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How Activist Hedge Funds Unlock Value for Shareholders

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Activist-targeted companies often perform well at the stock market. But why do these companies often need the prodding of hedge funds to do what's good for them?

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"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."

Twitter: @sterlingwong

No positions in stocks mentioned.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

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