and Hermes, Knight Vinke and Sparx Asset Management for the international mandate. In their current search, LACERS is interviewing six US firms and six international firms. In the first search, LACERS did not consider capitalization ranges when allocating capital in the strategy. However, they are considering size in the current search. LACERS uses Pension Consulting Alliance as their consultant. Since inception, the program has returned 6.3% versus 5.8% for the benchmark. The one year return ending June 2007 was 26.6% versus 21.7% for the benchmark. LACERS noted that returns have been volatile. Europe and the UK have been strong while Japan has lagged. Formal reporting by the managers has generally been good. Virginia Retirement System (VRS) Virginia has committed $1.3 billion to activist managers out of a total of $38 billion in the domestic equities asset class and $59 billion in the entire fund.29

28 Conference call between Barbara Sandoval of LACERS and Trent Webster. October 29, 2007.

The activist program accounts for 1.6% of domestic equities and 1.0% of the total fund.

29 Conference call between KC Howell of the Virginia Retirement System and Trent Webster. November 7, 2007.

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Currently, Virginia employs four activist managers Relational, Shamrock, ValueAct and New Mountain. The VRS has allocated $614 million in total to Relational. Relational was hired as their first activist manager in September 2003. Virginia classifies Relational as a traditional large cap manager. Shamrock was hired in May 2005 and is classified as a small cap manager. Virginia has committed $200 million to Shamrock with $134 million allocated. ValueAct was hired on May 1 and is classified as a hedge fund. ValueAct was allocated $263 million. New Mountain, which is better known as a private equity manager, launched an activist fund in which the VRS allocated $263 million. Virginia terminated Hermes, the UK activist manager, due to personnel turnover. Activist managers are not segregated into a separate program and are usually incorporated into the equities asset class, though activist managers can be classified as a hedge fund in the hedge fund program at VRS. Results have been very volatile. VRS does not aggregate performance as a separate program. However, if they did so, activist managers would show to have added value. Relational has added no value, though the swings have been dramatic, with performance oscillating between 0 basis points and +600 basis points above the benchmark twice while never going negative. Performance for New Mountain has been disappointing while ValueAct has been impressive. Mr. Howell of the VRS recommended the SBA not get involved with activist managers who invest directly in private equity deals. Such arrangements are headaches. Instead, if the SBA decides to invest with such managers, choose those that carve out private equity deals into sidepockets. Typically, lock-ups are for three to five years. Thereafter, when the initial lock-up expires, the investor is locked-up for another three to five years. Managers usually do not have gates. Fees vary. A typical fee structure was a 100 bp management fee and a 20% share return above the S&P 500. Shamrock charged a 100 bp management fee and a 20% share return over 5%. There is no negotiating ability with hedge funds. Managers usually report monthly, though one reports quarterly. Virginia has no problems with transparency. Relational is excellent, giving the rationale for every name in reports 50 pages long. ValueAct is pretty good with reporting while Shamrock is weak. The SBA should add an events of default clause into any contract signed with an activist manager. If there is fraud, organizational change or something happens to a key person, an investor can trigger the events of default clause and request their funds be returned.

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ACADEMIC REVIEW Pension Plan Activism Until recently, limited partnerships did not play a significant role in shareholder monitoring. Instead the role was played by control shareholders and other institutions such as pension funds and mutual funds. There is mixed evidence on the efficacy of public pension fund shareholder activism. Prevost and Rao detailed numerous studies that have both substantiated and negated the assertion that public pension plan activism has been effective.30 In their own research, they concluded that there is no statistical evidence that proxies initiated by public pension plans add value over time. Most evidence indicates that pension fund shareholder activism can prompt small changes in target firms governance structures but has negligible impacts on share values and earnings.31

Karpoff (2001) noted nine studies detailing short-run stock returns around key public releases of information regarding shareholder proposals, including press announcements, the date on which proxy materials containing the shareholder proposals are mailed, and the date of the shareholder meeting on which the proposal is voted. 32

In most cases, the average abnormal stock return was negative, and in all but one case, it was statistically insignificant. The studies examined return on assets (ROA), return on equity (ROE) and return on sales (ROS) changes following shareholder proposals or non-proposals by activist investors. Most researchers report insignificant changes in all three variables, with the exception of two studies, one which reported significant decreases in average ROA and ROS for firms subject to repeat targeting by pension funds, and the other which reported an increase in ROA for firms listed by the Council of Institutional Investors as potential targets for shareholder activism.

The greatest evidence of operational change following shareholder activism regards asset divestitures, restructurings or employee layoffs. Firms targeted by pension funds are more likely to experience such events during the three to four years following their initial targeting, though it is unclear whether or not such corporate actions are due to shareholder pressure since such firms tend to be poorly performing and are prime for restructuring without shareholder activism. Five studies examined announcements of negotiated settlements or non-proposal pressure by activist shareholders, all reporting positive shareholder value effects, with two statistically significant.

30 Prevost, Andrew K. and Ramesh P. Rao. Of What Value are Shareholder Proposals Sponsored by Public Pension Funds? Massey University and Texas Tech University Working Paper. 31 Karpoff, Jonathan. The Impact of Shareholder Activism on Target Companies: A Survey of Empirical Findings. Presented at the Corporate Governance i praksis: Internasjonalt Seminar. September 10, 2001. 32 Karpoff (2001).

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Over the long-run, there is evidence both for and against shareholder activism. According to Karpoff

[S]even studiesexamine long-run returns following shareholder proposals or non-proposal targeting announcements. Nesbitt (1994), Opler and Sokobin (1997), and Smith (1996) each report positive long-run stock returns. Del Guercio and Hawkins (1999), Martin, Kensinger, and Gillan (2000), and Wahal (1996), in contrast, each find statistically insignificant long-run returns. Prevost and Rao (2000) report statistically insignificant three-year buy-and-hold returns for a sample of 17 firms that each were targeted once by public pension funds, but statistically significant negative average abnormal returns for nine firms targeted more than once. [T]he most persuasive evidence is that the average abnormal long-run return is not significantly positive. Nevertheless, the size and sign of long-run returns following the initiation of activist shareholder pressure remain topics of genuine dispute in the empirical literature.

Karpoff concluded that the empirical findings imply six generalizations about institutional shareholder activism

Firms attracting activist efforts tend to be large and have high levels of institutional ownership.

Activists have been successful at prompting some firms to adopt limited changes in their governance structures.

When averaged over time periods, sponsor types and proposal types, shareholder proposals have negligible and statistically insignificant short-run effects on share values.

Announcements of non-proposal targetings and negotiated settlements between activist shareholders and target companies are associated with an average increase in share values, sometimes significant statistically.

The average abnormal stock return is non-zero for some subsets of proposal and non-proposal targetings.

Shareholder activism is not associated with subsequent changes in earnings, capital expenditures, earnings payout, CEO turnover, CEO compensation, or likelihood of control change, although it appears to be followed by an unusually high rate of asset divestiture and/or company restructurings.33

A Wilshire study on the effectiveness of CalPERS Focus List targeting underperforming stocks from 1987 through mid-2004 also yielded conflicting results.34

33 Karpoff (2001).

For the five years prior to the initiative date, the 117 Focus List stocks produced an average cumulative return of -93.5%, or an average annual return of -14.1% per year. For the first five years

34 Hewsenian, Rosalind M. and Andrew Junkin. The CALPERS Effect on Targeted Company Share Prices. Wilshire Associates. 2004.

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after the initiative date, the average cumulative return was 15.3%, or an average annual return of 2.9% per year. However, returns for the subsequent five years have steadily decreased over time. The cumulative five-year return was 41% in 1992, 54% in 1995, 13.6% in 2001 and 8.1% in 2003. Aggregate results were lifted by a handful of stocks that experienced large gains. Fully 61% of companies underperformed their benchmarks, with median performance -25.7% below the benchmark. Possible explanations for poor results include variations in degree of aggressiveness on the part of CalPERS in applying their process, and the sharp bear market during the 1990s as well as the following decade when low-quality stocks underperformed. The repeated failures of institutional shareholder activism is often blamed on three elements inadequate monitoring due to free riding, legal and institutional obstacles to activism, and incentive problems amongst institutional investors in the United States.35 Boyson and Mooradian write that the inability to improve long-term performance of targets has been explained by insufficient managerial skill among activists, political motivations amongst pension funds, short-term focus of activists goals other than long-term performance improvement, too little money and time spent on activism, and better alternatives than shareholder activism to effect change.36

Dedicated Manager Activism Unlike studies concluding there is no evidence institutional activist management adds value, studies regarding dedicated activism conclude that hedge fund activism does add value. In particular, Brav, Jiang, Partnoy and Thomas (2006), Klein and Zur (2006), Greenwood and Schor (2007) and Boyson and Mooradian (2007) all conclude dedicated activist hedge fund managers generate abnormal excess returns. Other, less in-depth studies also support this conclusion. However, it is not conclusive that all activist strategies add value. Brav, Jiang, Partnoy and Thomas37

Brav, Jiang, Partnoy and Thomas constructed a proprietary database of 131 activist hedge funds and examined 888 events involving 775 unique target companies from the beginning of 2001 through the end of 2005. They observed considerable heterogeneity in the degree of fund activism and range of activist techniques.

35 Becht, Marco, Julian Franks, Colin Mayer and Stefano Rossi. Returns to Shareholder Activism; Evidence from a Clinical Study of the Hermes UK Focus Fund. Working paper presented at Vanderbilt University. October 13, 2006. 36 Boyson, Nicole M. and Robert M. Mooradian. Hedge Funds as Shareholder Activists from 1994-2005. Working paper. July 31, 2007. 37 Brav, Jiang, Partnoy and Thomas (2006).

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Activist Strategies When Engaging Target Companies The authors identified seven distinct strategies

Communication to enhance shareholder value (64% of the sample) Seeking board representation without conflict (13%) Making formal shareholder proposals or publicly criticizing the company and

demanding change (24%) Threatening to wage a proxy war for board representation or suing a company for

breach of duty (5%) Launching a proxy fight to replace the board (12%) Suing the company (5%) Intending to take over the company (5%).

Hedge funds can launch more than one strategy, thus the percentages do not add to 100%. The authors defined the first two strategies as friendly, the third as aggressive if it involves a stated intention to remove the CEO, and the remaining strategies as aggressive. Hedge funds worked together in 21% of the events. This does not include when funds act in parallel with each other, i.e. their efforts are uncoordinated but are attempting to achieve the same ends. Nor does it include other hedge funds or investors that cascade into the target firms stock after the 13D filing38

to take a free ride.

In the 32 cases where ISS had an opinion, ISS recommended voting in favor of the activist manager 23 times. Activist Motives There are six major motivations behind dedicated activism that can be broken down further into multiple subcategories.

The activist believes the company is undervalued and/or the fund can help the manager maximize shareholder value. No further activism was launched. This category accounts for 51% of the sample.

Activism targeting operational efficiency, including general operating efficiency and cost cutting, and tax efficiency-gaining changes. This category accounted for 11% of the sample. Operational efficiency and cost cutting objectives achieved 36% success and 20% partial success. There were five tax-efficiency changes with three successful and two partially successful.

Activism targeting a firms payout policy and capital structure. Companies use cash or increase borrowings to increase dividends or share buybacks. This activism accounted for 11% of the sample and achieved 40% success and 30%

38 Investors are required to file Schedule 13D no later than 10 days after the transaction that triggers the 5% ownership level or greater and state the intent of the transaction.

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partial success. Equity issuance is another sub-category, defined as stopping or reducing equity offerings by the company and proposed debt restructurings. These events accounted for 4% of the sample and were successful 44% of the time and partially successful 29% of the time.

Activism targeting business strategy. Activists target companies they believe lack business focus or exhibit excessive diversification and propose a spin-off or refocusing the business strategy. These accounted for 6% of the sample, exhibiting a 33% success rate and a 32% partial success rate. Activists intervene in a proposed merger to get a better price. This category accounted for 6% of the sample and was successful in 41% of the cases and partially successful in 22%. Activists intervene to stop a merger. These accounted for 3% of the sample, exhibiting a 32% success rate and a 46% partial success rate. Finally, activists acquire a stake in the company to facilitate a transaction. These accounted for 12% of the sample, exhibiting a 92% success rate and a 1% partial success rate.

Activism to urge the sale of the target. Hedge funds attempt to force a sale of the target company, either to a third party or to themselves. Sales to a third party accounted for 11% of the sample, exhibiting a 47% success rate and a 20% partial success rate. Sales to themselves accounted for 4% of the sample, exhibiting a 37% success rate and a 27% partial success rate.

Activism targeting firm governance. There are a number of strategies in this category including rescinding takeover defenses (6% of the sample, 20% success, 39% partial success), ousting the CEO or Chairman (5% of the sample, 58% success, 22% partial success), challenging board independence and fair representation (11% of the sample, 38% success, 30% partial success), demanding more information disclosure and questioning potential fraud (4% of the sample, 44% success, 22% partial success), and challenging executive compensation (3% of the sample, 27% success, 33% partial success).

Activism in providing finance. In this category, activists are either financing growth (5% of the sample, 75% success) or a corporate restructuring out of bankruptcy or financial distress (5% of the sample, 72% success, 7% partial success). In most cases, the fund also seeks board representation and is accommodated by the board.

Target companies chose to fight 48% of the time. Target firms accommodate the activists 33% of the time. Companies negotiate in the remaining cases. Characteristics of Activist Funds The median size of the activist funds in the sample was $793 million. Activist funds ranking in the 25th and 75th percentiles had assets under management of $278 million and $4.44 billion. Activist funds are value investors. In about two-thirds of the cases, managers specifically state that the target company is undervalued.

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The median percentage ownership stake is 6% of the company. The median dollar value involves about $9.5 million at cost rising to $12-$13 million at the maximum level of investment, or 9%-10% of the company. Percentage ownership stakes are strongly negatively correlated to size of the target company. Activist funds seldom seek controlling positions. As of the end of the study, in 48% of the cases activists still maintained at least a 5% stake in the target. In the instances where the fund no longer owned a 5% stake, the median duration from the first Schedule 13D filing to divestment was 360 days, with the 25th and 75th percentile at 150 days and 720 days. These numbers indicate that activists investment horizons are not as short as the critics of activism imply. Characteristics of Target Firms Target companies tend to be value companies. Targets tend to be more profitable as defined by return on invested capital, return on assets and cash flow generated. They are no worse off than comparable companies regarding other operational issues. They generally have slightly higher leverage than peers, have significantly lower new equity issuance, payout a bit less in dividends, spend significantly less on research and development, spend a bit more on capital expenditures, are generally more diversified, have more takeover defenses, have greater institutional ownership, have higher trading liquidity, and recent stock performance is roughly on par with that of comparable firms. Activists identify potential problems at target firms that are general issues all firms face, such as governance, capital structure, dividend payout, etc., rather than firm-specific problems. Targeted firms do not suffer from serious operational problems. The problems identified by the activist fund are likely related to the misallocation of cash flows and diversifying investments that detract from shareholder value. Such targeting patterns are sensible given that activists, in general, are not experts in the specific business of the target firms. Corporate Operational Outcomes of Activist Campaigns Targeted companies have higher ROA and the difference is notably higher after activist intervention. ROE shows similar or even greater results. The average ROE is 4.0% (1.8%) above peers in the year prior to (during) activism and 8.0% two years later. During the year before activism, dividend payment is 0.42% lower than peers. The year after activism, the difference is +0.13%. If you include share buybacks, the difference rises to +1.66% a year after activism. Leverage also changes. The difference in the leverage ratio for the target firm compared to peers decreases from 3.2% to 2.3% in the year leading up to the target date then rises to 3.6% the year after.

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Target companies on average pay their CEO $862,000 more than peers in the same industry and of similar size and stock valuation. One year after targeting, there is no difference. If you include total compensation, i.e. stock options, pension benefits, etc., the difference in pay during the event year is $1,260,000 and zero a year after. CEO turnover is slightly higher for targeted companies before activism. One year after the targeted event, turnover was 13.6% higher for the targeted companies relative to peers. Returns Excess returns are positive and significant. The median excess return is 5-7% for the 20-day window around the Schedule 13D filing date. The average excess return is 9%. There is an abnormal return of 3.2% 10 days prior to filing the initial Schedule 13D and a 2.0% jump in the following two days. The abnormal cumulative buy and hold return is 7.2% 20 days before and 20 days after the date of the first action. A full 64% of events in the sample experience positive excess return. The 25th, 50th and 75th percentile experience excess returns of -5.4%, 5.1% and 17.4%. For hedge funds that describe a specific event in the 13D filing, i.e. do not communicate only that the stock is undervalued, the abnormal return is 5.3% 10 days before the filing and 3.3% the following two days. The average excess return 20 days after the filing is 10.1%. Confrontational events generated higher excess returns of 11.9% whereas friendly events generated excess returns of 5.3%. This makes intuitive sense since the cost of generating returns from a hostile event are higher, and returns should be higher to endure the higher costs. The market response to capital structure related activism including debt restructuring, recapitalization, dividends and share repurchases is insignificant. There is a similar insignificant reaction for corporate governance related activism such as attempts to rescind takeover defenses, to oust CEOs, to enhance board independence and to curtail CEO compensation. Instead, events that are associated with positive abnormal returns involve more dramatic events such as changes in business strategies, i.e. spinning off assets and the sale of the company, which had excess returns of 4.4%, and 10.9% respectively. It is possible excess returns are explained by alternate causes, such as market over-reaction and good stock-picking. There are several reasons to believe this is not the case.

There is no reversal in returns up to 12 months after the events. Hostile targeting generates significantly higher event-driven returns than non-

hostile targeting. Adjusting for size, the difference is 6.6%. Given that hostile activism is resisted by management, the positive market response must come from the potential value improvement through activism. Hostile activism is more

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costly, and funds should only resort to it when the perceived benefits are higher. If hedge funds were merely stock pickers, there should not be such significant variation.

Excess returns are different based on whether the stated goal of the activism is achieved. If a hedge fund fails or withdraws from ongoing activism, the excess return is -4% to -6% 20 days on either side of the time of the withdrawal. On the other hand, when a hedge fund withdraws after a successful intervention, there is no negative excess return

If activist managers were merely picking stocks, they would sell immediately after the market price reflected their finding that a companys shares were undervalued. However, activist hedge funds do not sell immediately after filing the Schedule 13D. Instead, funds continue to hold for relatively long time periods.

The median (average) abnormal return to dedicated activism in the sample steadily declined from 2001 to 2005, from 9.0% (10.6%) in 2001 to 3.1% (4.8%) in 2005. The strategy is relatively new. The number of dedicated activist funds surged after 2003 and activity continues to grow. It is possible that the new-found popularity of the strategy will reduce returns in the future. The documented excess returns may be understating actual results. If one views the 14.5% of the sample where targets are being liquidated, sold or taken private as a complete payout to shareholders, the post-activism payout is much higher than the conventional payout would indicate. Klein and Zur39

Using 13D filings from January 2003 through December 2005, Klein and Zur claim to have identified all or nearly all activist initial purchases that state the purpose of redirecting managements efforts. There were 194 13D filings pertaining to 155 events by 104 hedge funds. Klein and Zur included a control group of non-activist companies adjusted by industry, size and market-to-book. The study also compared hedge fund to non-hedge fund activists, i.e. pension funds, mutual funds, etc. The control group consisted of 209 13D filings for 164 separate target firms by 141 distinct non-hedge fund activist. Non-hedge fund activists are more likely to invest in restaurants, hotels, banking and communication firms and less likely to invest in pharmaceutical and retail firms compared to hedge funds. Activist Strategies When Engaging Target Companies Hedge funds use the threat of a proxy solicitation as a major weapon. Thirty-nine percent of the target firms in their sample were involved in either a proxy fight or threatened with a proxy fight. In almost all cases, the proxy fight was over board representation. 39 Klein and Zur (2006).

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Activist Motivations The authors identify two ways in which hedge funds can add value for shareholders. First, activists can alter the firms strategic policies, through redirections of investments, including spinning off assets. Second, the activist can reduce agency costs by forcing the firm to reduce its excess cash holding through increased dividends, higher debt loads and/or share buybacks. The most frequently stated purpose in the 13D filings was changing the boards composition. In the purpose statements, hedge funds demand board representation 26% of the time, 19% of the time they stated the firm should pursue alternative strategies, 12% opposed a merger, 10% demanded the firm sell itself, while the remaining incidents were cash payments, corporate governance issues or punishing the CEO. Hedge fund activists are more concerned about mergers, stock buybacks and cash dividends than non-hedge fund activists. Conversely, non-hedge fund activists are more interested in buying the target firm themselves, becoming an active investor and steering the firm towards alternative strategic goals than hedge funds. Both groups frequently demand changes in the composition of the board of directors. In 60% of the cases, the company agrees to implement the hedge funds demands. In 73% of the cases, hedge funds obtained board representation. There was a 100% success rate in convincing the firm to buy back its stock, replace the CEO and pay a cash dividend. In about half the occasions, the hedge fund was able to pressure the firm to change operational strategies, drop its merger plans or agree to be sold. Hedge funds waged 18 proxy fights in the study and achieved 13D stated goals 13 times, a success rate of 72%. For the firms threatening a proxy fight but not carrying one out, the hedge fund was successful in 62% of the 42 cases. In the 95 cases where there was no threat of a proxy fight, the hedge fund was successful 57% of the time. The vast majority of events are over board representation. Of the 155 events, activists were able to obtain at least one seat on the board 44% of the time. The authors find no evidence that target firms engage in share buybacks. In fact, in their sample, the number of shares outstanding per company actually increased by 3.75 million. Also, they found that total assets do not decline after the initial purchase, thus negating the view that target firms sell or spin-off assets. Characteristics of Target Firms Hedge fund targets generally are more profitable than targets of non-hedge funds, have higher ROE and higher earnings per share, have better balance sheets and have higher returns a year prior to the 13D filing. Non-hedge fund activists tend to buy companies with an Altman Z-score indicating a significant probability of bankruptcy. Thus, it appears that hedge funds target relatively profitable, healthy firms while other activists

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target lesser-performing companies. There is no statistical difference between hedge funds and non-hedge funds when comparing data on capital expenditures, R&D and dividends paid. Hedge funds do not target turnarounds. Instead, they target firms rich in cash and short-term investments with low debt. After gaining control of the firms agenda, they increase debt, reduce cash on hand and pay out higher dividends to shareholders. Activists target firms across a wide range of industries. However, only 10 were S&P 500 companies. The median assets of targeted companies were $209 million, the average assets $948 million. The average number of shares outstanding was 38.1 million, the median was 17.6 million. Hedge fund targets perform well in the year prior to being targeted, with the average stock rising 12.4% before the event. Corporate Operational Outcomes of Activist Campaigns In the fiscal year following the 13D filing, the mean earnings per share of the hedge fund target dropped from $0.138 to $0.075, whereas the control group increased earnings per share. Hedge fund targets experienced a decrease in return on equity of 7.1% while the control group increased 2.4%. Return on assets declined for the target firm one year after the event. There is no evidence that cash flows from operations fall, nor is there any significant change in R&D and capital expenditures. There is strong evidence that hedge fund activism reduces agency costs of excess cash. Cash dramatically fell a year after the 13D was filed. Dividends rose on average $0.116 while the median increase was $0.10. Debt levels also rose significantly after the hedge fund investment. Returns The median and mean returns of hedge fund targeted firms 30 days prior to the filing and 5 days after were 5.0% and 7.3%. Over a period 30 days before and 30 days after the announcement (-30, +30), the median and mean returns were 8.9% and 10.3% respectively, which is statistically significant at the 99% confidence interval level. The control group demonstrated 0.0% and -0.3% median and mean returns over the (-30, +5) day period, and 2.0% and 2.9% over the (-30, +30) day event horizon. The non-hedge fund group experienced respective returns of 3.5%, 4.3% and 6.8%, 5.2% respectively. Thus, hedge fund targets generate higher rates of return than both non-hedge fund activists and non-activists. Stocks tend to start reacting at day -15 and rise into day 0. Market reaction tends to flatten out around day +5, then begins to rise again through day +30.

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The authors concluded that hedge fund activism is primarily an exercise of hedge funds pressuring corporations to increase dividends, and funding the increase with cash on hand and debt. There was no statistical evidence any other strategy adds value. Greenwood and Schor40

Greenwood and Schor constructed a database of activist events by cross referencing Schedule 13D and proxy filings by activists from the EDGAR database with 13F filings from the third quarter of 1993 to the third quarter of 2006. This limits the database somewhat as only managers with assets of greater than $100 million have to file a form 13F. 13D filings by investors holding a position for investment purposes only non-activists, the majority of filers were used as a control group. In total, the authors documented 990 distinctive events. More than half the hedge fund events occurred in 2003 or later, while a third of hedge fund events came between 1994 and 2000. There were 139 unique hedge funds that initiated 784 events while 38 unique non-hedge funds initiated 196 events. Greenwood and Schor noted that non-hedge funds often engage in activism without filing SEC documents, and instead negotiate with management privately. Activist Strategies When Engaging Target Companies Greenwood and Schor delineated nine categories of activist demands

1. The intention to engage management (41% of events) 2. Capital structure issues (9% of events) 3. Corporate governance issues (27% of events) 4. Business strategy issues (5% of events) 5. Strategic alternatives (3% of events) 6. Calling for a sale of part or the entire company (17% of events) 7. Blocking a proposed merger or acquisition because of unfavorable pricing (6% of

events) 8. Financing and bankruptcy issues (2% of events) 9. Intention to engage in a proxy contest (8% of events)

Events do not add up to 100% since investors may have more than one demand. Characteristics of Activist Funds The median position was held for 1.5 quarters by hedge funds compared to seven quarters for non-hedge funds. The median assets under management for a hedge fund was $838

40 Greenwood, Robin and Michael Schor. Hedge Fund Investor Activism and Takeovers. Working paper. July 2007.

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million. The median position size was $16.4 million, representing 7.8% of the targets shares outstanding. Characteristics of Target Firms Activist targets tend to have similar characteristics. They are in the bottom 30% of size, have little or no analyst coverage, are cheap relative to book value and have underperformed relative to others in the industry. Hedge funds tend to target smaller firms more so than non-hedge funds. The median target firm underperformed slightly in the year prior to activism but significantly underperformed firms in its industry. There tended to be a fair amount of activist activity concentrated within industries. Corporate Operational Outcomes of Activist Campaigns The authors concluded that apart from an increase in leverage and a decrease in capital expenditures, there were no statistically significant changes in operating metrics. Return on assets, operating return on assets, cash flow, dividends, growth in assets and growth in sales showed no significant change in the time frame from one year prior to the 13F filing to one year after. Leverage increased 42% and capital expenditures declined 14.8%. Cash flow increased 49% but was not statistically significant. Returns The authors suggest that hedge funds are better at identifying undervalued companies, locating potential acquirers for those companies and removing opposition to a takeover. The majority of firms not acquired but instead owned by activist hedge funds do not earn average abnormal returns statistically distinguishable from zero, neither around the announcement date nor over the long-term. In the 10 day period before the 13D filing and 5 days after, activist demands to engage management, an asset sale, blocking a merger and a proxy fight all generated statistically significant positive abnormal returns, with asset sales generating the highest excess return of 6.8%. All other activist demands generated positive returns but were not statistically significant except for changes in strategy, which generated negative excess returns. In the period one month before the filing and 18 months after, for the entire sample, the excess return was 10.3%. Just under 7% of the excess return occurs after the third month, meaning that the market initially under-estimates the effect of the activist campaign. Every single one of the nine activist demands generated positive excess returns 18 months after the filing, ranging from a low of 3.5% for capital structure issues to 21.0% for blocking a merger. However, only blocking a merger and asset sale generated a significant t-statistic above 2.0. Corporate governance generated an excess return of 13.8% but with a t-statistic of 1.6, while proxy fights earned 14.9% with a t-statistic of 1.5 and strategic alternatives generated 12.6% with a t-statistic of 1.2. The t-statistic for

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the entire survey was 3.4. Thus, the authors conclude that activists add value only through asset sales and blocking mergers. When constructing abnormal returns, unlike the studies by Brav et al and Klein and Zur, the authors did not compare the target companies to matching stocks based on size, industry and book valuation. Compustat accounting data was available for only half the firms in their sample over the time period of their study. Instead, they constructed a matching portfolio based on Fama and Frenchs three factor market return model, where the difference between the target and the matching portfolio is regressed against beta, the small cap effect and the book-to-price effect. The authors detailed 16 possible outcomes which can be broken down into four broad categories

1. Asset sale related (32% of outcomes) 2. Capital structure (3%) 3. Corporate governance (17%) 4. Other (6%), comprised of an activist cutting the position to below 5% (4% of

outcomes) and the company involved in a financing/bankruptcy agreement (2% of outcomes).

There was no news for 42% of the events. The only broad category that generated statistically significant positive abnormal returns were asset sale related events. The cumulative abnormal return from 10 days before the 13D filing to 5 days after (-10, +5) for an announcement of an acquisition or the completion of an acquisition was 5.55%, and for one month prior to the 13D filing and 18 months after (-1, +18), the excess return is 25.7%. A company that spins off a division (which is included in the capital structure category) generated statistically significant abnormal returns of 6.4% in the (-10, +5) day time frame but lost 3.4% in the (-1, +18) month time frame. The study does not address the issue of the spun company, which may be held by the activist manager after the spin-off. Companies that have been spun off have been shown to generate abnormal excess returns.41

Companies where there was no news also generated statistically significant excess returns in the (-10, +5) day time frame of 2.3% but generated no excess returns in the (-1, +18) month time frame. Share repurchases generated excess returns of 30% over (-1, +18) months but the results were not significant.

Boyson and Mooradian42

The paper by Boyson and Mooradian covers the period from 1994 to 2005, and included 418 separate activist events involving 111 hedge funds, 89 hedge fund companies and 397 target firms. The year with the largest number of activist events was 1997. Boyson and Mooradian created a control group by matching similar characteristics to the targets. 41 The McKinsey Quarterly. 1999 Number 1. pp16-27. 42 Boyson and Mooradian (2007).

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Boyson and Mooradian differ from the other studies in that they measured the effect of activism on total hedge fund returns. The study also differs in that they identified the date when the 13D was filed (the filing) and when the hedge fund first became involved with the target company (the event) by searching the Lexis-Nexis and Factiva media databases. Activist Strategies When Engaging Target Companies Boyson and Mooradian delineate activist hedge funds three ways. Communication only funds are those that hold the company for investment purposes only. Communication then aggressive are funds that file a 13D then state their purpose at least 30 days after the filing. Aggressive funds are all others. Of the 418 filings, communication only accounted for 270 events, communication then aggressive 49 events and aggressive 99 events. In 75 cases, activism was ongoing by the end of the study. In 221 cases, the hedge fund signaled the activism was complete. In the remaining 122 cases, the target firm disappeared from the sample due to a merger, going private, being purchased by the hedge fund, or any other reason. Activist Motives There were 148 events that were not communication only, of which hedge funds proposed 365 actions. At the end of the study, 50 were still ongoing. Of the 315 remaining suggestions, the motives of the funds were as follows

1. Capital structure changes (23 completed actions, 7.3% of the total). Funds asked for a general change nine times and were successful on six occasions, partially successful once and failed twice. On two occasions, the fund suggested an increase in dividends, once failing and once meeting partial success. On 11 occasions, a buyback was requested, with the target agreeing six times, partially agreeing once and failing to act four times. Once, a fund requested a debt restructuring and the company declined. In total, 52% of the time, the hedge fund succeeded in initiating capital structure changes, partially succeeded 13% of the time and failed 35% of the time.

2. Operational changes (40 completed actions, 12.7% of the total). Hedge funds requested a general change twice, failing once and succeeding once. On four occasions, the hedge fund requested a spin-off. The company agreed to do so three times and did not do so once. On 34 occasions, the fund requested a merger, and was successful 68% of the time while failing 32% of time. In total, fund managers were met with success 67.5% of the time when requesting operational change and failed 32.5% of the time.

3. Sale of the company (40 completed actions, 12.7% of the total). On 23 occasions, the fund requested a sale and was successful 26% of the time. On 17 occasions,

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the fund offered to buy the company and was successful 35% of the time. In total, a sale was successful on 30% of the occasions.

4. Corporate governance (183 completed actions, 58.1% of the total). General recommendations were successful in two of the four cases and unsuccessful the other two. On 13 occasions, the fund recommended management be fired and was successful seven times, partially successful once and failed the other five. On 99 occasions, the fund requested board membership, and was successful in 74% of the cases, partially successful in 4% of the cases and failed in 22% of the cases. Funds requested more board independence in 27 instances and were successful on 44% attempts, partially successful on 7% and failed in 48% of the instances. On 15 occasions, the fund asked the company to increase the size of the board and succeeded 13 times and failed twice. Once, the fund complained about management compensation and failed. Sixteen times, the fund attempted to rescind anti-takeover provisions and succeeded in 31% of the cases, was partially successful in 6% of the cases and failed in 63% of the cases. On eight occasions, the fund attempted to change voting rules, succeed and failed three times each and was partially successful twice.

5. Provide financing (17 completed actions, 5.4% of the total). Hedge funds offered financing to the target and were successful on every occasion.

6. Lawsuit (12 completed actions, 3.8% of the total). Hedge funds were successful in their legal actions on 75% of their actions and failed the other 25%.

In total, hedge funds were successful 61% of the time, partially successful 6% and failed 33% of the time. Characteristics of Activist Funds The mean stake of the company owned by the hedge fund was 12% of the targets shares. The average dollar holding was $18 million. For communication only firms, the average holding period is about one year and four months. For all others, the average holding period was just over two years. Of the 111 individual hedge funds, 58 only had one target between 1994 and 2005. There is no evidence that hedge funds which took an activist position in one target firm outperformed hedge funds that had no activist positions. However, hedge funds taking aggressive positions in a target significantly outperformed non-activist hedge funds by 7.2% to 11.3%, while hedge funds taking communication then aggressive positions significantly underperformed non-activist hedge funds by 5.5% to 8.1%. Hedge funds that have a larger percentage of their assets in activist investments outperformed hedge funds that did not by as much as 26.6%, while hedge funds that took a