At the start of 2012, the Barry Rosenstein-founded hedge fund Jana Partners revealed that it held a 5.5% position in Marathon Petroleum
(NYSE:MPC), a development that excited Wall Street equity analysts.
The Street had been crying out for Marathon to spin off its midstream pipeline assets, but Marathon’s management had been resistant, with CEO Gary Heminger saying that “the “company’s crude and fuel transportation system provided flexibility and allowed it to buy cheaper oil and boost profit margins,” reported Businessweek
. After buying a big stake in Marathon, Jana, famed for its activism, convinced the company to consider a spin-off.
A few weeks later, Marathon announced its intentions and shares of the company promptly jumped close to 10% the same day, growing Marathon’s market capitalization by over $1 billion. In July, Marathon confirmed that it would spin off its pipeline asset in a master limited partnership, MPLX LP
(NYSE:MPLX), and take it public in a $365 million initial offering.
Jana began unloading its Marathon shares in February, reaping a quick profit of $44 million, but its activist actions also helped unlock value for other Marathon investors.
How did selling its pipeline assets unlock value for Marathon? Pipeline assets, such as Enbridge
(NYSE:EEP) or Markwest
(NYSE:MWE), can have enterprise multiples as high as 14. (An enterprise multiple is calculated as enterprise value/EBITDA, and is a useful metric to consider when valuating acquisition targets because it takes debt into account.) But as a refiner principally, Marathon Petroleum and others like Valero
(NYSE:VLO) and Tesoro
(NYSE:TSO) typically only have enterprise multiples of around 5.
Barry Rosenstein, founder and managing partner of activist hedge fund Jana Partners.
Thus by taking its pipeline assets public, Marathon was able to unlock as much as $3 billion in value, estimated
Oppenheimer analyst Fadel Gheit. Marathon investors liked what they saw, which explained the pop in Marathon’s share price the day of the announcement of the spin-off.
Jana employed the same strategy
(NYSE:MHP), another company in which it has a large stake. In 2011, after education revenue dropped for three successive quarters, Jana proposed that McGraw-Hill be split into four parts. Ultimately, McGraw-Hill decided to spin off its education unit, naming it McGraw-Hill Education, while McGraw-Hill would focus on business information under its new name, McGraw-Hill Financial.
After the spin-off was announced on September 21, 2011, McGraw-Hill saw its stock price rise by close to 40%. The company subsequently decided in November 2012 to sell its education spin-off to Apollo Global Management
(NYSE:APO) for $2.5 billion.
Jana Partners is one of several high-profile hedge funds -- including Jeffrey Smith's Starboard Value, Daniel Loeb's Third Point, and Jeffrey Ubben's ValueAct Capital -- that frequently make the news with activism campaigns against companies that they consider undervalued. David Einhorn’s Greenlight Capital is another notable activist hedge fund, having just sued Apple
(NASDAQ:AAPL) last week in an effort to push the company to make greater use of its hoard of cash.
“Activist investors typically invest in value stocks that trade at a discount to their intrinsic value, but unlike most value investors who hope a catalyst will unlock the value or patiently wait for the market to recognize the value in the stock, the activist investor takes action to address why the market undervalues the intrinsic assets of the company, thereby creating the catalysts that can build and unlock value for all shareholders,” explained Kenneth Traub, CEO of private investment and consulting firm Ethos Management, in a CNBC blog
Carl Icahn, one of the most renowned activist investors in the world.
Of course, these activist investors do not just press companies to unload assets. Depending on the individual situation, they might push for companies to increase their dividend or launch a share buyback program or push for management change, once they acquire at least 5% of a company’s stock. Apple's decision to reinstate its dividend in 2012 had a lot to do with pressure from shareholders, while Chesapeake’s
(NYSE:CHK) board shakeup and the subsequent ousting of CEO Aubrey McClendon could be attributed directly to activism from Carl Icahn, said Emory Redd, managing director at Pittsburgh, Pennsylvania-based private alternative investment firm Schenley Park Advisors.
“Another thing hedge funds can do is press for a company to be sold. Sometimes hedge funds will make a very low-ball bid to acquire a company. Of course, management will reject that bid. However, it will put the company in play [as a potential acquisition target], and other bidders will say: 'Wow, if there’s an offer on the table for X; I'm willing to go higher.' And so the auction process will begin,” Redd explained to Minyanville.
If the key to unlocking shareholder value was something as straightforward as unloading assets, why do companies like Marathon not do it in the first place? Sure, CEO Gary Heminger might have reasoned that “the company’s crude and fuel transportation system provided flexibility and allowed it to buy cheaper oil and boost profit margins,” as noted by Businessweek
, but Redd said that the reason why hedge funds often have to swoop in to compel corporations to take a certain set of actions has a lot to do with the lack of incentives for managers of public companies to maximize shareholder value. “It’s well-documented that a manager gets better benefits running larger enterprises. Managers running larger enterprises get paid better than managers at smaller enterprises. If you are a very confident CEO, as most CEOs are, you believe that you and your team are able to run two divisions better by yourselves as opposed to having two separate companies or two separate management teams,” Redd elaborated.
“There are also benefits in terms of prestige. Would you rather run an integrated oil and gas company or would you rather just run an E&P company? People want to run larger enterprises, and therefore do not want to voluntarily shed assets easily.”
While Chesapeake, Marathon Petroleum, and McGraw-Hill are shining examples of how hedge funds’ activism can be a force of good for ordinary investors, Redd warned that activist hedge funds can get it wrong sometimes.
“There are [funds] out there that are less about value-adding and more about hitting and running. The ones that are hit-and-run I don’t believe add any real value. They just cause confusion and distract from the real mission of a company,” said Redd.
On the whole, however, companies do benefit from the actions of activist hedge funds, especially those that engage in activism frequently, a study by Northeastern University finance professors Nicole Boyson and Robert Mooradian found. In their paper, “The Skill of Frequent Hedge Fund Activists,” the duo studied 269 activist events between 1994 and 2005. Their conclusion was that “targets of high frequency activist hedge funds – those that target ten or more firms between fund inception and 2005 – experience better long-term stock and operating performance than targets of lower frequency activist hedge funds or a matched sample.” Specifically, “targets of high frequency activists significantly outperform both targets of low frequency activists and a matched sample for up to three years post-activism,” they added in the paper, according to Forbes.
What does it take to become a successful activist investor, like the legendary Carl Icahn? Redd said that in the rarified world of hedge funds, size matters.
“A key thing that determines whether an activist investor is successful is the size of the fund versus the size of a target company. A larger fund will have a bigger war chest to purchase a large stake and will have the resources to do the analyses and make recommendations [to a target company]. So I find the best funds are the big ones that take on little companies, as opposed to a medium-sized fund going after a large company, because those are simply not able to acquire a large enough stake to make a difference,” Redd told Minyanville.
“If you look at Carl Icahn, who’s a very successful activist, one of the reasons he was successful in the Chesapeake deal was that he partnered up with the largest Chesapeake shareholder, Southeastern Asset Management [a Memphis, Tennessee-based fund]. Together, they held nearly 24% of Chesapeake, which was very significant, so management had to pay attention. They were able to shake up the board, lose the CEO, and Chesapeake’s share price went from around $14 to $20 in the period Icahn was involved,” he continued.
Icahn, whose shareholder activism in the 1980s gave rise to the term "corporate raider," confirmed the importance of having substantial capital, telling Businessweek last month, “Substantial amounts of money can be made through activism, but you have to have a large amount of long-term committed capital to be successful.”