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THE CASE FOR ACTIVIST STRATEGIES

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Ramius White Paper


December 2008
THE CASE FOR ACTIVIST STRATEGIES

Over the past decade, the hedge fund business has evolved from a cottage investment
industry to an institutionalized alternative asset class controlling approximately $1.0 trillion to
$1.2 trillion in assets. Corporate and public pension funds, university endowments, family
offices and insurance companies have allocated meaningful percentages of their portfolios to
hedge funds in search of diversified, risk-adjusted returns.

While these trends lend credence to the industry as a whole, asset growth has arguably
outpaced the analysis and understanding of the hedge fund investment strategies that
investors have been required to evaluate. The recent unprecedented dislocation in global
financial markets has compelled investors to re-evaluate the merits of these strategies. In the
face of broad deleveraging, market illiquidity, and government intervention, it is critical that
investors recognize the fundamental value proposition of these strategies in order to make
the most prudent investment decisions going forward.

Activism, the investment approach of initiating company change to unlock value, is a strategy
that is widely discussed yet characterized by misconceptions and incomplete understanding.
Some critics and regulators question whether the work of activist investors actually benefit
and create value for shareholders, and others debate the long term viability of the strategy.
Furthermore, the diversity of methods and techniques employed by activist managers are
often eclipsed by the most visible “hostile” tactics used by a minority of activist investors.
Despite activism emerging as one of the most prominent hedge fund investment strategies, it
is only recently that comprehensive studies have assessed (and confirmed) its effectiveness
in creating value.1

This paper will provide clarity and insight into activist strategies by:

(i) Providing a context and rationale for its emergence, evolution, and value creation
capabilities,
(ii) Discussing the breadth of opportunities and consequent methodologies employed by
activist investors (the activist toolbox)
(iii) Evaluating its success in boosting firm performance and identifying the requisite skill
set needed
(iv) Assessing the current environment, and
(v) Presenting the portfolio applications for the strategy.

1
Alon Brav, et al, Hedge Fund Activism, Corporate Governance, and Firm Performance (September
2006), available at http://www.fdic.gov/bank/analytical/CFR/2006/oct/hedge_fund.pdf.com; April Klein
and Emanuel Zur, Entrepreneurial Shareholder Activism: Hedge Funds and Other Private Investors
(October 2006), available at http://ssrn.com/abstract=913362

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EMERGENCE, EVOLUTION, AND RATIONALE

The emergence of hedge fund activism over the past several years can be attributed to a
confluence of factors: corporate malfeasance by Enron, Worldcom and other major
corporations weakened the power of corporate management teams and heightened demand
for improved corporate governance; the increase in overall M&A activity and related growth
of private equity funds have led to greater opportunities for activists to execute their
investment strategies; the migration of former Wall Street sell-side research professionals
(after Eliot Spitzer-led reforms) to activist managers; and lastly, a number of legal reforms
and court decisions that have largely supported proxy contests and shareholder activism.2

These forces have helped activists evolve from their ill-perceived corporate raider forefathers
to respected value creating investors. The corporate raiders of the 1980s made hostile bids
for corporations with the intent of quickly selling the pieces to strategic buyers to turn a profit
or engaging in greenmail tactics for their own benefit. While hostile bids for companies are
still part of the activist landscape today, the predominant method of generating value is
through collaborative engagement with the management of target companies, much of which
is done privately behind the scenes. Today’s activist seeks to identify and execute financial,
strategic, corporate governance, and/or operational catalysts to unlock value for the entire
shareholder base. Activist investors take a medium to long-term perspective (one to two
years on average) to implement their initiatives.3

Still, at the core, the basic theory behind the corporate raiders of the 1980s and present day
activists are similar in that both seek to address the fact that corporations do not always do
what is in the best interests of their shareholders. It is the classic agency problem of public
corporations whereby ownership and control are separated. Shareholders typically remain
relatively powerless because of collective action problems, insufficient incentives, conflicts of
interest, legal obstacles, and management power. Activist investors are different because
they have enough shares to overcome collective action impediments, are sufficiently
concentrated in their holdings to provide incentives, understand the legal and corporate
governance methodology for enacting change, are able to attract support from existing
shareholders and turn over the shareholder base with other like-minded institutional
investors, and can pay the legal fees needed to execute the strategy. Consequently, the
principal purpose of the activist investor is to function as a bridge between the shareholders
and corporate directors, which explains why opportunities for activist investors will continue
to exist.4

2
Ronald D. Orol, Extreme Value Hedging: How Activist Hedge Fund Managers Are Taking on the World,
John Wiley & Sons, Inc. (2008) at 5-13.
3
Id at 13-24.
4
Thomas W. Briggs, Corporate Governance and the New Hedge Fund Activism: An Empirical Analysis,
Journal of Corporation Law, University of Iowa College of Law (2007) at 710-713.

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THE ACTIVIST TOOLBOX

It is within the agency problem framework that the activist investment toolbox—financial,
strategic, corporate governance, and/or operational catalysts—makes the most sense (see
Figure 1 on Page 4). For example, financial catalysts such as share buybacks, special
dividends, or balance sheet improvements are used by activists to optimize a company’s
capital structure and return unused cash to shareholders. The reluctance of management
teams to either reinvest their retained earnings back into their business or return cash to
shareholders has attracted activists to advocate for alternate uses. Activists also work to
unlock cash from assets so that it can be returned to shareholders or redeployed where it
can be more productively utilized.

Strategic activist campaigns that target the sale of the company, the divesting of non-core
assets, or changes in corporate strategy, have historically been one of the most effective
means of unlocking value by hedge fund activists. Management teams are naturally biased
when it comes to assessing certain aspects of their businesses (as it is inherently difficult to
evaluate one’s own initiatives). This is particularly apparent when the company in question
has a Founder/CEO whose leadership is often left unquestioned. This management bias
can often lead to conflicts of interest when strategic options are evaluated such as the
divesting of business units. A management team is often incentivized to pursue growth at all
costs—an incentive structure which can promote mergers and acquisitions that may
ultimately be detrimental to the business. The opportunity for activist investors to be a voice
of reason and bring an outside perspective is undeniable.

Corporate governance initiatives focused on improving the quality and effectiveness of the
Board of Directors and management teams are also important catalysts used to enhance
value. Activist campaigns that increase transparency and work toward better aligning and
incentivizing management teams with shareholders has been a frequent strategy for activist
investors. Activist investors typically target companies where executive compensation is high
despite poor performance—a clear “red flag” that signals a flawed pay arrangement may be
causing the company to underperform.

Operational improvements in the form of restructurings, productivity improvements, and cost


cutting have also emerged as tools of choice for certain activist managers. With the rapid
advances in technology over the last several decades, efficiency maximizing tools such as
process automation have been increasingly used by activist managers to grow the bottom
line. The opportunity in this area for activist investors to work collectively with management is
great as interests are often aligned and the activist can serve as incentivized consultants to
maximize the earnings potential of the business.

While some activists may have a particular expertise in identifying and executing one type of
catalyst over another, all four are intertwined and cannot be viewed in silos. For example,
financial, strategic and corporate governance issues frequently need to be tackled as a
prerequisite to achieve operational improvements. Because of this link between the tools in
the activist toolbox, the activist skill set must be broad and contain the necessary versatility
to participate in the wide range of value creation activities.

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Figure 1: Activist Toolbox Value Creation Capabilities

Operational Corporate Governance


ƒ Operational restructuring ƒ Improve quality & effectiveness
ƒ Productivity improvements of Board of Directors
ƒ Cost reductions ƒ Improve quality & effectiveness
of management team
ƒ Incentivize management team
Value Creation

Financial Strategic
ƒ Balance sheet improvements ƒ Refocus corporate strategy
ƒ Recapitalizations ƒ Mergers
ƒ Share buybacks ƒ Acquisitions
ƒ Special dividends ƒ Divestitures

THE SUCCESS OF ACTIVISM

With the prevalence of activist investors utilizing financial, strategic, operational and
corporate governance catalysts, the debate on the effectiveness of the strategy had been
largely anecdotal until two recent comprehensive studies5 (each as further discussed below)
confirmed the value proposition of the strategy.

The first, “Hedge Fund Activism, Corporate Governance and Firm Performance,” conducted
by four university professors, analyzed nearly 800 activist events in the US from 2001 to
2006. The authors found that success or partial success was attained in nearly 2/3rds of the
cases. The study highlighted that the target firm typically outperforms the market by 7% to
8% over a four-week period before and after announced activist campaigns by hedge funds.
If this boost in performance was temporary and activist funds did little to generate value, the
stock price would have reverted back over the course of the investment but the study
concluded that this was not the case. The study also found that the highest market
performance response to activist activities were when the stated objective was strategic in
nature whether intending to sell the company, divest non-core assets, or refocus the
business strategy. It also found that the effects of activist activities improved long term
operational performance at target firms, demonstrated by ROE and ROA increases, while
evidence of positive financial and corporate governance effects were observed in the form of
increased dividend payouts and lowered CEO compensation. Another interesting conclusion
was that hostile activism, which was found in roughly 30% of the cases, typically received
more favorable market responses than non-hostile activism.

The second, “Hedge Fund Activism” by April Klein, an associate professor at NYU, examined
a sample group of 155 activist campaigns. Her conclusion was that in many cases the
perceived threat of a proxy fight was sufficient for the activist to achieve its goal. This study
reaffirmed many of the same conclusions as the previously mentioned study, including the

5
See Footnote 1.

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abnormal stock returns surrounding the initial announcement. This study also found that the
abnormal return of activist targets during the subsequent year was even greater, roughly
11%, confirming that activists generate returns significantly beyond the initial market
reaction.

While these two comprehensive studies confirm the success of activist investors in
generating value during a normal market environment, some have argued that this success
will ultimately lead to a natural saturation point where the number of attractive targets will
diminish as the number of participants in the strategy continues to rise. In the
aforementioned study, “Hedge Fund Activism, Corporate Governance and Firm
Performance,” the authors found that the average benchmark adjusted return attributed to
hedge fund activism in their sample steadily declined during the 2001 to 2006 time period.

Without question, as more and more managers follow the capital into the strategy, the
greater the variance between the most and least skilled activist investors, and the greater the
dilution of the strategy’s performance in the aggregate. However, in spite of this apparent
trend, the top tier of activist hedge funds continues to generate substantial alpha year in and
year out. This is because only a select group of activist managers have sustainable
competitive advantages in the form of reputation, scale, network, business infrastructure,
industry expertise, and the ability to correctly identify undervalued companies, to conduct
detailed fundamental analysis, and to create catalysts for increasing shareholder value.
Successful activist managers typically have private equity, investment banking, and or
operating experience as well as corporate board experience, well beyond that of portfolio
management experience. The art of activist investing is underappreciated by managers and
investors alike.

THE CURRENT ENVIRONMENT

In addition to the unique skill set that has been required to be a successful activist investor in
the past, this past year has demonstrated the importance of being able to recognize and
incorporate the macro-economic environment into the value creation thesis. Over the past 15
months, we have seen macro-economic factors (and technical pressures) completely
overwhelm fundamentals, causing companies to trade at or below intrinsic value despite the
activist manager’s otherwise thoughtful plan to unlock value.

The severe decline in equity prices this year has generated a plethora of opportunities for
activist managers not seen since 2001 (post-tech bubble). While most activist managers
have had negative performance in 2008, the performance of top-tier managers relative to
equity indices has been outstanding. Those that built up their cash reserves and/or
successfully hedged their portfolios have been able to reset their portfolios in companies
trading at or below intrinsic value. This will allow many of these managers to not only make-
up their high-water marks but also generate returns well above their historical average
annualized return targets. Additionally, hedging for beta reduction or alpha generation will
become increasingly important as well. Activist managers that do not hedge fared worse
than those that did over the past year.

The last year has also shown us different forms of activism work better than others during
different parts of the investment cycle. The current environment has placed a premium on
being able to create value by identifying tangible strategic change or operational change. It
is important to understand this nuance when allocating capital to activist managers. For
example, strategic initiatives such as stock buybacks and company sales have faced
difficulty given the removal of financial buyers and the unwillingness of Boards to sell at
current stock price levels. Additionally, hostile type activist campaigns have recently been

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met with strong resistance as managements deflect responsibility for poor performance on
the general market environment. Some managers have even begun to rethink the
effectiveness of hostile-style engagement with management in its entirety.

ACTIVIST STRATEGY IN AN INSTITUTIONAL & HNW PORTFOLIO

Substitute for Traditional Value Equity Allocations


Successful activist managers have many of the skills of a traditional value investor. It is no
coincidence that most activist investors have emerged from traditional value investing
backgrounds. The ability to identify undervalued, out-of-favor companies is the greatest risk
mitigant to any activist portfolio. Therefore the correct framework to view activist portfolios is
as concentrated or “best ideas” value portfolios that are augmented by the unique skills of
the manager to be a catalyst to unlock embedded value. As a result, managers should be
judged on their ability to generate a premium to a value equity index that corresponds to the
average market cap of their portfolio holdings.

Due to the deep value bias of activist portfolios, institutional investors are increasingly
deploying activist strategies within the traditional value equity portion of their asset allocation.
In the quest to maximize the efficiency of risk budget usage, the “style box” approach to
diversification is being broken down in favor of sourcing diversified, non-correlating sources
of alpha, such as activist strategies. As the catalyst to unlocking embedded value, activist
strategies are being utilized in place of traditional deep value equity strategies that may
invest in similar companies but do not possess the expertise to create catalysts in order to
unlock the embedded value as a way to generate alpha.

While many activists have provided substantial alpha over the relevant value equity
benchmarks in bullish and bearish equity markets, they can also provide positive absolute
returns during periods when other value strategies may be lagging the broader markets, as
in 2007, when there was a rotation away from value strategies back into growth strategies.
As noted earlier, the severe decline in equities in 2008 has significantly expanded the
opportunity set for activist managers given the number of targets now trading at or below
intrinsic value levels not seen since 2001. Overall, activist strategies tend to generate higher
alpha than traditional value equity strategies in most market environments and can offer a
substantial portfolio benefit to institutional and HNW equity allocations.

Substitute for Private Equity


Due to the long investment horizons of each underlying position, many investors think of
activist strategies as private equity investing in the public domain, and as a result, augment
their private equity portfolios with activist strategies as well. The benefits of increased
liquidity and transparency, absence of the “J-curve” effect and private equity premiums, and
diminished cyclicality all offer considerable value to private equity portfolios.

Furtherance of Corporate Governance Initiatives


Additionally, the value creation techniques of activist managers are rooted in good corporate
governance practices, which are playing a more important role in pension fund investment
guidelines. Increasingly, pension funds are viewing activism as an efficient way to discharge
their fiduciary obligations as shareholders.

Diversified Portfolio Approach


In conjunction with the increase in capital flows to the strategy and profusion of activist
managers, fund-of-funds have increasingly gained in importance and preference as the
vehicle of choice for many institutional investors. The fund-of-funds platform gives institutions
the necessary diversification across these various styles which is essential in a strategy
characterized by highly concentrated portfolios. The landscape of activist investors is

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extremely diverse and the differentiation among managers is vast. The methods of value
creation (strategic, corporate governance, financial, and operational) utilized by managers
depends on the particular expertise of the activist. The degree of activism, geographic focus,
portfolio concentration, and market cap focus all differ greatly among activist managers. The
ability to select the best activist managers requires a deep understanding of the strategy.
With the differences among hedge activists growing, specific expertise in the activist space
regarding manager selection, manager access, and portfolio construction are crucial skills for
fund-of-funds to generate alpha at the portfolio level.

CONCLUSION

The purpose of this paper has been to explain how a seemingly crude investment tactic has
evolved into a multi-dimensional investment strategy which has had a significant impact on
the investment community and corporate world. While relatively small in size compared to
the hedge fund industry as a whole, the influence of activism has been anything but small, as
it has established itself as a new force for creating shareholder value and improving
corporate governance – with the role of resolving the inherent conflicts of interest that exist
between shareholders, directors and management. This role of activist investors
fundamentally transcends geography and market capitalization – although modifications of
form and technique will be necessary as activism begins to penetrate untapped
opportunities.

As both of the recent comprehensive studies referenced earlier in this paper affirm activism
is successful in creating value, and as traditional passive value investors seek to augment
returns, the strategy has grown in assets and participants despite the fact that only a small
minority of activists have the requisite time, energy and skill to be effective. These successful
activists have sustainable competitive advantages that have enabled them to consistently
outperform their peers (and most equity benchmarks) in the face of heightened competition
that has diluted collective performance and increased dispersion.

While institutional investors invest directly in private equity and hedge fund managers, the
nuances and subtle complexities of the activist strategy has led to the emergence of fund-of-
funds portfolios that invest exclusively in activist managers. Fund-of-funds can offer value
through their ability to analyze and access activist managers, properly construct a diversified
portfolio, and even hedge the beta inherent in the long-biased strategy through macro
overlays that isolate alpha. With that said, no matter what form the institutional investor
chooses to express activism in their portfolios, the value proposition of activist strategies has
clear attractions for the rational return-seeking investor.

Ramius LLC is a global alternative investment firm and a leading manager of activist strategies
in both single strategy and fund-of-funds formats. Since 2002, Ramius has managed a $500
million US small cap value activist portfolio which has achieved a significant return premium to
the Russell 2000 Value Index. Additionally, Ramius Fund of Funds Group has invested more
than $1 billion with global activist managers and offers a commingled global activist fund as well
as separate accounts with an optional internally-managed hedging overlay to help reduce overall
portfolio beta. For more information, please visit our website at www.ramius.com.

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