Hedge Fund Activism: a Blessing or a Curse

Faculty of Economics and Business Bachelor thesis of Finance June 2007 Zornitsa Mihaylova Supervisor: Jenke ter Horst ANR 983989

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Contents

Introduction ...... 3 Problem statement definition ...... 4 I. Brief review on issues of institutional investors ...... 4 II. funds ...... 7 II.I. Set-up ...... 7 II.II. Strategy ...... 8 II.III. Management compensation ...... 9 II.IV. Regulation ...... 9 II.V. Performance and returns ...... 10 III: Shareholder activism ...... 12 VI. Shareholder activism applied to Hedge funds ...... 15 V. Blessing or curse ...... 17 V.I. The blessing ...... 17 V.II. The curses ...... 18 VI. ABN Amro Group ...... 19 VI.I. The case ...... 19 VI.II. Implications ...... 20 VII. Prevention methods ...... 22 VIII. Conclusion ...... 22 XI. Appendices ...... 24 Table 1 ...... 24 Table 2 ...... 25 Table 3 ...... 26 Reference list ...... 27 Additional references for section VI. ABN Amro Group ...... 28

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Introduction

One topic that has lately been all over the news is the drastic actions undertaken by large shareholders in big conglomerate companies like the recent incident with ABN Amro Holding N.V. which became the target of Children’s Fund (TCI). The trouble often arises, as with ABN Amro, from shareholders. The funds unexpectedly come up with demands for restructuring, spin-offs or sell-offs of parts of the business or the whole company. The commotion around ABN Amro started with TCI’s official shareholder letter addressed to Mr. Groenink, the chairman of the managing board and Mr. Martinez, chairman of the supervisory board of the company. The letter includes five resolutions aimed at criticism upon the conglomerate’s “terrible shareholder return”, failure to maximize shareholder value and low profitability. 1 Based on ABN Amro’s article 28.5 2, which refers to the General Board Meeting of Shareholders, investors with holdings of at least 1% can propose discussion items for the upcoming meetings. Due to this argument 3, TCI’s letter could not be ignored, leaving ABN Amro’s executives quite unhappy with the proposal for sell-off of the business. Few decades ago, the pursuit of such extreme measures would have been considered an extraordinary act because it is risky, expensive and requires a majority of shareholder votes in order to be effective. However, what has recently become popular under the term of “shareholder activism” is a favoured move by big institutional investors. In the past, mutual and pension funds engaged into activism. Nowadays, hedge funds have successfully replaced them due to beneficial changes in strategic financial innovation and regulation relieves. What still remains unclear is the actual motivation behind the activists’ actions and the results that follow. The contradictory newspaper headlines about hedge funds saving and ruining companies have left the public confused about the advantageous or disadvantageous overall effects the funds produce.

1 http://ftalphaville.ft.com/blog/2007/02/21/2666/tcis-letter-to-abn-amro/ 2 http://www.abnamro.com/com/ir/data/gsm2005_statuten_en.pdf 3 In the publicly posted letter to ABN Amro, TCI does not mention more details besides the fact that it does hold more than 1% of the shares of the company. 3 | P a g e

Problem statement definition

In this paper I will be discussing the threats and the improvements that shareholder activism proposes to targeted companies. The paper combines results from previous studies about hedge funds and also stresses how they fit into the context of shareholder activism. Since hedge fund activism is a relatively new topic with little research conducted on it, I make a liaison between former findings on activist pension funds and recently developed research on hedge funds. The paper is structured as follows: section I presents some preliminaries on the failure of institutional investors to successfully engage into shareholder activism. Section II covers hedge funds in their essence, talks about their strategies, returns, targeted companies, management compensations and regulation restrictions. Section III looks into shareholder activism reviewing remarks from previous studies which examine activism. Section IV combines relatively new research findings on activism and underlines the differences between shareholder activism exercised by pension funds and hedge funds. Section V presents the benefits and costs to companies targeted by activist hedge fund shareholders. Further, Section VI examines the ABN Amro Holdings N.V. case and its implications as an example to link the theories presented to practice. Section VII proposes methods for preventing attacks by activists. The final Section VIII presents some concluding remarks.

I. Brief review on issues of institutional investors

In the 1990’s institutions collectively held more than 50% of the shares of most large public companies. Simultaneously, large institutional shareholders would have been able to adopt better corporate governance through monitoring management and insisting on wealth-maximization strategies. However, collective actions performed by institutions like mutual funds and pension funds turned out to be more difficult to implement than expected. There are numerous reasons for these institutions to be unwilling or unable to perform monitoring activities. Coffee (1991) points out liquidity, conflict of interest, management apathy and political relations for some of the reasons in the way of institutional investors to exercise 4 | P a g e

activism. Liquidity is mainly an issue for mutual funds since shareholders can withdraw their funds on notice which means it is unacceptable for these institutions to own large blocks of illiquid shares. On the other hand, pension funds are not facing the same problem since their need for liquidity is lower. As Kahan and Rock (2006) state pension funds are also not subject to diversification requirements as mutual funds are which permits them to own a higher number of shares in one companay. The conflict of interest and management apathy are related to reputation and compensations structures, respectively. The involvement in activism is related to proxy contests and bad publicity for the management in charge. Since the labor market for fund managers is extremely competitive and any act of activism might jeopardize their careers, fund managers are reluctant to engage into any type of activism which can harm their reputation. Additionally, when engaging into a proxy fight it is hard to estimate in advance the damage on reputation which the activism will bring. However, for institutional investors like mutual and pension funds, the gains from improved corporate governance after activism could be substantial since they own big blocks of shares in a given company. That means improving the company performance, ensures them higher gains and prevents losses. Yet, as Coffee (1991) confirms that until institutions have the option to exit a certain company by selling off its shares when it is not performing well versus engaging into activism, they will choose the safer bet of exiting. Management apathy is provoked by conflict of interests between management and shareholders. Managers are not given enough incentives to monitor and perform at their best which is further stimulated by shareholders’ failure to track down this behaviour. The manager’s motivation should come from the compensations they receive. However, mutual fund management bears the fund’s administrative costs and receives an annual payment based on a declining percentage of the returns on the fund’s . In other words, management carries the costs and shareholders benefit from any gains, which does not give managers the proper incentives to produce higher returns. The Investment Advisers Act of 1940 restricts both mutual and pension funds from awarding motivation based payments to registered investment advisers e.g. managers. The limitations produced are not as big for mutual funds as they are for pension funds. Mutual fund managers are compensated with a declining percentage of profits but they can still

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earn a significant amount by attracting new capital into the fund. On the other hand, pension funds’ sponsors have the proper stimulus to monitor managers, while the latter are not permitted, as mentioned above, to receive motivation-based compensation. The sponsor who holds the largest defined benefit plan is intersted in the manager providing superior performance, since the former has to contrubute less funds if the manager does well. A study on pension plans by Ruah (2006) states that sponsors of defined benefit plans have a financial obligation equivalent to the present discounted value of payments guaranteed to clients. Determined by, wheather the market value of the pension plans is higher or lower than the dicounted estimante, the defined benefit plans held can be, respectively, overfunded or underfunded. Sponsor firms of underfunded plans are obliged by the Employment Retirement Income Act (ERISA) to deliver payments corresponding to the present value of the unpaid pension benefits plus addititional installment payments on unfunded liabilities. On the contrary, sponsors of overfunded plans do not have to contribute any resources and are entitled to certain exemptions. Thus, sponsors are very well intersted in simulating managers to equate the market value of their holdings to the required level. However, this motivation barely involves more than involvement in proxy contests. In sum, management compensations are calculated by flat formulas which do not give enough incentive to management to get involved in the company performance and diminish the conflict of interest. Political relations are a major problem for pension funds but not for mutual funds which are rather affected by penalties for lower than expected returns. Kahan and Rock (2006) discuss in their research that pension funds are usually governed by union representatives, bureaucrats and politicians which can push for politically affiliated actions than for investor maximization returns. In addition, Pantoy and Thomas (2006) support this statement by adding that labor unions also incur additional agency costs due to pursuing self-intersted agendas. They often demand for changes which are best not for the shareholders but rather for the employees. Other reasons for institutional investors to avoid shareholder activism are pointed out by Pantnoy and Thomas (2006). Among these are surpressed earnings, extensive expenses for activism and additional agency costs.

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Activism is executed most often through proxy fights which can be quite time- and money-consuming. The extensive costs for monitoring activities are solely bared by the activist party with no guarantee for compensation, particularly if the contest turns out to be unsuccessful. Further, this is proved to surpress the earnings of the activist institution while at the same time other shareholders also profit from the monitoring activities performed. Mutual and pension funds conflicts of interest, liquidity, management apathy problems and political constraints make them reluctant to implement shareholder activism either due to reputation, government restrictions or compensations. The easiness of selling off the shares of a troubled company is the preferred way of dealing with the problems of future losses.

II. Hedge funds

II.I. Set-up Hedge funds emerged in the 1950s as the new market players which could hold both long and short positions while creating a exposure. Soon thereafter hedge funds were discovered to be able to fill in the gap of market inefficiency, a function that institutional funds, like mutual funds and pension funds, did not manage to exercise as discussed in section I. In few words hedge funds can be described as loosely regulated, organized investment vehicles that allow private investors to pool assets which are to be administered by professional fund managers. 4 Since they are not open to the general public, hedge funds attract only “accredited” and “qualified” investors. The required amounts to be contributed by investors can vary across hedge funds. Klein and Zur (2006) set an annual income over $200 000 or net worth over $1 million and at least $5 million worth in investment as representative figures. Hedge funds are set up as limited partnerships (LP) or limited liability companies (LLC) which allows them to be extremely flexible in their investment strategies. As opposed to pension and mutual funds, they engage into dynamic trading strategies. Hedge funds are allowed to take long and short positions in their holdings which the other

4 Bodie, Kane and Marcus (2007), Essentials of investment 7 | P a g e

institutions are restricted from by law. Hedge funds are also able to use instruments like derivatives, leverage and highly concentrated investment positions.

II.II. Strategy Goetzmann and Ross (2000) view hedge funds as profiting from management skill and producing positive returns while minimizing the systematic risk exposure. The research argues that hedge funds manage to implement their strategies by taking long positions in securities that are perceived as underpriced while taking short positions in securities with similar risk characteristics that are overpriced. The spread between the two securities is known as . Invested in this way portfolios of hedge funds remain unresponsive to swings in the market e.g. market neutral. Besides this approach hedge funds have developed others which all have different risk characteristics. Management Account Report (MAR) classifies hedge funds into seven categories according to their investment styles which are summarized in Table 1. These include event driven, global, , market neutral, short sales, U.S. opportunistic and funds of funds. The produced returns are due to recognizing opportunities namely mispriced securities. Furthermore, hedge fund tactic plans diverge from those of traditional investment vehicles. Fung and Hsieh (1997) prove this by empirically showing significant differences between hedge fund and mutual fund strategies. This research supports Edwards’s (1999) findings which state that hedge fund returns display relatively low correlations to traditional assets classes like and bonds. Thus, the returns of hedge funds are less sensitive to broad market movements and accordingly have a lower in comparison to the market beta.5 These results are also provided by Ackermann, McEnally, Ravenscraft (1999). Due to the risky strategies pursued, hedge funds require investors to keep their assets without the option of withdrawal for periods ranging from one quarter to several years. These periods are called “lockups” and give managers the opportunity to invest in illiquid assets without being troubled with meeting the demands of investors for redemption of funds.

5 Beta measures the sensitivity of a financial instrument or a portfolio to broad market movements. The formula for beta is covariance of the portfolio(or instrument) return and the market return divided by the variance (volatility) of the market return 8 | P a g e

II.III. Management compensation As mentioned earlier, hedge funds are run by professional fund managers who are assumed exceptionally knowledgeable and skillful in their job. Liang (1998), Goetzmann and Ross (2000), Partnoy and Thomas (2006) have all found significant empirical evidence for positive alpha returns, which suggests that managers in fact are able to recognize arbitrage opportunities. Based on management’s sophistication, quickness and acquaintance with the markets, hedge funds provide higher value to their shareholder. As a result, the payments managers receive correspond to their abilities to yield abnormal returns in comparison to vehicles like mutual funds and pension funds (See II.V.). The hedge funds’ management compensation structure takes into account strong performance incentives. Roughly estimated by Edwards (1999), the funds charge an administrative fee of 1-1.5% of assets under management per year and a management incentive fee ranging from 15% to 25% of net new profits. However, bonus fees are paid only after the returns surpass some hurdle rate – “high-water mark”. The high-water marks limit managers from receiving payment until the fund recovers from any losses incurred in the past .

II.IV. Regulation Unlike mutual funds and pension funds, hedge funds are barely regulated. They are free to take positions focused in one firm, sector or industry. In addition, as mentioned before they are not restricted from pursuing speculative strategies like executing short sales and building up leverage. Regulators have developed these restrictions for traditional institutions, in order to protect investors from unforeseen losses. On the other hand, that is the reason why hedge funds are private investment funds where investors are carefully selected to be wealthy, sophisticated institutions or individuals. Thus, such parties enter the funds at their own risk and are knowledgeable enough to look after their own interests. Furthermore hedge funds are exempt, under certain requirements, from a number of clauses of regulatory vehicles, for example in the US they are not influenced by the Investment Company Act of 1940, the Securities Act of 1933 and 1934 Securities Exchange Act. These regulations concern pension funds and mutual funds by restricting them from a number of activities. Even more merits are offered by offshore hedge funds which are based on places like the British Virgin Islands, Bermuda, Bahamas, Luxembourg, etc. These exotic

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locations offer extensive tax advantages and unregulated grounds for hedge funds to prosper freely.

II.V. Performance and returns Due to all the advantages mentioned above, hedge funds are considered a lucrative investment means because their high returns are based on exploiting price inefficiencies, superior management skills or simply because the large risks undertaken pay off. Previous research conducted by Ackermann, McEnally and Ravenscraft (1999) shows hedge funds significantly outperform other institutional investors like mutual funds but are not consistently able to beat the market based on absolute or total-adjusted returns. They suggest that on average hedge funds are able to earn superior gross returns in comparison to the market, which are best explained by the incentive and administrative fees. The same study also argues that hedge funds’ capabilities to beat the market are reliant on the time period, the benchmark index and the hedge fund style. In another research on offshore hedge fund Brown, Goetzmann and Ibbotson (1999) conclude that as a group offshore hedge funds display positive risk-adjusted returns based on Sharpe rations and Jensen’s alphas. The paper also discloses that on average hedge funds maintain positive exposure to the market and do act as market neutral players. Additionally, they find significant evidence for management skill being dependent on the style of hedge fund strategy implemented. Another researcher Liang (1998) finds that on overall hedge funds outperform mutual funds with lower market risk, higher Sharpe ratios and abnormal returns. The same paper empirically shows that hedge funds exhibit low systematic risk and that they have outperformed the S&P500 on a 7-year period (1990- 1996). For the graphed results, refer to Figure 1 and 2. According to the research, eleven out of sixteen groups of hedge fund styles exhibit abnormal returns. In general, there is significant evidence for hedge funds outperforming other investment vehicles and the market. However, shortcomings of these studies are related to the difficulty of accessing reliable hedge fund databases and constructing evaluation models. Some further problems, discussed by Ackermann, McEnally, Ravenscraft (1999) like back-fill, survival and liquidation bias, have made it hard for researchers to predict correctly hedge funds returns and performance.

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Figure 1: Cummulative monthly returns : Hedge funds versus S&P 500(1990:01-1996:12) . The returns are plotted on the vertical axis while the time (in months) is ploted on the horizontal one. The figure shows that hedge funds (pink line) outperform the S&P 500 (blue line). Source: Liang B. (1998), On the Performance of Hedge Funds

Figure 2: The efficiency frontiers: Hedge funds versus Mutual funds. The vertical axis plots monthly returs and the horizontal one – monthly standard deviations. It is evident that hedge funds (blue curve) can achieve higher returns than mutual funds (pink curve) for the same amount of risk exposure. Source: Liang B. (1998), On the Performance of Hedge Funds

So far hedge funds suggest to be “the perfect” investment opportunity for wealthy investors because of all the mentioned benefits they offer. Unfortunately, there is no free lunch and even though investors pay a high price for superior returns there is one catch that has been discussed by analysts as the big issue of hedge funds. They are criticized for the generally short-term focus of their . Since hedge funds mostly base their

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strategies on speculative positions (e.g. shorting, leverage, derivatives) and they try to profit from price discrepancies, analysts argue that they do not bring any added value in the long- run. I will cover this problem of short-termism in more detail in section VI.

III: Shareholder activism

Smith (1996) claims that shareholder activism was registered for the first time by Responsibility Research Center reports when public pension funds sponsored 463 proxy proposals seeking changes in corporations’ governance. Due the specific pension fund strategies and the fact that they often hold a relatively big block of shares (more than 5%), selling out all their holdings when companies are underperforming will trigger instant price reduction. Often the concentration of ownership of one fund in a company can be too large. In this case the fund’s assets in that company become illiquid because when the firm is underperforming, the fund must be willing to bear a large price drop. Since indexing gives an opportunity to pension funds to earn the market return, they prefer to index large portions of their portfolios. Here indexing is defined as a passive investment strategy in which investors hold a portfolio of assets, adjusted by weight to match the performance of a certain indexing. This strategy prohibits many public pension funds from selling underperformers because of their large concentrated investments. Chan and Lakonishok (1995) present the main reason for this phenomenon. Prices change around block transactions especially if there are no perfect substitutes for a given stock. In this case, the seller faces a downward- sloping demand curve and has to sell his shares at discount in order to attract buyers. Due to pension funds’ large holdings, when they want to exit e.g. sell the shares they own, it rarely happens in a one-day trade. Finalizing the transaction is more likely to take a few days. However, during that time the stock price continues to fluctuate and reflects the new information. The same researchers showed that the corresponding price change from the first day of the transaction to the closing day is -0.35% for packages 6 and -0.04% for individual transactions. Thus, when exiting pension funds bear a loss depending on the number of shares, owned in a certain company but since they often own more than 5%, the costs are extensive. In this case pension funds can either accept the facts of losing money or

6 In this context ‘package’ is defined as a sequance of trades which are all together regarded as one basic unit for conducting analysis. Chan and Lakonishok (1995) 12 | P a g e

engage into activism to oppose corporate governance. Consequently, the fact that selling off underperformers might spur large losses and that indexing prohibits such sales in the first place proves to be an important reason for public pension funds to perform shareholder activism and protect their investments. Fama and Jensen (1993) argue that in general, the threat of provides a vigorous incentive for management teams to perform well but in an ineffective capital market, which was the case in the 1990’s, Jensen (1993) observed that large shareholders had additional motivation to actively participate in the company’s strategic decisions. The main reason for institutional investors like mutual funds and pension funds to avoid or not practice shareholder activism at all is the cost incurred. Activism is exercised through intensive monitoring and proxy contests, which both are time-consuming and very costly. Bebchuk (2005) has discussed that proxy contest costs are related to mailing and administering proxy cards, legal and fees, registering the proxy statement for completeness and accuracy with the and Exchange Commition (SEC), convincing shareholders in the actions to be undertaken and travelling costs. These costs could sum up to the enormous amount of more than $ 4.5 million as with the case of Six Flags amusement parks observed by Bebchuk (2005). In addition, the process faces the problem of free-riding because one investor sponsors the control activity while the others share the benefits. Klein and Zur (2006) find the stem of the free-riding problem is committing to an action the costs of which will overcome the benefits. In a large company where shareholder activism is exercised often only one large shareholder incurs the costs of monitoring activities while the other shareholders do not contribute significant amount of resources. The latter do share the benefits of aligning management incentives with the shareholder interests but avoid the costly procedures. Nevertheless, the investor who owns the largest stake has the strongest incentive to carry out the monitoring activities. It is in his best interest to align management activities with shareholders’ interest since that investor is likely to benefit or lose the most. Large investors are also the ones who are able to cover the extensive activism costs through achieving abnormal returns. Even though it is expensive to pursue such a strategy, investors evaluate well the alternatives and when it is cost-effective, they do engage into activism. Evidence from Smith (1996) shows that the companies targeted when shareholder activism was first

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initiated were large poor performing companies with a high level of institutional ownership. Moreover, Bethel, Liebeskind and Opler (1998) discuss that a significant reason for large companies to underperform in the 1980s was the excessive level of business diversification caused by inefficient allocation of resources. Another reason for that was that diversification might have been undertaken to protect managerial rather than shareholder wealth. By diversifying into unrelated business lines, management enlarges the business and compensation it receives while simulating value creation. The results from these studies argue that shareholder activism targets are over- diversified, large conglomerates, which underperform the market benchmark. If targeted properly these victims of shareholder activism can be turned into fully- functional profitable companies. Smith (1996) empirically studies shareholder activism with evidence form CalPERS pension funds and observes that when effective, it increases shareholder wealth. He indicates that the effect of activism is fairly successful in adopting performance related, governance structure changes and that the alteration in organizational structure of the targeted company can be unfavorable to its shareholders. The damaging effect of inept activism might mount up to large sums, mainly due to management’s resistance to take on the proposed changes. The study shows that on overall, targets do not underperform. On the contrary, successful targets slightly outperform unsuccessful targets, where successful targets are considered as the companies, which adopt the proposed governance and strategy changes after activism, and unsuccessful targets are the ones that do not adopt them. Figure 3 below examines wealth effect of activism compared to estimate dollar value changes in activist holdings. It shows cumulative abnormal (market-adjusted returns) for all targets and samples of successful and unsuccessful targets. Even though Smith (1996) did not find any significant relationship between activism and stock price, the fact that on average targeted companies in which activism has been adequately implemented outperform unsuccessful companies implies that shareholder activism might be a useful tool in preventing poor stock performance.

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Figure 3: Posstrageting stock price performance of firms targeted by CalPERS 1987-93. Cumulative abnormal returns for 51 firms targeted by CalPERS over the 1987-93 period and for subsamples of firms that either adopt CalPERS’s shareholder proposals or make changes sufficient to a settlement (‘successful targets’, 27 firms) and firms that do not adopt or setlle (‘unsuccessful targets’, 24 firms). Cumilative abnormal returns are compounded daily market adjucted returns using Center for Research in Security Prices (CRSP) value-weighted index. Returns are calculated over the three-year period beginning the calender year of targeting. Source: Smith M. (1996), Shareholder Activism by Institutional Investors: Evidence from CalPERS

VI. Shareholder activism applied to Hedge funds

So far, I discussed shareholder activism in principle, focusing on active pension funds. In this section, the emphasis falls on a few particularities of hedge funds activism. One significant difference between hedge funds and pension funds is the targeted companies. While Smith (1996) shows that pension funds target poor performing companies, Klein and Zur (2006) argue that hedge funds seek out rich in cash, profitable firms with short-term investments and low debt capacity. Their strategy after gaining certain control over the governance of the company is to increase the debt load, reduce the cash on hand and pay out increased dividends to build up shareholder’s value. It is worth mentioning that hedge funds hold stakes of the company, which means that an increase in shareholder value brings higher returns to the hedge fund as well.

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Brav, Jiang, Partnoy and Thomas (2006) have categorized hedge fund activism by the approach pursued regarding target companies and the goals established after it has been performed. They form seven different approaches, which can be found in Table 2 with the corresponding frequency percentage outcomes from the study. These actions are undertaken in order to achieve one or more of the following results: improving company efficiency and maximizing shareholder value, changing and business strategies, selling off the target, improving governance issues and providing finance. Table 3 summarizes the results of the study. The type of strategy the hedge fund uses also determines the characteristics of the targeted companies. The latter most often are undervalued entities with too much cash on hand, continuous underperformance, assets available for monetization or companies with capital-intensive investment plans. Kahan and Rock (2006) argue that companies with such characteristics are most likely to be pressured to, respectively, repurchase their own stock or issue dividends, sell off the company or change management, monetize current assets and oppose capital-intensive plans. Even though, hedge funds have developed these strategies as an alternative to traditional investment vehicles, practitioners argue that the funds all have a short-term focus, which is regarded as speculative. However, these strategies can only be implemented, if the traditional shareholders of the targeted company approve them. Since these stakeholders most often are large institutions, which invest for the long-term, they might find hedge fund propositions quite unattractive. In the end, it all boils down to how well hedge fund representatives can persuade other shareholders that pursuing the proposed moves is more beneficial than not pursuing them. The vehicles used most often by hedge funds to reach their goals are proxy solicitations also known as proxy fights and proxy contests. As mentioned before, proxy solicitations are very time consuming and costly which makes them quite difficult for general shareholders to engage into. However, hedge funds have available for use the assets of their wealthy investment parties, which implies that capital is not an issue. Similarly, the free-riding problem, which institutional investors face when being active, can easily be alleviated. Through a hedge fund perspective, the free-riding issue is downgraded because the funds are able to use a significant amount of funds, which are available from “accredited” and “qualified” investors, mentioned in Section I.

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V. Blessing or curse

V.I. The blessing Even though hedge funds activism has become a new controversial subject, it has been proven in practice that there are gains to be achieved by exercising it. If implemented in the appropriate way hedge fund activism can stimulate wealth maximization, shareholder value, company performance and leave all, investors, managers and shareholders better-off. In order to tackle shareholder wealth and company value maximization, hedge funds activists have been observed to successfully alter strategic and governance policies through reductions or redirections of investments, sell-offs of inefficient assets and equipment while making the firm more efficient. As discussed in section III appropriate activism is most successful in aligning management incentives with shareholder interests. Furthermore, Klein and Zur (2006) state that decreasing excess holdings in cash through increased dividends, more leverage and shareholder buybacks is implemented to attack the agency problem. Management no longer holds excess cash on hand which prevents it from engaging into undesirable activities like personal purchases, costly acquisition and firm-size increases. The latter two are often used by managers to simulate shareholder value creation. Stakeholders are not fooled easily but when that happens the consequences might be futile for the company while managers can exit wealthier. Hedge funds also prevent consummation of transactions which are perceived as value destroying because they are assumed to undermine shareholder wealth and not yield expected return. 7 Furthermore, as mentioned in section III, evidence from Smith (1996) suggests that activism can hamper poor stock performance in successfully targeted companies which leads to gains for both shareholders and the firm. This has not been particularly proved for hedge funds but since the activism performed by both institutions pension and hedge funds is most significant regarding changing corporate governance, it can be inferred that the same effect will be observed with hedge funds as with pension funds.

7 Value-destruction was given as a reason by TCI hedge funds when in 2005 when it opposed the acqisition of London Stock Exchange by Deutsche Bourse. http://www.bloomberg.com/apps/news?pid=10000102&sid=azePgLzAHUrQ&refer=uk http://businessweek.com/magazine/content/05_21/b3934161_mz035.htm 17 | P a g e

By implementing corporate control and therefore improving company performance both hedge funds activists and shareholders share the benefits from strategic changes .

V.II. The curses The dark side of hedge fund activism is related to self-interest actions which, as opposed to the said above, destroy company value and harm shareholder wealth. Kahan and Rock (2006) propose a controversial theory to explain the reasons behind that. They argue that hedge funds buy shares in a firm in order to engage into activism in the future. As opposed to mutual and pension fund activism which is ex-post, hedge funds’ activism is ex-ante. These funds estimate the benefits of targeting a certain company and then become shareholders in it. The same authors also reason that hedge funds’ configuration and strategies are designed for their investors to benefit from. In other words, hedge funds take positions into companies as a means of providing absolute gains to their investors while disregarding fellow shareholders. Hedge funds engage into complicated hedging strategies and price arbitrage to please their investors but these strategies involve speculation trades for example shorting, which is basically betting on a company to underperform. In this case, hedge funds expect the company’s stock to fall which is the opposite of what the firm’s shareholders want. Even some of the benefits mentioned earlier can be a two-edged sword. Paying out dividends and taking in debt are discussed as effective strategies in aligning management incentives with shareholder interests. On the other hand, through these actions hedge funds can also milk the cash out of companies and return them to shareholders. In this situation shareholders might be better off but the company can suffer severe losses since it is highly leveraged and unstable. As mentioned earlier, hedge funds also hold stakes in the victim-company and by increasing shareholder value they ensure higher returns for themselves. Thus, the value-maximization actions could be entirely motivated by self- interest. Kahan and Rock (2006) discuss another severe disadvantage of hedge funds activism, which is related to their focus on short-term gains at the costs of long-term profitability. Due to the adoption of speculative strategies and exploitation of price inefficiencies, professionals have characterized them as investment vehicles ripping out momentum profits. Yet, short-termism has not been empirically proved. In general, large shareholders are risk-averse and long-term focused, that is they prefer passive buy-and-hold 18 | P a g e

strategies to activism. As follows, arbitrage strategies aiming at short-term gains and sacrificing long-term losses are not appealing to the shareholder. In addition, Brav, Jang, Partnoy and Thomas (2006) argue that hedge funds often do not hold controlling shares in companies, their positions are limited to 5-10% and give them only enough power to propose changes but not to exercise control over target firms. Therefore as discussed earlier, large shareholders have the last voice to decide whether short-term speculative strategies are to be implemented.

VI. ABN Amro Group

VI.I. The case Coming back to the ABN Amro Holding N.V. example I am going to discuss the situation that the company is into and how it fits with the theory discussed until know. Referring to the introductory case, ABN Amro, a Dutch banking conglomerate was challenged by one of its shareholders, namely the TCI hedge fund on base of underperformance and shareholder dissatisfaction. The amendments of the bank allow shareholders with holdings of at least 1% of the economic values of the company’s capital to propose discussion subjects for the General Board Meeting. That gives TCI enough power to engage into activism. As mentioned before hedge funds often engage into activism, in order to achieve more than one desired outcome. Following Table 3, TCI wants to achieve shareholder value maximization, capital structure and business strategy alterations, due to diminishing returns and finally indirect changes in governance issues. The hedge fund engages into Type 3 activism according to Table 2, namely it addresses a formal shareholder proposal with demands for changes. The hedge fund has already taken an equity position in the company which is only big enough to propose subjects for discussion on the General shareholder meeting. In order to achieve the above mentioned goals, it is pushing ABN Amro to pay substantial dividends, take on more leverage, repurchase shares, and even sell parts of the company or the whole entity. The rumours about a takeover attempt came out on March 19, 2007 and the letter with demands from TCI was published a couple of days later on numerous financial papers’ websites and blogs. The same day ABN Amro’s stock price went up by 14% (from €36.24 to

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€41.36) which correctly reflects investors’ optimism about the success of the activist strategy. As stated in section II and shown by Figure 3, successful targets outperform unsuccessful targets. To satisfy TCI’s demands ABN Amro published a press release proposing the following changes: divesting ABN Amro Mortgage Group, promising to increase dividends, announces €1 billion share-buyback programme and confirming the merger plans with Barclays 8. This supports the theory presented earlier that hedge funds demand disinvestment of inefficient or underperforming assets and dividend changes. In the consequent weeks TCI also implemented type 4 activism from Table 2 that is threatening the bank with a lawsuit. This was a consequence of Barclays’s price proposal of €64.6 billion (€34 per share) when ABN Amro’s book-market value was estimates at €80 billion. Thus, TCI also implemented strategy 3 of Table 3 – negotiating for a better price for the target of acquisition. The follow-up resulted in ABN Amro being forced to introduce its financial details to other bidders namely, the consortium Fortis, Royal Bank of Scotland and Santander, which offered € 72.27 billion for the bank. The decisive moment came after the General shareholder meeting was held and after 4 out of the 5 9 proposed changes were approved. Even though, ABN Amro’s executives had requested the rejection of the sell-off proposal, it was overruled by an approval vote of 67.9%. Instead of accepting, the € 72.27 billion bid, ABN Amro tried to fight with a poison pill strategy when it sold its American daughter company LaSalle to . However, the bank engaged into the sale without consulting shareholders, which lead to problems with the Dutch Enterprise Chamber. Moreover, ABN Amro also rejected Royal Bank of Scotland’s bid solely for LaSalle. During that time, TCI also tried to achieve Type 5 goal from Table 2 – governance issue targeting by trying to oust the chairman of the managing board, Mr. Groenink. The trial was unsuccessful but only for the moment.

VI.II. Implications According to what has been happening to ABN Amro, the theories presented in this paper prove to be right. TCI’s attack serves as a suitable example to show the convergence of theory and practice.

8 http://www.barclays.co.uk/ 9 http://www.abnamro.com/pressroom/releases/2007/2007-04-26-en-a.jsp 20 | P a g e

The changes which the hedge fund pushed for, at first seemed as a blessing for the company and especially for shareholders. The stock went up 14% for one day and in a one month period managed to achieve an all-time high for the last 10 years. The stock performance of ABN Amro is presented in Figure 4.

Fugure 4: The stock performance of ABN Amro (12:1996-05:2007). The arrow points out the jump of 14% the day after the hedge fund’s complaint letter was registered. Source: www.finance.google.com/finance?q=ABN

The payment of extra dividend and the disposal of ineffective assets made both investors and the market better-off. TCI seemed to be bringing focus to the company’s business and strategies while maximizing value and efficiency. On the other hand, TCI pushes for sell-off of the company and shareholders agree with its proposals. The sale of the company will cost thousands of jobs and a disruption among customers. As already mentioned in section V.I. hedge funds have their own agenda and as long as they keep their investors happy they are not concerned with the consequences of their moves. Being a shareholder itself, TCI has an advantage of assuring a better acquisition deal even by threatening with lawsuit. However, section IV.I. has also concluded that the final decision remains in the hands of shareholders since hedge funds do not own a controlling share of the company but rather try to persuade major holders to approve the changes proposed. In the case of ABN Amro, the company’s poor past performance and evidently unsatisfied shareholders are reasons for the confirmation of the sale.

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VII. Prevention methods As showed in the ABN Amro case it is difficult to resist hedge fund activism ex-post since the attackers have already recognized the weaknesses of the company and are willing to expose them to shareholders as a means of conducting changes. On the other hand, after thoroughly investigating the strategies of hedge fund activists and their targets, companies would be able to make comparative analysis to check if they fit the profile of an activist target. Kahan and Rock (2006) have discussed some ex-ante prevention actions which can be taken against hedge fund activism. The recommendations propose routine briefings on the board of directors; constant communication with large institutional investors; reassessment of dividend plans; detailed information for the reasoning behind any downturns in company performance; inspections of core company strategies with the board. The paper also points out that open communication in advance to significant shareholders is crucial for conducting an accurate and clear message. In cases where misunderstandings occur stakeholders are more easily persuaded to vote for adopting changes proposed by activists. One more remedy that the authors propose for companies in distress is . This investment vehicle has similar characteristics and strategies to hedge funds but practitioners perceive it as having a long-term focus as opposed to hedge funds short- termism. However, this suggestion is ambiguous because in recent years practitioners have also argued that there has been a convergence between hedge funds and private equity due to the fact that at present more hedge funds have increased their lockup periods and have adopted a long-term perspective. Kahan and Rock (2006) also support that notion by arguing that even though hedge funds have created the problem of short-termism, they might be able to solve it themselves by continuously evolving.

VIII. Conclusion In this paper I have combined the results of different academic studies on shareholder activism applied to hedge funds. I have introduced the stem of the problem and elaborated on why institutional investors in the past were not able to successfully engage into activism. Shareholder activism was discussed in the context of pension funds since there is more research conducted on traditional investors than on hedge funds. I have also 22 | P a g e

introduced hedge funds as a high-returns alternative investment vehicle which differs from mutual and pension funds by trading strategies, regulation restrictions, management compensation structure and returns. Further, the paper has made links between the pension fund activism and relatively new research findings on hedge funds activism. Evidently, numerous studies argue that hedge funds conduct a different type of activism which has not been familiar until now. They target different companies than pension funds and have a set of strategies to implement in order to achieve the desired final goals. Hedge funds have proved that they can bring efficiency and value maximization to the company while guaranteeing higher returns for the shareholders. There is significant evidence that they manage to align management and shareholder interests, prevent stock drops and bring back the focus in the company. On the other hand, they have also been observed to be self-interested and act in a way which is beneficial solely for their investors while the targeted company’s shareholders and the entity itself might be left to suffer losses. However, I have also noted that hedge funds often do not own a controlling share in their targets, thus the final vote still depends on large stakeholders. The paper has also discussed the current issue of the Dutch conglomerate ABN Amro Holding N.V. which has been under a hedge fund attack. The proceeds of the case evidently mirror the results from the findings which were discussed. In the end, I have argued that it is difficult to fight activism once it has occurred while some researchers propose methods for prevention of activism, like providing on time accurate information to shareholders and explaining thoroughly downturns in the company. Thus, it is still doubtful if hedge fund activism brings more benefits or losses to targeted companies. That can depend on the overall performance of the company, the willingness of management and shareholders to approve the proposed changes and the intentions of the hedge fund.

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XI. Appendices

Table 1 : Definitions of Managed Account Reports (MAR) categories. MAR definitions of hedge fund types and subtypes are listed below. The MAR database classifies funds at the type of level. Category Sub -category Description Event Driven Manager focu ses on securities of companies in reorganization and bankruptcy, ranging from senior secured debt to common stock of the company Manager simultaneously buys stock in a company being acquired and sells stock in the acquirer Global Interna tional Manager pays attention to economic change around the world but more bottom -up orientated in that mangers tend to be stock-pickers in markets they like. Uses index derivatives to a much lesser extent than macro managers Emerging Manager invests in less mature financial markets of the world, e.g. Honk Kong, Singapore, Pakistan, India. Because shorting in not permitted in many emerging markets, managers must go to cash or other markets when valuations make being long unattractive Regional Manager fo cuses on specific regions of the worlds, e.g. Latin America, Asia, Europe Global Macro Opportunistic trading manager that profits from changes in the global economies typically based on major interest rate shifts. Uses leverage and derivatives Market Ne utral Long/short stocks Half long/half short. Manager attempts to lock -out or neutralize market risks. In theory, market risk is greatly reduced but it is very difficult to make a profit on a large diversification portfolio so stock picking is critical. Manager goes long convertible securities and short the underlying equities Stock index arbitrage Manager buys a basket of stocks and sells short stock index futures, or the reverse Fixed income arbitrage Manager buys T -bonds and s ells short T -bonds that replicate the purchases in terms of rate and maturity Short Sales Manager takes a position that stock prices will go down. Used as a hedge for long -only portfolios and by those who feel market is approaching a bearish trend U.S. Opportunistic Value Manager focuses on assets, cash flow, book value, out -of -favour stocks. Growth Manager invests in growth stocks; revenues, earnings and growth potential are key Short term Manager holds positions for a short time frame Funds o f Funds Capital is allocated among a number of hedge funds, providing investors with access to managers they might not be able to discover or evaluate on their own. Usually has a lower minimum than a hedge fund Source : Ackermann C., McEnally R., Ravenscraft D. (1999), The Performance of Hedge Funds: Risk, Return and Incentives

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Table 2 : The types of activism approaches and the results from the study on how frequently each approach is implemented

Percentage of Type Description implementation in sample The hedge fund states that it intends to communicate with the Category 1 board/management on a regular basis with the goal of enhancing 51.9% shareholder value The hedge fund seeks board representation without a proxy Category 2 contest or confrontation with the existing management/board 16.6% The hedge fund makes formal shareholder proposals, or publicly Category 3 criticizes the company and demands change 26.6% The hedge fund threatens to wage a proxy fight in order to gain board 7.5% Category 4 representation, or to sue the company for breach of duty, etc. The hedge fund launches a proxy contest in order to replace the Category 5 board 16.0% The hedge fund sues the company Category 6 7.5% The hedge fund intends to take full control of the company, e.g., Category 7 with a takeover bid 5.9% Source : Brav, Jiang, Partnoy and Thomas (2006), Hedge Fund Activism, Corporate Governance and Firm Performance

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Table 3 : Summary of activist events by stated goal of the hedge funds in the study

Type Description % Successful % Partially Successful 10 1. General statement of undervaluation/maximize shareholder value/inefficient management -- -- 2. Capital Structure Excess Cash, under-leverage, more dividends, more repurchases 28.57% 7.14% Equity issuance; restructure debt 30.43% 13.04% 3. Business Strategy Investment: lack of business focus/excess diversification/business restructuring including spinning 28.57% 9.52% off M&A: as target 43.33% 23.33% M&A: as acquirer 35.71% 7.14% Tax: tax efficient transaction 25.00% 0.00% 4. Sale of the Target Company Sell company or main assets to a third party 26.19% 11.90% Take control/ company and/or take it private 35.71% 17.86% 5. Governance Rescind takeover defenses 22.22% 11.11% Oust CEO, chairman 60.00% 5.00% Board independence and Fair Representation 27.27% 6.06% More information disclosure/potential fraud 53.85% 7.69% Excess executive compensation/pay for performance 19.05% 19.05% 6. Financing/ Turnaround Provide financing for business growth 60.00% 4.00% Bankruptcy reorganization 81.82% 0.00% Source : Brav, Jiang, Partnoy and Thomas (2006), Hedge Fund Activism, Corporate Governance and Firm Performance

10 Successful’ are the cases in which the company reached the hedge fun’s original goal. ‘Partially successful’ are the one that some settlement was made through negotiations. The remaining events (not shown) are either classified as a “failure” or “ongoing.”

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Reference list

Ackermann C., McEnally R., Ravenscraft D. (1999), The Performance of Hedge Funds: Return, Risk, and Incentives , The Journal of Finance, Vol.LIV, No. 3 Bodie, Kane and Marcus (2007), Essentials of investment, McGraw-Hill, 102-103 Bebchuk L. (2006), The Myth of shareholder franchise, Harvard Law School, Discussion Paper No.567 Bethel, Liebeskind, Opler (1998) Block Share Purchases and Corporate Performance, The Journal of Finance , vol. LIII, No. 2 Brav A., Jiang W., Partnoy F., Thomas R. (2006), Hedge Funds Activism, Corporate Governance, and Firm Performance, Finance Working Paper No. 139, ECGI Working Paper Series in Finance Brown S., Goetzmann W., Ibbotson R.(1999), Offshore Hedge Funds: Survival and Performance, The Journal of Business, Vol. 72, No. 1 Chan L., Lakonishok J. (1995), The Behavior of Stock Prices Around Institutional Trades, The Journal of Finance , Vol. 50, No.4, pp. 1147-1174 Edwards F. (1999), Hedge Funds and the Collapse of Long-Term Capital Management, The Journal of Economic Perspectives , Vol. 13, No. 2. pp. 189-210. Fung W., Hsieh A.D. (1997), Empirical Characteristics of Dynamic Trading Strategies: The Case of Hedge funds, The Review of Financial Studies , Vol. 10, No. 2, pp. 275-302 Gillan S., Starks L. (2000), Corporate governance proposals and shareholder activism: the role of institutional investors, Journal of Financial Economics , 275-305 Goetzmann W., Ross S. (2000), Hedge Funds: The Theory and Performance, Yale University, Massachusetts Institute of Technology Klein A., Zur E. (2006), Hedge funds activism, Working paper, Stern School of Business, New York University Kahan M., Rock E. (2006), Hedge Funds in Corporate Governance and Corporate Control, Working paper, New York University School of Law and Economics Liang B. (1998), On the Performance of Hedge Funds, University of Massachusetts at Amherst

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Partnoy F., Thomas R. (2006), Gap Filling, Hedge Funds, And Financial Innovation, Working paper No. 06-21, Vanderbilt University Law School Rauh J.D. (2006), Investment and Financing Constraints: Evidence from the Funding of Corporate Pension Plans, The Journal of Finance, Vol. LXI, No. 1, pp. 33-71 Smith M. (1996), Shareholder Activism by Institutional Investors: Evidence from CalPERS, The Journal of Finance , Vol. 51, No. 1., pp. 227-252.

Additional references for section VI. ABN Amro Group http://www.abnamro.com/pressroom/pressroom.jsp http://finance.google.com/finance?q=ABN http://finance.yahoo.com/q/h?s=ABN http://stocks.us.reuters.com/stocks/keyDevelopments.asp?symbol=ABN&WTmodLOC=L2- LeftNav-12-KeyDevelopments

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