ACTIVIST INVESTING

Trent Webster
State Board of Administration of Florida





December 2007



1
INTRODUCTION

There is substantial evidence to suggest activist investing generates statistically
significant excess returns greater than the market. Four major academic papers have been
published within the past two years concluding that activist investing generates excess
returns of 5% to 16%, and returns may be even higher over longer time periods. The six
public pension funds contacted attested that, in aggregate, the hired activist managers
produced returns in excess of their assigned benchmarks. A preliminary database was
constructed with returns provided to the SBA by activist managers and by Mercer
whereby activist managers generated significant outperformance in total over time.

Though investors have engaged in activist strategies for many years, activist investing is
not widespread in the public pension plan domain. Apart from specific high-profile funds
such as CalPERS and the Virginia Retirement Fund, few public pension plans have a
governance activist program where capital is committed to effect change at the corporate
level. The lack of widespread participation in the strategy offers an opportunity to the
SBA. Committing capital to an activist strategy also demonstrates a greater interest in
improving governance at corporations, which is consistent with the SBAs expanding
corporate governance program.

The primary structure of an activist manager is a limited partnership. These structures
offer several advantages over traditional fund managers. Managers are more incentivized
and less conflicted. The cost of activism is lower since they operate with less regulatory
scrutiny, and limited partnerships are more nimble. However, activism as an institutional
strategy is still nascent, many activist fund managers are not used to the demands of
institutions, activist returns can be very volatile, transparency can be lacking, and
activists may engage in activities inconsistent with other shareholders and the social
good.

The strategy carries other risks. Investments can be illiquid as managers will take large
positions in single companies. This can lead to large losses in individual stocks if the
manager is wrong. Such large losses may bring headline risk. Headline risk may also be
prevalent when a manager undertakes a high-profile, hostile action against a company.

It is recommended that the SBA allocate capital to an activist governance investment
program, potentially within the Strategic Investments asset class. Since the strategy is a
hybrid between Domestic and International Equities investments are in public equities
and Alternative Investments the legal structures are similar to private equity funds an
activist program would best fit in Strategic Investments.

A significant amount of capital should be allocated to affect the overall performance of
the total fund. It is also recommended that several managers be hired over time by
developing a forward calendar of potential activist funds, possibly with the assistance of
outside consultants. Activist managers tend to run concentrated portfolios, sometimes
holding as little as one name, and thus returns can be highly volatile. Hiring several
managers would mitigate the volatility of activist returns.
2
ACTIVIST FUNDS

Definition

The ownership of publicly traded securities is often widely dispersed amongst institutions
and the public. Motivations and rationales for holding a publicly traded security differ
materially between investors.

The dispersion of ownership and different motivations create market structures which
may impede the optimum return of an investment. Such market structures include the
proliferation of passive indexing investment strategies, large institutions with a primary
focus on short-term returns, institutional philosophies and resources which preclude
meaningful active engagement with company management, investment consultants and
their clients who expect limitations on the actions of institutional investors, widespread
ownership amongst a well-meaning though ill-equipped public, agency problems inherent
within investment institutions, liquidity constraints, and laws, amongst others. Time
frames, resources, expectations and expertise may all contribute to market structures that
generate sub-optimal investment returns.

Most owners of securities wish to generate a reasonable rate of return. However,
investors responses to the lack of a reasonable return may also contribute to sub-optimal
returns. For example, a large institution with a significant stake in a company which has
performed poorly is more likely to simply sell the security than to partake in a
meaningful engagement with company management to fix the problem causing poor
returns. With a critical mass of such institutional investors, problems specific to the
corporation may remain unsolved for some time as there may be little incentive for
management to fix the problem.

Meaningful engagement of company management is expensive and costly for an
institution, let alone an individual investor. Engagement of corporate management
requires a skill set and special expertise often lacking within traditional investment
institutions. Since large institutions usually have many different investment options, and
specific problems within a portfolio of investments require a disproportionate amount of
time and resources, there can be little motivation for a large institution to develop the
expertise required to engage management.

In a market where such neglect occurs, the price of a security may not reflect the intrinsic
value of the business. Such mis-pricing may give rise to abnormal returns. However, it
is not a corollary that a mis-priced security will give rise to abnormal returns. After all, if
a security is chronically undervalued, there is usually a reason. Thus, arbitraging the
abnormal return in a mis-priced security usually requires action to remove the
impediments which have inhibited full valuation.

Activist investing attempts to initiate change within the corporation to unlock the value
inherent in the mis-priced security by actively engaging management. The activist
investor may engage management in a friendly way by offering expertise and advice on
3
business or financial matters, or the activist investor may engage management in a hostile
way, threatening to remove board members and managers whom the activist investor
view as impediments to unlocking value.

Activist investing has, in recent times, been the purview of a few large pension funds. A
particular type of activist investor, the corporate raider, evoked negative reactions
amongst the public, politicians and, eventually, the investment community itself in the
1980s and early 1990s. Through changes in laws and attitudes, the influence of corporate
raiders dissipated, leaving large institutional funds, particularly public pension plans, as
the highest profile proponents of activist investing.

It is not clear that the direct corporate governance efforts of pension funds have been
effective. There is no statistical evidence confirming that activist programs of pension
funds have generated excess returns (though there is some evidence of improvements in
operations and corporate governance metrics).
1

It may be that pension funds are subject
to similar constraints faced by other institutions as well as constraints unique unto
themselves.
The failure of pension funds to arbitrage differences between the prices of stocks and the
intrinsic values of specific companies has lead to the formation of new activist-specific
funds, particularly during this decade. The organization of activist funds is designed to
overcome the structural impediments that may face traditional institutions. Issues of time
frames, resources, expectations and expertise are solved by activist funds so that
structural impediments towards unlocking value are diminished.

Gillan and Starks (1998) state that the most common form of shareholder activism is an
investor who attempts to change the status quo through voice, that is without a change
in control of the firm. The voice reflected in the most common form of shareholder
activism encompasses a broad range of activities a shareholder proposal to the proxy
statement, direct negotiation with management, and public targeting of a corporation
using the media to send information to other investors about the problems and needed
changes at a firm.
2


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

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

1
See Crutchley, Hudson and J enson (1998); Karpoff (2001); Prevost and Rao; Romano (2000); Smith
(1996); and Wahal (1996).
2
Gillan, Stuart and Laura Starks. Corporate Governance Proposals and Shareholder Activism: The Role
of Institutional Investors. J ournal of Financial Economics. 1998.
3
Schulte Roth & Zabel LLP. 15
th
Annual Private Investment Funds Seminar, Activist Investing. J anuary
19, 2006.
4
Higher or extra dividend payments
Higher or more stock buybacks
A management change, usually the CEO

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

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


Types of Activist Managers

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


Constructive Activists
Constructive managers are managers who fly under the radar, send letters and call
management, suggesting ways to improve value. They are deliberately non-
confrontational and stay out of the media.

Operational Activists
Operational activists are managers who bring a team of experts to help improve a
companys value, either by joining the board or working as consultants

Reluctant Activists
Reluctant managers are managers who have held the stock a long time and have not
gained from the position. Reluctant managers become activists to effect change or create
a liquidity event to get out of the stock. Private Capital Management in Domestic
Equities is an example of a reluctant activist manger.

Pure activists
Pure activists are managers who make headlines taking a position in a company with the
intention of enacting a sale, a big share buyback or some other event. A better moniker
for pure activists may be noisy activists or confrontational activists.

The motive of much shareholder activism is forcing CEOs away from the status quo and
into a strategy that is not in the CEOs own self-interest. One activist manager stated that
there is no better method to improve a poorly run company than full disclosure to
shareholders who are ignorant about what is going on.
5



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

Activist Fund Structures

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


Hedge fund structure
Hedge funds are fully funded. The capital is funded at closing and invested as the
manager sees fit. The funds are open-ended and additional investors can come in from
time to time, buying in at marked-to-market prices. Investments recycled as liquidated
positions are reinvested in other investments. The carry is taken on a marked-to-market
basis, reflecting realized and unrealized gains and losses. The life of the fund is
unlimited, and there is no limit on the number of investments that can be made.
Withdrawals are subject to lockups, gates or other limitations, though investors usually
can withdraw periodically. Liquidity varies enormously from fund to fund. There are
usually no hurdle rates and there is usually no claw back. However, there are high water
marks as a loss in one time period is carried over to the next and must be made up in the
following periods before any carry is assigned.

Brav, J iang, Partnoy, and Thomas (2006) identified four characteristics of hedge funds
they are pooled, privately organized investment vehicles; they are administered by
professional investment managers; they are not widely available to the public; and they
operate outside securities regulation and registration requirements.
7


It is important to note that the term hedge fund is a nebulous term with wide
connotations. An investment structure deemed a hedge fund may be anything but, and
may have little in common with another hedge fund other than its legal structure and fees.
Thus, definitions of hedge funds are broadly descriptive. In this paper, the term hedge
fund is interchangeable with the terms activist fund and limited partnership.

Private equity structure
Unlike a typical hedge fund structure, capital is called from the investor as required, and
investors usually enter into an agreement where the investor is committed for five to
seven years. The funds are closed-ended. Additional investors may come in during some
finite time period after the initial closing, often one year, but not thereafter. If a manager
wishes to commit more capital, the manager opens another fund. Profits from the sale of
an investment are distributed back to the investor and not re-invested, though if an
opportunity for a quick flip arises, the manager may not return capital to the investor
arising from the flip. Carry is taken on realized returns only. The funds have a finite life
and there are no withdrawals from the fund. Managers must obtain a hurdle rate before
the manager is able to take carry. Finally, the manager must give back carry to the extent
that over the life of the fund, the manager receives more than the carry percentage of
realized profits.

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

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


Liquidity

Liquidity conditions are more similar to private equity structures than public market
funds. Nissenbaum and Bianchini (2005) highlight three liquidity issues regarding
activist managers.
8


Lockups
Activist managers tend to have lockup periods longer than typical hedge fund managers.
Lockup periods of 18 months or more are often considered. Lockups can be hard or soft.
A soft lockup usually entails the ability to withdraw money during the lockup period at a
cost of 1%-5% of the amount to be withdrawn. Many activist fund managers find that
permitting quarterly or semi-annual withdrawals upon 60 days notice after an initial
lockup to be manageable.

Side Pockets
Side pockets, or special investment accounts, have been gaining in popularity as hedge
funds hold greater amounts of illiquid or hard to value assets such as distressed debt and
private placements. It is a mechanism built into a funds documents which tracks an
illiquid or hard-to-value investment in a memorandum account that is apart from the
funds liquid assets. Typically, the manager must designate an investment as a special
investment at the time the investment is made. Only the investors who were investors in
the fund when the special investment was made participate in the special investment. The
special investment is held at fair value usually at cost, unless a reliable mark-up or
write down is possible and performance compensation is paid only after there is a
realization of the special investment. The portion of an investors' capital held in special
investment accounts cannot be withdrawn until each special investment is realized or
deemed to be realized, i.e., a privately placed security becomes freely tradable. A
manager may reserve the right to designate 10% to 20% of the value of the fund's assets
as special investments.

Activist funds invest in liquid securities, the opposite of the types of securities for which
side pockets have traditionally been used. However, special investment accounts can be
adapted to help deal with the liquidity needs of an activist fund. First, an activist fund can
permit a position that the fund manager wishes to hold for a longer term be designated as

8
Nissenbaum, David and Maria Gabriela Bianchini. Activist Investing Developments. Activist Fund
Structuring. Spring 2005.
7
a special investment, i.e. the fund manger does not want to sell before a certain event
occurs, such as a shareholder vote or merger. Second, the activist fund can permit a
special investment be designated by the fund manager at any time, i.e. if a position
eventually exceeds 10% of the company's stock and cannot be sold because of short-term
trading liability or if the fund manager comes to possess inside information.

Gates
A gate provision is where the fund manager limits withdrawals on any withdrawal date to
less than a stated percentage of a fund's net assets, often 10% to 25% depending on how
frequently investors have a right to withdraw capital. Gates are a very common feature in
hedge funds of almost all strategies. Imposing a gate slows a potential run on the fund by
forcing investors to wait until the next regular withdrawal date. Imposing a gate can be
viewed by investors as a negative event.


Advantages and Limits of an Activist Program

Advantages

Robert Thompson (2006) outlined several advantages of an activist hedge fund program.
9


He noted that hedge funds have several advantages over traditional investment managers
that permit hedge funds to be more effective champions of shareholders.
Hedge fund compensation provides stronger performance incentives. The bulk of
hedge fund compensation arises from the performance fee whereas traditional
managers are generally paid a flat salary plus a bonus.
Traditional managers are often part of a larger organization that competes to win
retirement account management from corporations. Conflicts arise for the
traditional manager as the corporate objective in winning the retirement business
is not in step with the need to unlock shareholder value at the same corporation.
Hedge funds incur lower costs for activism since they operate under less
regulatory scrutiny. They can disclose less about holdings and trades, they can
hedge and they can avoid diversification requirements.
Because hedge funds often have lock ups, they do not have to provide liquidity in
the same manner as other funds such as mutual funds and pension funds, which
must provide investors liquidity on demand.
Hedge funds generally are more nimble, flexible and aggressive than other forms
of investment vehicles. Such characteristics make hedge funds better candidates
for activism.

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

9
Thompson, Robert B. The Limits of Hedge Fund Activism. Working paper presented at Vanderbilt
University. October 13, 2006.
8
management.
10

To qualify for tax benefits, mutual funds must be diversified, which
means they cannot own more than 10% of the outstanding securities of any company, nor
can 5% of the funds total assets be invested in any one security. Hedge funds are not
subject to such tax rules and can hold large amounts of stock in their portfolios without
penalty. Also, hedge fund managers are free from pay-for-performance restrictions
imposed on mutual fund managers by the Investment Advisors Act of 1940. Finally,
hedge funds do not have the conflicts mutual funds and investment managers who run
corporate pension plans have.
Unlike the 1980s, when corporations developed poison pill defenses to fend off corporate
raiders, no new innovative defenses have emerged to counter activism thus far, though
that may be changing.
11
However, targets of hostile activism are learning the tactics of
activists and working preemptively to defend their position thereby potentially raising the
cost, extending the duration and lowering the success rate of hostile activism.
12



Limits to Hedge Fund Activism

Thompson noted several limits to hedge fund activism.
13

Hedge funds are generally
motivated to produce above average returns and use governance to drive gains.
However, more hedge funds and pension funds are employing corporate governance
activist strategies and opportunities for above average returns may be limited. The same
ease with which hedge funds were able to adapt to governance activism can be
transferred to other strategies. Thus, hedge funds may not be long-term participants in
activist strategies.
The gains from strategies promoted by activists can be achieved more by financial buyers
rather than strategic buyers. Activists often do not bring economies of scale or value
from vertical integration. They do not necessarily bring knowledge for a particular
industry or complimentary skills. Rather, they instill a discipline that existing
management could implement without the activist. In fact, the gain they plan to deliver
does not necessarily come from displacing inefficient management. As a result, this
discipline is more likely to show up in segments of the economy vulnerable to financial
acquisitions. The inclination to push for cash payments or to monetize assets is most
likely to occur at the point of the economic cycle where cash is most likely to
accumulate. This could pose a problem for the SBA as the SBA may hold a target firm in
an index fund, though it is unclear whether it would be detrimental at the total fund level.

Activist behavior may be inconsistent with the social good. Activist managers may act in
a manner that enrich themselves while leaving the rest of society poorer. Generally, there

10
Klein, April and Emanuel Zur. Hedge Fund Activism. Working Paper, New York University. October,
2006.
11
Thompson (2006).
12
Ben-Ur, David. Shareholder Activism. Corbin Capital Partners. J anuary 2007.
13
Thompson (2006).
9
is little evidence of such widespread abuse, though there are examples of activists acting
in a manner which may be construed as not acting in the best interests of society.

Activists may harm their own investors. Volatility and the size of some hedge funds
could lead to a run on the bank or pose a threat to markets. Compensation schemes
utilized by hedge funds may create perverse economic incentives and may induce market
manipulation. Shareholder activism may threaten other constituencies, and may impose
financial distress and costs on employees, creditors and communities.

A worrisome aspect is the use of financial tools to separate the interests of ownership and
control from economic interests. This strategy is known as empty voting, and the
motivation is usually to enhance the value of another asset, for example, acquiring votes
in a bidder to help ensure approval of the takeover of a target where the investor has a
large stake.

An example of empty voting was Mylan Laboratories attempted purchase of King
Pharmaceuticals. Perry Capital had acquired a large block of Mylan and entered a
derivatives contract to hedge away the economic interest but retain the voting rights.
14


Perry used its position to pressure Mylan into purchasing King, in which Perry had a
significant interest, at a hefty premium.
Shareholder interests may not be aligned. As Anabtawi and Stout (2006) note, minority
shareholders can have private interests that are pitted against other shareholders common
interests in enhancing value.
15

Common and increasing sources of conflict between
minority and other shareholders include
Empty voting, demonstrated in the Mylan example above.
Significant and undiversified holdings in other components of a firms capital
structure such as stocks or bonds of the corporation or equity ownership in other
companies whose value is affected by business decisions that also affect the
value of the companys shares.
Economic interests, in particular business transactions with corporations such as
greenmail repurchases, employment contracts, or collective bargaining
agreements that are not shared by other equity holders.
A short-term interest in enhancing the value of the shares at the expense of long-
term equity value.








14
Anabtawi, Iman and Lynn Stout. A General Theory of Shareholder Fiduciary Duty. Working paper
presented at Vanderbilt University. October 13, 2006.
15
Anabtawi and Stout (2006).
10
Risks as a Strategy

As an Asset Manager

There are several risks unique to activist investing. These risks include
16


Time and money. It takes an enormous time commitment as activists are waging
political and strategic offensives. Political offensives include the media,
politicians and the courts. Strategic offensives include proxy fights and
acquisition proposals. All the while, managers are researching and trading a
balanced portfolio. Target management is fighting with the activists own money
as the executives and the board defend their own honor and use shareholders
resources to do so.
Obtaining a material position in the stock without alerting the market.
Information leakage is common in financial markets, and it increases the price of
the stock, boosting basis cost and diluting returns.
Finding companies where the shareholder base are people the manager can
convince. Generally, the more diverse the shareholder base and the lower the
percentage of stock held by institutions, the greater the difficulty in effecting
change.
Returns are very sporadic. This was a common theme voiced by other institutions
investing in an activist program. Returns of individual managers can be very
volatile.
Illiquidity and the difficulty in reversing course. Once the investment occurs, it is
expensive to liquidate the position.

For the SBA

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

Illiquidity. If ever the need to access funds were to arise, it would be difficult to
do so given the structure of activist funds.
Large loss of money in any one investment held within a relatively concentrated
portfolio.
Relative organizational instability of activist managers. Activist managers may
only have one product, the activist fund they are managing. Because
underperformance is tolerated less willingly by many who invest in hedge funds,
underperformance can lead to a run on assets and possibly a shuttering of the
fund. For example, activist manager Pirate Capital saw its capital fall to an
estimated $375 million on September 1, 2007, from an estimated $1.8 billion the
year before.
17

16
Accredited Investor. Activism Roundtable. pp16-19. J une 2007.

17
Losses Force Pirate to Pull up the Plank. DealBook,
http://dealbook.blogs.nytimes.com/2007/09/12/after-losses-pirate-pulls-up-the-plank/. September 12, 2007.
11
Lack of institutional experience. The nascent nature of this strategy means asset
managers in general have less experience dealing with large institutions such as
the SBA.
Headline risk. Companies may use the media to portray the activist investor in a
negative light.
Declining alpha. Alpha is positive within activist investing. However, more
capital is being committed to the strategy, which may mean lower excess returns
in the future.
Activists tend to invest in small cap value companies. Small cap value indices
have been the best performing indices of all US public equities this decade.
Shareholder conflicts. Actions undertaken by activist managers to increase
returns in the short-run may not be in the best interests of the company nor the
industry in the long-run.


ACTIVIST MANAGER RETURNS

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


Databases of activist manager returns are scant. Hedge Fund Research of Chicago
offered a database of hedge fund returns totaling 45 names at the time of this writing.
The cost of obtaining the database was $4500. At $100 per return stream, it was not
considered good value, especially when the vendor stated that many other activist funds
and multi-strategy funds engaging in activism were not represented in the database. In
Wilshires database of hedge fund returns, only seven of the 5500 funds were considered
activist.

Given the nature of the hedge fund industry, where it is common for funds to close a year
or two after opening, the problem of survivorship bias in hedge fund databases is acute.
According to one estimate, over 1000 hedge funds closed in 2005 and 2006.
19


Also, many activist events are driven by multi-strategy hedge funds, or equity hedge
funds that are initiating activist campaigns in which they had not intended to launch but
felt compelled to do so to unlock the value in their investment. Such campaigns are not
captured in return databases, potentially skewing the return distribution.

A problem arises in the measurement of the effects of activist management. Much
activism occurs behind the scenes through private negotiation where there is no external
observation of the event.
20

18
Brav, J iang, Partnoy and Thomas (2006).
One study measured the size of this dynamic. The study
19
Despite Blue-Chip Gains, Hedge Funds are Faltering. Pittsburgh Post-Gazette. http://www.post-
gazette.com/pg/06277/727312-28.stm. October 4, 2006.
20
Gillan and Starks (2003).
12
found that of 45 firms contacted by TIAA-CREF regarding an issue brought forth by the
fund, 71% reached a negotiated settlement prior to the vote on the shareholder proposal.
The remaining 29% resisted TIAA-CREFs pressures and the shareholder proposals went
to a vote.
21


In the past, various activist money managers have submitted marketing material to the
SBA. Often included in the marketing materials was a stream of returns representing the
actual portfolio or a composite of a representative portfolio. Mercer also provided the
SBA with a table of returns generated by activist managers hired by CalPERS. From this
data, a preliminary comparative universe of activist managers was created.

The funds were spread across geography, with data available from the United States,
Europe, the UK and J apan. Within the United States, there were funds benchmarked
against a broad market benchmark and others that were considered small-cap funds.

Returns for 22 activist funds were compiled. Due to the differing time frames for which
managers submitted data, only returns for full calendar years were included. For
example, one manager submitted calendar year returns for 1994 through 2006 while
returns for only one full calendar year could be constructed for other funds.

The total number of full calendar year returns compiled was 98. The average number of
calendar year returns for the managers was 4.5 years whereas the median number of years
was 3.0.

The average annual active return above the benchmark for the managers was 12.6%. The
median annual active return was 10.5%. The standard deviation of active returns was
31.1%. The largest positive active return was +176%. The largest negative active return
was -55%. Sixty-eight of the 98 calendar years were positive, or 69% of the time.
Universe returns broken down by geography are in the Appendix.

A hypothetical portfolio of activist managers was created from the returns provided,
shown in Table 1. The hypothetical portfolio assumes the managers were hired on the
first day of the year for when returns were available. Manager returns are equal-weighted
as are benchmark returns.










21
Carleton, Willard T., J ames M. Nelson and Michael Weisbach. The Influence of Institutions on
Corporate Governance through Private Negotiations: Evidence from TIAA-CREF. University of Arizona
Working Paper. 1997.
13

Table 1 Active Returns of an Equal-Weighted Activist Portfolio
Managed Return Benchmark Return Active Managers
1994 1.4% 7.5% -6.1% 3
1995 56.3% 25.5% 30.8% 3
1996 21.6% 9.8% 11.8% 3
1997 40.2% 14.1% 26.1% 3
1998 -3.6% 19.8% -23.3% 3
1999 40.2% 28.2% 12.1% 5
2000 16.4% -6.6% 23.0% 7
2001 31.6% -15.4% 47.0% 7
2002 1.9% -18.4% 20.3% 8
2003 51.3% 29.7% 21.6% 11
2004 23.4% 16.4% 7.0% 17
2005 18.9% 12.4% 6.6% 13
2006 17.7% 20.3% -2.6% 14

Total 1390.2% 241.1% 1149.1%
Annualized 23.1% 9.9% 13.2%

The annualized return for the hypothetical portfolio is 23.1% versus 9.9% for the
hypothetical aggregate benchmark.

Because of the limits of the database, it should not be considered a definitive universe.
Rather, it is best viewed as an incomplete representative sample.


PEER PRACTICES

California Public Employees Retirement System (CalPERS)

CalPERS began investing in activist strategies in 1986.
22
Recently, CalPERS announced
their activist allocation will increase from $5.1 billion to $10 billion.
23

The allocation
had been 1%-5% of the total Global portfolio of more than $150 billion. The new
allocation will be 2%-8%. Currently, external activist managers run $4.2 billion for
CalPERS and $860 million is managed internally in a co-investment program.
CalPERS expanded their activist program in 2005 when several new managers were
hired. CalPERS currently employs 11 external managers, six focused on the United
States and five on Europe and J apan. Of the 11 managers, two focus exclusively on
small-cap companies. CalPERS allocated approximately $200 million to each manager.

The aggregate activist portfolio consisted of roughly 110 companies, with no managers
holding the same stock. When CalPERS constructed the portfolio, the fund deliberately
diversified across geographies and market capitalizations. The smallest company owned

22
Teleconference between Dennis J ohnson of CalPERS and Scott Seery and Trent Webster of the SBA on
October 2, 2006.
23
CalPERS press release. J une 18, 2007.
14
by market cap was $200 million while the largest was $30-$40 billion. Companies are
typically owned for two to four years.

The strategy is primarily deep value. Though governance is a focus, managers are not
necessarily out to improve governance. Governance is a means to higher returns, not an
end unto itself. Managers are not necessarily interested in long-term value creation.
Managers are focused primarily on the more efficient allocation of capital by
management and on board changes. Activist fund managers will take board seats but
usually would rather not as board members are insiders and subject to insider trading
laws. None of the managers short or use derivatives. Several managers are interested
only in balance sheet restructuring. CalPERS deliberately avoids high profile managers.
Most managers are low profile and do not pursue hostile strategies.

The typical activist manager has a three year lock-up period. CalPERS sits on many of
the funds advisory boards and uses ISS and Glass-Lewis as advisors.

CalPERS has a co-investment program and runs an internal activist portfolio that, in late
2006, comprised of six companies four in the United States, one in J apan and one in
Europe, with another name to be added. The co-investment portfolio has beaten the over-
all portfolio by about 2% per year. Managers are compensated on a performance-based
fee structure if one of their companies is in the co-investment portfolio.

Four employees worked on the program, with no one dedicated full-time. However,
CalPERS had intended to hire a portfolio manager who would be dedicated solely to the
activist program.

Risk adjusted returns for CalPERS have been strong. Up until mid-2005, the information
ratio of the activist program was 1.23.
24
As of the end of March 2007, the governance
program had returned 14.4% versus a benchmark return of 6.4% since inception, while
over the past five years, the program had gained 14.5% compared to the benchmark
return of 10.9%.
25



24
Anson, Mark. CIO CalPERS. Presentation entitled Building Investment Products for Institutional
Portfolios. J une 6, 2005.
25
CalPERS revision of global equity sub asset class allocation ranges policy recommendation to members
of the policy committee, p6. J une 18, 2007.
15


The activist program had both the highest standard deviation and highest alpha of all
investment strategies at CalPERS. There was no targeted alpha, nor was there a risk
budget although CalPERS was working on one at the time.


California State Teachers Retirement System (CalSTRS)

CalSTRS began their activist investing program three years ago when they hired
Relational Advisors.
26

They are currently in the process of hiring seven new managers
four in the US, one in Europe and two in J apan. Hermes had been hired as the European
manager while Sparx and Taiyo Pacific had been hired as managers for J apan. Two
managers in the United States will be large cap and two managers will be small/mid-cap.
They tend to hire managers that avoid hostile engagements.
Currently, CalSTRS has $1.2 billion with Relational. The fund intends to increase the
allocation to $2.5-$3.0 billion. Total fund assets under management at CalSTRS is
currently $170 billion.

CalSTRS conducted the search. They used a consultant but only in an advisory role.
Managers not hired are part of a bench that may be hired in the future. A few managers
in the search were new and did not have track records.


26
Conference call between Brian Rice, California State Teachers Retirement System, and Trent Webster.
November 19, 2007.
16
To date, the program has been successful. Relational had returns of 30% in the previous
fiscal year, which was 8%-10% ahead of their benchmark. Since then, returns have fallen
to 3%-4% for the year. Thus, though returns are attractive, they are also volatile.

The activist program is considered a corporate governance portfolio and is part of the
global equities asset class. Private equity is not part of global equities at CalSTRS.

Lock-ups were for one to three years, and fees were generally 2% of assets and 20% of
returns above a benchmark. Benchmarks are broad market benchmarks such as the
Russell 1000, Russell 2000 and MSCI Europe.

Managers were generally accommodative for reporting purposes.


Canada Pension Plan (CPP)

The activist program at the Canada Pension Plan began in J anuary 2007.
27

CPP describes
their activist program as Relationship Investments. Relationship Investments include
not only activist managers but all engagement of public companies, including proxies and
governance.
Total assets under management at CPP are $120 billion. By 2022, CPP expects assets
under management to grow to $450-$500 billion. Relationship Investing is domiciled
within the public markets group, which currently has $105 billion in assets.

CPP has hired two funds and will hire two more in the near future, totaling $1.2-$1.3
billion in assets. It is their intention to grow to $3-$5 billion over time and hire 15 to 20
external activist mangers. They intend to hire 2-3 US larger-cap activist managers, 2-3
US smaller-cap activist managers, 3-4 European managers and a few J apanese managers.
They expect to hire a mix of friendly and more confrontational managers.

As their expertise grows, internal staff will invest directly in target companies. They
expect capital allocated to the internal program will eventually equal the external
allocation. Thus, total assets under management in the relationship program is expected
to be $5-$10 billion.

CPP approaches benchmarking in a unique manner. All investments are benchmarked to
a global passive portfolio. All active investments are expected to beat whatever portion
of the benchmark from which capital was drawn. For example, if KKR draws on a
commitment to buy Dollar General, the benchmark for the private equity investment in
Dollar General is the returns from a passive index of US retail stocks. The relationship
managers are benchmarked in the same manner. Internally, however, CPP expects the
activist program to generate 300-400 basis points of return over the global passive equity
benchmark.

27
Conference call between Nikhil Shah, Canada Pension Plan Investment Board, and Trent Webster.
November 14, 2007.
17

When asked about fees, they said that even large institutions have little or no leverage
when negotiating. One manager agreed to a 1.5% management fee and a 20% incentive
fee, locked in over three years. Another manager agreed to 2% and 20% over three years.
Another agreed to 1% and 20% in excess of a large-cap benchmark. Yet another agreed
to 1.5% and 20% relative to CPPs internal benchmarks, their preferred fee structure.
Managers were hesitant to be judged against an equity benchmark.

On disclosure, one current manager supplies CPP with anything requested. The other
current manager is reluctant to do so.

CPP conducted the search entirely on their own. They did not use a consultant.


Los Angeles City Employees Retirement System (LACERS)

LACERS has invested $150 million in an activist strategy, representing 1.6% of the total
fund.
28

They are expanding the program, perhaps by as much as 100%. LACERS has
issued RFIs and will determine the commitment after the selection process.
The activist program began in 2005. Half the capital committed was with funds focusing
on domestic companies and half with funds focusing on international companies.
LACERS hired Relational for the US strategy and Hermes, Knight Vinke and Sparx
Asset Management for the international mandate.

In their current search, LACERS is interviewing six US firms and six international firms.
In the first search, LACERS did not consider capitalization ranges when allocating
capital in the strategy. However, they are considering size in the current search.
LACERS uses Pension Consulting Alliance as their consultant.

Since inception, the program has returned 6.3% versus 5.8% for the benchmark. The one
year return ending J une 2007 was 26.6% versus 21.7% for the benchmark. LACERS
noted that returns have been volatile. Europe and the UK have been strong while J apan
has lagged.

Formal reporting by the managers has generally been good.


Virginia Retirement System (VRS)

Virginia has committed $1.3 billion to activist managers out of a total of $38 billion in
the domestic equities asset class and $59 billion in the entire fund.
29

28
Conference call between Barbara Sandoval of LACERS and Trent Webster. October 29, 2007.
The activist
program accounts for 1.6% of domestic equities and 1.0% of the total fund.
29
Conference call between KC Howell of the Virginia Retirement System and Trent Webster. November
7, 2007.
18

Currently, Virginia employs four activist managers Relational, Shamrock, ValueAct
and New Mountain. The VRS has allocated $614 million in total to Relational.
Relational was hired as their first activist manager in September 2003. Virginia classifies
Relational as a traditional large cap manager. Shamrock was hired in May 2005 and is
classified as a small cap manager. Virginia has committed $200 million to Shamrock
with $134 million allocated. ValueAct was hired on May 1 and is classified as a hedge
fund. ValueAct was allocated $263 million. New Mountain, which is better known as a
private equity manager, launched an activist fund in which the VRS allocated $263
million. Virginia terminated Hermes, the UK activist manager, due to personnel turnover.

Activist managers are not segregated into a separate program and are usually
incorporated into the equities asset class, though activist managers can be classified as a
hedge fund in the hedge fund program at VRS.

Results have been very volatile. VRS does not aggregate performance as a separate
program. However, if they did so, activist managers would show to have added value.
Relational has added no value, though the swings have been dramatic, with
performance oscillating between 0 basis points and +600 basis points above the
benchmark twice while never going negative. Performance for New Mountain has been
disappointing while ValueAct has been impressive.

Mr. Howell of the VRS recommended the SBA not get involved with activist managers
who invest directly in private equity deals. Such arrangements are headaches. Instead, if
the SBA decides to invest with such managers, choose those that carve out private equity
deals into sidepockets.

Typically, lock-ups are for three to five years. Thereafter, when the initial lock-up
expires, the investor is locked-up for another three to five years. Managers usually do not
have gates.

Fees vary. A typical fee structure was a 100 bp management fee and a 20% share return
above the S&P 500. Shamrock charged a 100 bp management fee and a 20% share return
over 5%. There is no negotiating ability with hedge funds.

Managers usually report monthly, though one reports quarterly. Virginia has no
problems with transparency. Relational is excellent, giving the rationale for every name
in reports 50 pages long. ValueAct is pretty good with reporting while Shamrock is
weak.

The SBA should add an events of default clause into any contract signed with an
activist manager. If there is fraud, organizational change or something happens to a key
person, an investor can trigger the events of default clause and request their funds be
returned.


19
ACADEMIC REVIEW

Pension Plan Activism

Until recently, limited partnerships did not play a significant role in shareholder
monitoring. Instead the role was played by control shareholders and other institutions
such as pension funds and mutual funds.

There is mixed evidence on the efficacy of public pension fund shareholder activism.
Prevost and Rao detailed numerous studies that have both substantiated and negated the
assertion that public pension plan activism has been effective.
30
In their own research,
they concluded that there is no statistical evidence that proxies initiated by public pension
plans add value over time. Most evidence indicates that pension fund shareholder
activism can prompt small changes in target firms governance structures but has
negligible impacts on share values and earnings.
31


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

In most cases, the
average abnormal stock return was negative, and in all but one case, it was statistically
insignificant. The studies examined return on assets (ROA), return on equity (ROE) and
return on sales (ROS) changes following shareholder proposals or non-proposals by
activist investors. Most researchers report insignificant changes in all three variables,
with the exception of two studies, one which reported significant decreases in average
ROA and ROS for firms subject to repeat targeting by pension funds, and the other which
reported an increase in ROA for firms listed by the Council of Institutional Investors as
potential targets for shareholder activism.
The greatest evidence of operational change following shareholder activism regards asset
divestitures, restructurings or employee layoffs. Firms targeted by pension funds are
more likely to experience such events during the three to four years following their initial
targeting, though it is unclear whether or not such corporate actions are due to
shareholder pressure since such firms tend to be poorly performing and are prime for
restructuring without shareholder activism.

Five studies examined announcements of negotiated settlements or non-proposal pressure
by activist shareholders, all reporting positive shareholder value effects, with two
statistically significant.


30
Prevost, Andrew K. and Ramesh P. Rao. Of What Value are Shareholder Proposals Sponsored by
Public Pension Funds? Massey University and Texas Tech University Working Paper.
31
Karpoff, J onathan. The Impact of Shareholder Activism on Target Companies: A Survey of Empirical
Findings. Presented at the Corporate Governance i praksis: Internasjonalt Seminar. September 10, 2001.
32
Karpoff (2001).
20
Over the long-run, there is evidence both for and against shareholder activism.
According to Karpoff

[S]even studiesexamine long-run returns following shareholder
proposals or non-proposal targeting announcements. Nesbitt (1994),
Opler and Sokobin (1997), and Smith (1996) each report positive long-run
stock returns. Del Guercio and Hawkins (1999), Martin, Kensinger, and
Gillan (2000), and Wahal (1996), in contrast, each find statistically
insignificant long-run returns. Prevost and Rao (2000) report statistically
insignificant three-year buy-and-hold returns for a sample of 17 firms that
each were targeted once by public pension funds, but statistically
significant negative average abnormal returns for nine firms targeted more
than once.

[T]he most persuasive evidence is that the average abnormal long-run
return is not significantly positive. Nevertheless, the size and sign of long-
run returns following the initiation of activist shareholder pressure remain
topics of genuine dispute in the empirical literature.

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

Firms attracting activist efforts tend to be large and have high levels of
institutional ownership.
Activists have been successful at prompting some firms to adopt limited changes
in their governance structures.
When averaged over time periods, sponsor types and proposal types, shareholder
proposals have negligible and statistically insignificant short-run effects on share
values.
Announcements of non-proposal targetings and negotiated settlements between
activist shareholders and target companies are associated with an average increase
in share values, sometimes significant statistically.
The average abnormal stock return is non-zero for some subsets of proposal and
non-proposal targetings.
Shareholder activism is not associated with subsequent changes in earnings,
capital expenditures, earnings payout, CEO turnover, CEO compensation, or
likelihood of control change, although it appears to be followed by an unusually
high rate of asset divestiture and/or company restructurings.
33


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

33
Karpoff (2001).
For the five years
prior to the initiative date, the 117 Focus List stocks produced an average cumulative
return of -93.5%, or an average annual return of -14.1% per year. For the first five years
34
Hewsenian, Rosalind M. and Andrew J unkin. The CALPERS Effect on Targeted Company Share
Prices. Wilshire Associates. 2004.
21
after the initiative date, the average cumulative return was 15.3%, or an average annual
return of 2.9% per year. However, returns for the subsequent five years have steadily
decreased over time. The cumulative five-year return was 41% in 1992, 54% in 1995,
13.6% in 2001 and 8.1% in 2003. Aggregate results were lifted by a handful of stocks
that experienced large gains. Fully 61% of companies underperformed their benchmarks,
with median performance -25.7% below the benchmark. Possible explanations for poor
results include variations in degree of aggressiveness on the part of CalPERS in applying
their process, and the sharp bear market during the 1990s as well as the following decade
when low-quality stocks underperformed.

The repeated failures of institutional shareholder activism is often blamed on three
elements inadequate monitoring due to free riding, legal and institutional obstacles to
activism, and incentive problems amongst institutional investors in the United States.
35

Boyson and Mooradian write that the inability to improve long-term performance of
targets has been explained by insufficient managerial skill among activists, political
motivations amongst pension funds, short-term focus of activists goals other than long-
term performance improvement, too little money and time spent on activism, and better
alternatives than shareholder activism to effect change.
36


Dedicated Manager Activism

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

Brav, J iang, Partnoy and Thomas
37


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






35
Becht, Marco, J ulian Franks, Colin Mayer and Stefano Rossi. Returns to Shareholder Activism;
Evidence from a Clinical Study of the Hermes UK Focus Fund. Working paper presented at Vanderbilt
University. October 13, 2006.
36
Boyson, Nicole M. and Robert M. Mooradian. Hedge Funds as Shareholder Activists from 1994-2005.
Working paper. J uly 31, 2007.
37
Brav, J iang, Partnoy and Thomas (2006).
22
Activist Strategies When Engaging Target Companies

The authors identified seven distinct strategies

Communication to enhance shareholder value (64% of the sample)
Seeking board representation without conflict (13%)
Making formal shareholder proposals or publicly criticizing the company and
demanding change (24%)
Threatening to wage a proxy war for board representation or suing a company for
breach of duty (5%)
Launching a proxy fight to replace the board (12%)
Suing the company (5%)
Intending to take over the company (5%).

Hedge funds can launch more than one strategy, thus the percentages do not add to 100%.
The authors defined the first two strategies as friendly, the third as aggressive if it
involves a stated intention to remove the CEO, and the remaining strategies as
aggressive.

Hedge funds worked together in 21% of the events. This does not include when funds act
in parallel with each other, i.e. their efforts are uncoordinated but are attempting to
achieve the same ends. Nor does it include other hedge funds or investors that cascade
into the target firms stock after the 13D filing
38

to take a free ride.
In the 32 cases where ISS had an opinion, ISS recommended voting in favor of the
activist manager 23 times.

Activist Motives

There are six major motivations behind dedicated activism that can be broken down
further into multiple subcategories.

The activist believes the company is undervalued and/or the fund can help the
manager maximize shareholder value. No further activism was launched. This
category accounts for 51% of the sample.
Activism targeting operational efficiency, including general operating efficiency
and cost cutting, and tax efficiency-gaining changes. This category accounted for
11% of the sample. Operational efficiency and cost cutting objectives achieved
36% success and 20% partial success. There were five tax-efficiency changes
with three successful and two partially successful.
Activism targeting a firms payout policy and capital structure. Companies use
cash or increase borrowings to increase dividends or share buybacks. This
activism accounted for 11% of the sample and achieved 40% success and 30%

38
Investors are required to file Schedule 13D no later than 10 days after the transaction that triggers the 5%
ownership level or greater and state the intent of the transaction.
23
partial success. Equity issuance is another sub-category, defined as stopping or
reducing equity offerings by the company and proposed debt restructurings.
These events accounted for 4% of the sample and were successful 44% of the
time and partially successful 29% of the time.
Activism targeting business strategy. Activists target companies they believe lack
business focus or exhibit excessive diversification and propose a spin-off or
refocusing the business strategy. These accounted for 6% of the sample,
exhibiting a 33% success rate and a 32% partial success rate. Activists intervene
in a proposed merger to get a better price. This category accounted for 6% of the
sample and was successful in 41% of the cases and partially successful in 22%.
Activists intervene to stop a merger. These accounted for 3% of the sample,
exhibiting a 32% success rate and a 46% partial success rate. Finally, activists
acquire a stake in the company to facilitate a transaction. These accounted for
12% of the sample, exhibiting a 92% success rate and a 1% partial success rate.
Activism to urge the sale of the target. Hedge funds attempt to force a sale of the
target company, either to a third party or to themselves. Sales to a third party
accounted for 11% of the sample, exhibiting a 47% success rate and a 20% partial
success rate. Sales to themselves accounted for 4% of the sample, exhibiting a
37% success rate and a 27% partial success rate.
Activism targeting firm governance. There are a number of strategies in this
category including rescinding takeover defenses (6% of the sample, 20% success,
39% partial success), ousting the CEO or Chairman (5% of the sample, 58%
success, 22% partial success), challenging board independence and fair
representation (11% of the sample, 38% success, 30% partial success), demanding
more information disclosure and questioning potential fraud (4% of the sample,
44% success, 22% partial success), and challenging executive compensation (3%
of the sample, 27% success, 33% partial success).
Activism in providing finance. In this category, activists are either financing
growth (5% of the sample, 75% success) or a corporate restructuring out of
bankruptcy or financial distress (5% of the sample, 72% success, 7% partial
success). In most cases, the fund also seeks board representation and is
accommodated by the board.

Target companies chose to fight 48% of the time. Target firms accommodate the activists
33% of the time. Companies negotiate in the remaining cases.

Characteristics of Activist Funds

The median size of the activist funds in the sample was $793 million. Activist funds
ranking in the 25
th
and 75
th
percentiles had assets under management of $278 million and
$4.44 billion.

Activist funds are value investors. In about two-thirds of the cases, managers specifically
state that the target company is undervalued.

24
The median percentage ownership stake is 6% of the company. The median dollar value
involves about $9.5 million at cost rising to $12-$13 million at the maximum level of
investment, or 9%-10% of the company. Percentage ownership stakes are strongly
negatively correlated to size of the target company. Activist funds seldom seek
controlling positions.

As of the end of the study, in 48% of the cases activists still maintained at least a 5%
stake in the target. In the instances where the fund no longer owned a 5% stake, the
median duration from the first Schedule 13D filing to divestment was 360 days, with the
25
th
and 75
th
percentile at 150 days and 720 days. These numbers indicate that activists
investment horizons are not as short as the critics of activism imply.

Characteristics of Target Firms

Target companies tend to be value companies. Targets tend to be more profitable as
defined by return on invested capital, return on assets and cash flow generated. They are
no worse off than comparable companies regarding other operational issues. They
generally have slightly higher leverage than peers, have significantly lower new equity
issuance, payout a bit less in dividends, spend significantly less on research and
development, spend a bit more on capital expenditures, are generally more diversified,
have more takeover defenses, have greater institutional ownership, have higher trading
liquidity, and recent stock performance is roughly on par with that of comparable firms.

Activists identify potential problems at target firms that are general issues all firms face,
such as governance, capital structure, dividend payout, etc., rather than firm-specific
problems. Targeted firms do not suffer from serious operational problems. The
problems identified by the activist fund are likely related to the misallocation of cash
flows and diversifying investments that detract from shareholder value. Such targeting
patterns are sensible given that activists, in general, are not experts in the specific
business of the target firms.

Corporate Operational Outcomes of Activist Campaigns

Targeted companies have higher ROA and the difference is notably higher after activist
intervention. ROE shows similar or even greater results. The average ROE is 4.0%
(1.8%) above peers in the year prior to (during) activism and 8.0% two years later.

During the year before activism, dividend payment is 0.42% lower than peers. The year
after activism, the difference is +0.13%. If you include share buybacks, the difference
rises to +1.66% a year after activism.

Leverage also changes. The difference in the leverage ratio for the target firm compared
to peers decreases from 3.2% to 2.3% in the year leading up to the target date then rises
to 3.6% the year after.

25
Target companies on average pay their CEO $862,000 more than peers in the same
industry and of similar size and stock valuation. One year after targeting, there is no
difference. If you include total compensation, i.e. stock options, pension benefits, etc.,
the difference in pay during the event year is $1,260,000 and zero a year after.

CEO turnover is slightly higher for targeted companies before activism. One year after
the targeted event, turnover was 13.6% higher for the targeted companies relative to
peers.

Returns

Excess returns are positive and significant. The median excess return is 5-7% for the 20-
day window around the Schedule 13D filing date. The average excess return is 9%.
There is an abnormal return of 3.2% 10 days prior to filing the initial Schedule 13D and a
2.0% jump in the following two days. The abnormal cumulative buy and hold return is
7.2% 20 days before and 20 days after the date of the first action. A full 64% of events in
the sample experience positive excess return. The 25
th
, 50
th
and 75
th
percentile
experience excess returns of -5.4%, 5.1% and 17.4%.

For hedge funds that describe a specific event in the 13D filing, i.e. do not communicate
only that the stock is undervalued, the abnormal return is 5.3% 10 days before the filing
and 3.3% the following two days. The average excess return 20 days after the filing is
10.1%.

Confrontational events generated higher excess returns of 11.9% whereas friendly events
generated excess returns of 5.3%. This makes intuitive sense since the cost of generating
returns from a hostile event are higher, and returns should be higher to endure the higher
costs.

The market response to capital structure related activism including debt restructuring,
recapitalization, dividends and share repurchases is insignificant. There is a similar
insignificant reaction for corporate governance related activism such as attempts to
rescind takeover defenses, to oust CEOs, to enhance board independence and to curtail
CEO compensation. Instead, events that are associated with positive abnormal returns
involve more dramatic events such as changes in business strategies, i.e. spinning off
assets and the sale of the company, which had excess returns of 4.4%, and 10.9%
respectively.

It is possible excess returns are explained by alternate causes, such as market over-
reaction and good stock-picking. There are several reasons to believe this is not the case.

There is no reversal in returns up to 12 months after the events.
Hostile targeting generates significantly higher event-driven returns than non-
hostile targeting. Adjusting for size, the difference is 6.6%. Given that hostile
activism is resisted by management, the positive market response must come from
the potential value improvement through activism. Hostile activism is more
26
costly, and funds should only resort to it when the perceived benefits are higher.
If hedge funds were merely stock pickers, there should not be such significant
variation.
Excess returns are different based on whether the stated goal of the activism is
achieved. If a hedge fund fails or withdraws from ongoing activism, the excess
return is -4% to -6% 20 days on either side of the time of the withdrawal. On the
other hand, when a hedge fund withdraws after a successful intervention, there is
no negative excess return
If activist managers were merely picking stocks, they would sell immediately
after the market price reflected their finding that a companys shares were
undervalued. However, activist hedge funds do not sell immediately after filing
the Schedule 13D. Instead, funds continue to hold for relatively long time
periods.

The median (average) abnormal return to dedicated activism in the sample steadily
declined from 2001 to 2005, from 9.0% (10.6%) in 2001 to 3.1% (4.8%) in 2005. The
strategy is relatively new. The number of dedicated activist funds surged after 2003 and
activity continues to grow. It is possible that the new-found popularity of the strategy
will reduce returns in the future.

The documented excess returns may be understating actual results. If one views the
14.5% of the sample where targets are being liquidated, sold or taken private as a
complete payout to shareholders, the post-activism payout is much higher than the
conventional payout would indicate.

Klein and Zur
39


Using 13D filings from J anuary 2003 through December 2005, Klein and Zur claim to
have identified all or nearly all activist initial purchases that state the purpose of
redirecting managements efforts. There were 194 13D filings pertaining to 155 events by
104 hedge funds.

Klein and Zur included a control group of non-activist companies adjusted by industry,
size and market-to-book. The study also compared hedge fund to non-hedge fund
activists, i.e. pension funds, mutual funds, etc. The control group consisted of 209 13D
filings for 164 separate target firms by 141 distinct non-hedge fund activist. Non-hedge
fund activists are more likely to invest in restaurants, hotels, banking and communication
firms and less likely to invest in pharmaceutical and retail firms compared to hedge
funds.

Activist Strategies When Engaging Target Companies

Hedge funds use the threat of a proxy solicitation as a major weapon. Thirty-nine percent
of the target firms in their sample were involved in either a proxy fight or threatened with
a proxy fight. In almost all cases, the proxy fight was over board representation.

39
Klein and Zur (2006).
27

Activist Motivations

The authors identify two ways in which hedge funds can add value for shareholders.
First, activists can alter the firms strategic policies, through redirections of investments,
including spinning off assets. Second, the activist can reduce agency costs by forcing the
firm to reduce its excess cash holding through increased dividends, higher debt loads
and/or share buybacks.

The most frequently stated purpose in the 13D filings was changing the boards
composition. In the purpose statements, hedge funds demand board representation 26%
of the time, 19% of the time they stated the firm should pursue alternative strategies, 12%
opposed a merger, 10% demanded the firm sell itself, while the remaining incidents were
cash payments, corporate governance issues or punishing the CEO.

Hedge fund activists are more concerned about mergers, stock buybacks and cash
dividends than non-hedge fund activists. Conversely, non-hedge fund activists are more
interested in buying the target firm themselves, becoming an active investor and steering
the firm towards alternative strategic goals than hedge funds. Both groups frequently
demand changes in the composition of the board of directors.

In 60% of the cases, the company agrees to implement the hedge funds demands. In
73% of the cases, hedge funds obtained board representation. There was a 100% success
rate in convincing the firm to buy back its stock, replace the CEO and pay a cash
dividend. In about half the occasions, the hedge fund was able to pressure the firm to
change operational strategies, drop its merger plans or agree to be sold.

Hedge funds waged 18 proxy fights in the study and achieved 13D stated goals 13 times,
a success rate of 72%. For the firms threatening a proxy fight but not carrying one out,
the hedge fund was successful in 62% of the 42 cases. In the 95 cases where there was
no threat of a proxy fight, the hedge fund was successful 57% of the time. The vast
majority of events are over board representation. Of the 155 events, activists were able to
obtain at least one seat on the board 44% of the time.

The authors find no evidence that target firms engage in share buybacks. In fact, in their
sample, the number of shares outstanding per company actually increased by 3.75
million. Also, they found that total assets do not decline after the initial purchase, thus
negating the view that target firms sell or spin-off assets.

Characteristics of Target Firms

Hedge fund targets generally are more profitable than targets of non-hedge funds, have
higher ROE and higher earnings per share, have better balance sheets and have higher
returns a year prior to the 13D filing. Non-hedge fund activists tend to buy companies
with an Altman Z-score indicating a significant probability of bankruptcy. Thus, it
appears that hedge funds target relatively profitable, healthy firms while other activists
28
target lesser-performing companies. There is no statistical difference between hedge
funds and non-hedge funds when comparing data on capital expenditures, R&D and
dividends paid.

Hedge funds do not target turnarounds. Instead, they target firms rich in cash and short-
term investments with low debt. After gaining control of the firms agenda, they increase
debt, reduce cash on hand and pay out higher dividends to shareholders.

Activists target firms across a wide range of industries. However, only 10 were S&P 500
companies. The median assets of targeted companies were $209 million, the average
assets $948 million. The average number of shares outstanding was 38.1 million, the
median was 17.6 million.

Hedge fund targets perform well in the year prior to being targeted, with the average
stock rising 12.4% before the event.

Corporate Operational Outcomes of Activist Campaigns

In the fiscal year following the 13D filing, the mean earnings per share of the hedge fund
target dropped from $0.138 to $0.075, whereas the control group increased earnings per
share. Hedge fund targets experienced a decrease in return on equity of 7.1% while the
control group increased 2.4%. Return on assets declined for the target firm one year after
the event. There is no evidence that cash flows from operations fall, nor is there any
significant change in R&D and capital expenditures.

There is strong evidence that hedge fund activism reduces agency costs of excess cash.
Cash dramatically fell a year after the 13D was filed. Dividends rose on average $0.116
while the median increase was $0.10. Debt levels also rose significantly after the hedge
fund investment.

Returns

The median and mean returns of hedge fund targeted firms 30 days prior to the filing and
5 days after were 5.0% and 7.3%. Over a period 30 days before and 30 days after the
announcement (-30, +30), the median and mean returns were 8.9% and 10.3%
respectively, which is statistically significant at the 99% confidence interval level. The
control group demonstrated 0.0% and -0.3% median and mean returns over the (-30, +5)
day period, and 2.0% and 2.9% over the (-30, +30) day event horizon. The non-hedge
fund group experienced respective returns of 3.5%, 4.3% and 6.8%, 5.2% respectively.
Thus, hedge fund targets generate higher rates of return than both non-hedge fund
activists and non-activists.

Stocks tend to start reacting at day -15 and rise into day 0. Market reaction tends to
flatten out around day +5, then begins to rise again through day +30.

29
The authors concluded that hedge fund activism is primarily an exercise of hedge funds
pressuring corporations to increase dividends, and funding the increase with cash on hand
and debt. There was no statistical evidence any other strategy adds value.

Greenwood and Schor
40


Greenwood and Schor constructed a database of activist events by cross referencing
Schedule 13D and proxy filings by activists from the EDGAR database with 13F filings
from the third quarter of 1993 to the third quarter of 2006. This limits the database
somewhat as only managers with assets of greater than $100 million have to file a form
13F.

13D filings by investors holding a position for investment purposes only non-activists,
the majority of filers were used as a control group. In total, the authors documented 990
distinctive events. More than half the hedge fund events occurred in 2003 or later, while a
third of hedge fund events came between 1994 and 2000. There were 139 unique hedge
funds that initiated 784 events while 38 unique non-hedge funds initiated 196 events.

Greenwood and Schor noted that non-hedge funds often engage in activism without filing
SEC documents, and instead negotiate with management privately.

Activist Strategies When Engaging Target Companies

Greenwood and Schor delineated nine categories of activist demands

1. The intention to engage management (41% of events)
2. Capital structure issues (9% of events)
3. Corporate governance issues (27% of events)
4. Business strategy issues (5% of events)
5. Strategic alternatives (3% of events)
6. Calling for a sale of part or the entire company (17% of events)
7. Blocking a proposed merger or acquisition because of unfavorable pricing (6% of
events)
8. Financing and bankruptcy issues (2% of events)
9. Intention to engage in a proxy contest (8% of events)

Events do not add up to 100% since investors may have more than one demand.

Characteristics of Activist Funds

The median position was held for 1.5 quarters by hedge funds compared to seven quarters
for non-hedge funds. The median assets under management for a hedge fund was $838

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

30
million. The median position size was $16.4 million, representing 7.8% of the targets
shares outstanding.

Characteristics of Target Firms

Activist targets tend to have similar characteristics. They are in the bottom 30% of size,
have little or no analyst coverage, are cheap relative to book value and have
underperformed relative to others in the industry. Hedge funds tend to target smaller
firms more so than non-hedge funds. The median target firm underperformed slightly in
the year prior to activism but significantly underperformed firms in its industry. There
tended to be a fair amount of activist activity concentrated within industries.

Corporate Operational Outcomes of Activist Campaigns

The authors concluded that apart from an increase in leverage and a decrease in capital
expenditures, there were no statistically significant changes in operating metrics. Return
on assets, operating return on assets, cash flow, dividends, growth in assets and growth in
sales showed no significant change in the time frame from one year prior to the 13F filing
to one year after. Leverage increased 42% and capital expenditures declined 14.8%.
Cash flow increased 49% but was not statistically significant.

Returns

The authors suggest that hedge funds are better at identifying undervalued companies,
locating potential acquirers for those companies and removing opposition to a takeover.
The majority of firms not acquired but instead owned by activist hedge funds do not earn
average abnormal returns statistically distinguishable from zero, neither around the
announcement date nor over the long-term.

In the 10 day period before the 13D filing and 5 days after, activist demands to engage
management, an asset sale, blocking a merger and a proxy fight all generated statistically
significant positive abnormal returns, with asset sales generating the highest excess return
of 6.8%. All other activist demands generated positive returns but were not statistically
significant except for changes in strategy, which generated negative excess returns.

In the period one month before the filing and 18 months after, for the entire sample, the
excess return was 10.3%. J ust under 7% of the excess return occurs after the third month,
meaning that the market initially under-estimates the effect of the activist campaign.

Every single one of the nine activist demands generated positive excess returns 18
months after the filing, ranging from a low of 3.5% for capital structure issues to 21.0%
for blocking a merger. However, only blocking a merger and asset sale generated a
significant t-statistic above 2.0. Corporate governance generated an excess return of
13.8% but with a t-statistic of 1.6, while proxy fights earned 14.9% with a t-statistic of
1.5 and strategic alternatives generated 12.6% with a t-statistic of 1.2. The t-statistic for
31
the entire survey was 3.4. Thus, the authors conclude that activists add value only
through asset sales and blocking mergers.

When constructing abnormal returns, unlike the studies by Brav et al and Klein and Zur,
the authors did not compare the target companies to matching stocks based on size,
industry and book valuation. Compustat accounting data was available for only half the
firms in their sample over the time period of their study. Instead, they constructed a
matching portfolio based on Fama and Frenchs three factor market return model, where
the difference between the target and the matching portfolio is regressed against beta, the
small cap effect and the book-to-price effect.

The authors detailed 16 possible outcomes which can be broken down into four broad
categories

1. Asset sale related (32% of outcomes)
2. Capital structure (3%)
3. Corporate governance (17%)
4. Other (6%), comprised of an activist cutting the position to below 5% (4% of
outcomes) and the company involved in a financing/bankruptcy agreement (2% of
outcomes).

There was no news for 42% of the events.

The only broad category that generated statistically significant positive abnormal returns
were asset sale related events. The cumulative abnormal return from 10 days before the
13D filing to 5 days after (-10, +5) for an announcement of an acquisition or the
completion of an acquisition was 5.55%, and for one month prior to the 13D filing and 18
months after (-1, +18), the excess return is 25.7%. A company that spins off a division
(which is included in the capital structure category) generated statistically significant
abnormal returns of 6.4% in the (-10, +5) day time frame but lost 3.4% in the (-1, +18)
month time frame. The study does not address the issue of the spun company, which may
be held by the activist manager after the spin-off. Companies that have been spun off
have been shown to generate abnormal excess returns.
41

Companies where there was no
news also generated statistically significant excess returns in the (-10, +5) day time frame
of 2.3% but generated no excess returns in the (-1, +18) month time frame. Share
repurchases generated excess returns of 30% over (-1, +18) months but the results were
not significant.
Boyson and Mooradian
42


The paper by Boyson and Mooradian covers the period from 1994 to 2005, and included
418 separate activist events involving 111 hedge funds, 89 hedge fund companies and
397 target firms. The year with the largest number of activist events was 1997. Boyson
and Mooradian created a control group by matching similar characteristics to the targets.

41
The McKinsey Quarterly. 1999 Number 1. pp16-27.
42
Boyson and Mooradian (2007).
32

Boyson and Mooradian differ from the other studies in that they measured the effect of
activism on total hedge fund returns. The study also differs in that they identified the
date when the 13D was filed (the filing) and when the hedge fund first became
involved with the target company (the event) by searching the Lexis-Nexis and Factiva
media databases.

Activist Strategies When Engaging Target Companies

Boyson and Mooradian delineate activist hedge funds three ways. Communication
only funds are those that hold the company for investment purposes only.
Communication then aggressive are funds that file a 13D then state their purpose at
least 30 days after the filing. Aggressive funds are all others. Of the 418 filings,
communication only accounted for 270 events, communication then aggressive 49 events
and aggressive 99 events.

In 75 cases, activism was ongoing by the end of the study. In 221 cases, the hedge fund
signaled the activism was complete. In the remaining 122 cases, the target firm
disappeared from the sample due to a merger, going private, being purchased by the
hedge fund, or any other reason.

Activist Motives

There were 148 events that were not communication only, of which hedge funds
proposed 365 actions. At the end of the study, 50 were still ongoing. Of the 315
remaining suggestions, the motives of the funds were as follows

1. Capital structure changes (23 completed actions, 7.3% of the total). Funds asked
for a general change nine times and were successful on six occasions, partially
successful once and failed twice. On two occasions, the fund suggested an
increase in dividends, once failing and once meeting partial success. On 11
occasions, a buyback was requested, with the target agreeing six times, partially
agreeing once and failing to act four times. Once, a fund requested a debt
restructuring and the company declined. In total, 52% of the time, the hedge fund
succeeded in initiating capital structure changes, partially succeeded 13% of the
time and failed 35% of the time.
2. Operational changes (40 completed actions, 12.7% of the total). Hedge funds
requested a general change twice, failing once and succeeding once. On four
occasions, the hedge fund requested a spin-off. The company agreed to do so
three times and did not do so once. On 34 occasions, the fund requested a merger,
and was successful 68% of the time while failing 32% of time. In total, fund
managers were met with success 67.5% of the time when requesting operational
change and failed 32.5% of the time.
3. Sale of the company (40 completed actions, 12.7% of the total). On 23 occasions,
the fund requested a sale and was successful 26% of the time. On 17 occasions,
33
the fund offered to buy the company and was successful 35% of the time. In total,
a sale was successful on 30% of the occasions.
4. Corporate governance (183 completed actions, 58.1% of the total). General
recommendations were successful in two of the four cases and unsuccessful the
other two. On 13 occasions, the fund recommended management be fired and
was successful seven times, partially successful once and failed the other five. On
99 occasions, the fund requested board membership, and was successful in 74%
of the cases, partially successful in 4% of the cases and failed in 22% of the cases.
Funds requested more board independence in 27 instances and were successful on
44% attempts, partially successful on 7% and failed in 48% of the instances. On
15 occasions, the fund asked the company to increase the size of the board and
succeeded 13 times and failed twice. Once, the fund complained about
management compensation and failed. Sixteen times, the fund attempted to
rescind anti-takeover provisions and succeeded in 31% of the cases, was partially
successful in 6% of the cases and failed in 63% of the cases. On eight occasions,
the fund attempted to change voting rules, succeed and failed three times each and
was partially successful twice.
5. Provide financing (17 completed actions, 5.4% of the total). Hedge funds offered
financing to the target and were successful on every occasion.
6. Lawsuit (12 completed actions, 3.8% of the total). Hedge funds were successful
in their legal actions on 75% of their actions and failed the other 25%.

In total, hedge funds were successful 61% of the time, partially successful 6% and failed
33% of the time.

Characteristics of Activist Funds

The mean stake of the company owned by the hedge fund was 12% of the targets shares.
The average dollar holding was $18 million. For communication only firms, the average
holding period is about one year and four months. For all others, the average holding
period was just over two years.

Of the 111 individual hedge funds, 58 only had one target between 1994 and 2005. There
is no evidence that hedge funds which took an activist position in one target firm
outperformed hedge funds that had no activist positions. However, hedge funds taking
aggressive positions in a target significantly outperformed non-activist hedge funds by
7.2% to 11.3%, while hedge funds taking communication then aggressive positions
significantly underperformed non-activist hedge funds by 5.5% to 8.1%.

Hedge funds that have a larger percentage of their assets in activist investments
outperformed hedge funds that did not by as much as 26.6%, while hedge funds that took
a larger stake in their targets outperform by 42.2% to 49.0%.

Characteristics of Target Firms

34
Target companies are generally small cap, value companies. Relative to the control
group, they are cheaper, are slower growing, are as profitable, have a higher return on
assets and throw off more cash. Generally, targets have issued less equity, have a lower
dividend yield, and spend less on research and development and capital expenditures.
Target firms can best be described as cash cows with limited growth prospects hampered
by the agency costs of free cash flow.

Corporate Operational Outcomes of Activist Campaigns

Corporations that were targets of activist campaigns by hedge funds experienced
operational improvements. When comparing companies one year before the filing or
event by the hedge fund and one year after, returns on assets (ROA) improved 6.0%, and
was statistically significant at the 10% level. For changes in cash flow as a percentage of
assets, targets experienced an increase of 8.4% a year after the event or filing compared
to a year prior, and was statistically significant at the 5% level. There were other changes
in operational characteristics between the target companies and the control group, such as
changes in leverage and dividend payout. No other metric was statistically significant.

Over the same time period, ROA improved 7.7% for communication only firms, and was
statistically significant at the 1% level. For aggressive targets, ROA improved by 24.7%,
and was statistically significant at the 5% level.

When looking at motives driving ROA improvements, targets changing their capital
structure (which usually meant targeting free cash flow) saw a 22.7% improvement in
ROA, and was statistically significant at the 1% level. Targets receiving financing saw a
decrease of 37.9% in ROA, also statistically significant at the 1% level. (Many targets
receiving financing were on the verge of bankruptcy). Governance related activities
generated a 32.1% improvement in ROA, statistically significant at the 5% level.
Operational improvements saw a 54.4% improvement in ROA whereas the sale of a
company experienced a 12.3% improvement, both significant at the 10% level.

When looking at motives driving cash flow as a percentage of assets, targets improving
corporate governance experienced a 38.1% increase, significant at the 5% level.
Operational improvements experienced an increase of 57.7%, significant at the 10%
level. Financing experienced a 44.1% decrease, significant at the 1% level.

Returns

Within 25 days of either the filing or event to 25 days after the filing or event (-25, +25),
the cumulative abnormal return ranged from 8.9% to 16.5%. Using a (-10, +10) day time
frame, the excess return ranged from 6.8% to 8.7%. Using a (0, +2) day time frame, the
excess return was 2.1% to 2.3%. Using a (0, +10%) day time frame, the excess return
was 3.2% to 5.6%. Using a (0, +25) day time frame, the excess return was 2.3% to 6.9%.
All results were statistically significant at the 1% level, except for the (0, +25) day time
frame, which was statistically significant at the 1% to 5% level.

35
Results by style of activism varied widely. Communication then aggressive firms
generated abnormal excess returns of 11.6% in the (-25, +25) day interval, and was
statistically significant at the 10% level. Aggressive firms, however, dramatically
outperformed as excess returns were 25.1% in the (-25, +25) day interval.

When measuring excess returns over the (-25, +25) day interval by motives, with the
exception of corporate governance, none of the motives generated statistically significant
returns. However, all returns were better than the benchmarks, with excess returns as high
28.7% for capital structure changes and 25.1% for changes in operations. The only
motive that was statistically significant was corporate governance, which generated
excess returns of 38.5%, and was significant at the 5% level.


Other Studies

Brecht, Franks, Mayer and Rossi

Brecht, Franks, Mayer and Rossi (2006) were given complete access to the dealings of
the activist program funded by Hermes, the pension plan of British Telecom and the Post
Office.
43

The paper studied shareholder activism over the period 1998-2004 by the
Hermes UK Focus Fund while having access to all public and private communications by
Hermes.
The Fund invested in 41 companies between October 1, 1998 and December 31, 2004.
There were four to eight new investments per year with an average holding period of 491
trading days. Of the 41 investments, 30 were actively engaged, three companies were
invested shortly before December 31, 2004 and engagement had not begun, and eight
were sold relatively quickly after the initial investment as the stocks rose due to
exogenous events. There were 98 events for the 30 engagements, averaging just over
three per company. Over half were engaged with other executives and stakeholders. In
more than 80% of the cases, Hermes contacted other shareholders. Sixteen companies
had generated bottom quartile returns six months prior to the investment.

Shareholder activism was undertaken predominantly through private interventions as
opposed to shareholder proposals, such as letters to the board and executives, meetings,
site visits, soliciting of support from other investors and occasional press campaigns, but
few interventions at public meetings. In all the annual meetings attended by Hermes, the
manager posed a question or added an item to the agenda only once, and in only two
cases did Hermes solicit votes against management. Hermes voted against management
four times in extraordinary meetings, but the meetings were never initiated by Hermes.
Litigation was rarely used. Engagement rarely was confrontational.

Hermes sought to restructure the company on 28 occasions and was successful 15.5
times. (Partial restructuring was counted as half successful). Selling non-core assets was
an objective 10 times, and they were successful in six. There were 10 engagements

43
Becht , Franks, Mayer and Rossi (2006).
36
where Hermes attempted to impose capital expenditure discipline and was successful 8.5
times. There were 17 engagements to increase cash payouts to shareholders, and they
were successful 11.5 times. There were eight engagements to improve operational
activities, and they were successful every time.

The fund generated abnormal annual returns of 4.9% net of fees over the holding periods
of their investments. The mean abnormal return in the seven day window around the
announcement date of the engagement was 5.30% and the median return was 3.69%. The
largest excess return, 6.6%, was associated with restructuring activities. Changes of CEO
and chairman generated excess returns of 6.0%. Confrontational engagements generated
mean abnormal returns of 6.07% (median 5.73%) while collaborative engagements
generated 3.96% (2.78%) excess returns. Collaborative investments were held for a
median of 352 trading days, confrontational engagements 875 trading days. Of the 38
companies bought and sold, absolute returns on individual holdings ranged from -66% to
+158%.

Bratton

Bratton examined 130 activist events by 104 companies identified in the business press
from 2002 through J une 30, 2006.
44
Bratton substantiates the findings of the other papers
though his conclusions regarding the efficacy of activism as a strategy were less strong
than the papers cited above. However, Brav et al opined that Brattons paper was useful
anecdotal evidence but cover[s] only a small percentage of events [and does not]
examine returns, performance or cross-sectional variation in any detail.
45


According to Bratton, activism is focused on four strategies selling the company at a
premium, spinning off or selling a significant asset, cash payments to shareholders and
altering the business plan.

Most activists did not pressure management to engage in brutal cost cutting. Nor did
managers engage in highly leveraged restructurings on a large scale similar to the
leveraged restructurings of the 1980s. In fact, whenever cost cutting has been a reason
for activist involvement, SG&A expenditures actually rose on both a median and mean
basis. However, ratios of R&D fell fairly significantly, though in more than half the
cases, actual R&D expenditure rose.

When agitating for a sale, activists search for smaller, weaker, underleveraged firms
within a concentrating industry. Activists search for cash rich firms that would be able to
distribute cash payments to shareholders. Activists tend to target underperforming
companies at the beginning of the engagement but by the end, most targets were
outperforming.


44
Bratton, William W. Hedge Funds and Governance Targets. Working paper presented at Vanderbilt
University. October 13, 2006.
45
Brav, J iang, Partnoy and Thomas (2006).
37
Most activists are not hostile. In hostile cases, 18% of the engagements never went past
the initial stage, with the funds public presence by itself inducing target management to
make concessions. In 82% of the hostile cases, activists were able to engineer a
successful outcome of some kind. Of the hostile engagements, 39% were mid or large
cap companies.

In the full sample, 63% of the activists still held at least a 5% position at the end of the
time period. In another 19% of the cases, the target was either sold or went bankrupt.
Approximately 80% of the activists had retained a significant position in the target
company at the end of the sample. The ratio is roughly similar for those that were
purchased at least a year beforehand.

Large cash payouts had been made by a minority of firms and borrowing was the mode of
finance in only a small number of payout cases. For activists seeking a cash payout,
target firms tend to be larger than the sample for all activist targets. Seventy-four percent
of large and mid cap companies made cash payments in response to pressure while only
26% surrendered board seats. Thirty-two percent of companies paying cash did so with
cash on hand. The remaining raised cash in other manners, such as selling assets the
most popular choice future cash flows or borrowings.

Activists tend to be biased towards small-cap companies. The percentage of shares a
fund holds in a given target is negatively correlated with the targets market cap.

Target stocks rose on average 36% per year compared to 23% for the market. However,
returns are somewhat skewed by five of the 104 observations. Excluding those five (all
of which were friendly), the total average return was 123% versus 120% for the market.
On a weighted basis, the total return of the universe was 110%. For companies that were
sold, returns were 31% compared to 30% for the market. For companies that merged,
returns averaged 18% versus 21% for the market.

Risk is higher for the target companies, with the average beta 1.24 and the weighted
average beta 1.37.

Others

Akhigbe, Madura and Tucker (1997) found that there were strong valuation effects for
firms following shareholder activism.
46

46
Akhigbe, Aigbe, J eff Madura and Alan L. Tucker. Long-term Valuation Effects of Shareholder
Activism. J ournal of Applied Financial Economics, vol. 7. pp567-73. 1997.
The valuation effects accumulated to 23% on
average by the end of the third year following shareholder activism over the 1985-1992
time period. This study included public pension plans and investors who were not public
pension plans. The specific activities included requests to obtain board seats, elimination
of board seats, replacing board members, adding independent board members, replacing
top management, divesting businesses, forcing managers or directors to fulfill their
fiduciary duties, capital restructuring, revising allegedly false financial information,
revising acquisition strategies and improving overall performance. On average, the
38
cumulative abnormal return for the first year after the proposal was 9.27%, 8.24% during
the second year, and 5.54% in the third.

Activist managers have become more successful at pressuring boards to adopt
shareholder-friendly policies.
47
Though the number of proxy fights has remained flat, the
percentage of dissident victories has increased to 59%,
48

up from 48% in 2005 and 40%
in 2001. Investment bankers believe the biggest reason for the activists success has been
because of Sarbanes-Oxley, as restrictions arising from Sarbanes-Oxley have injected a
dose of caution, conservatism and even nervousness into boards, and have heightened
shareholders awareness. Sharply rebuked after the Enron and WorldCom debacles,
boards now tend to react more quickly to shareholder concerns, which plays into the
hands of activist hedge funds.
In a study of 98 proxy fights without an accompanying takeover bid from1988 to 2000,
Faleye (2005) discovered that target firms hold 23% more cash than similar non-targets.
49


He also reported that after a proxy fight, excess cash holdings significantly decline, most
prominently in the form of special cash dividends.
Cremers and Nair (2004) concluded that a portfolio which bought companies with a high
takeover vulnerability and shorted companies with a low takeover vulnerability when the
level of institutional ownership was high generated annualized excess returns of 10%-
15%.
50
Similarly, a portfolio long stocks with a high level of institutional ownership and
short stocks with a low level of institutional ownership and few takeover defense
mechanisms generated annualized excess returns of 8%. Excess returns were statistically
zero if either a high level of institutional ownership or a high vulnerability to a takeover
was absent, meaning the two situations worked well together but did not work with
statistical confidence separately. Also, the authors concluded that the effects were most
pronounced for smaller firms, and when the level of debt relative to the capital structure
was low. The paper was a follow-on to the works of Gompers, Ishi and Metrick (2003)
who concluded that, over the time period 1990 through 1999, a portfolio of 1500 stocks
which bought firms with the highest level of shareholder rights and sold firms with the
lowest levels of shareholders rights generated an annualized abnormal return of 8.5%.
51


Gillan, Hartzell and Starks (2003) concluded that greater board independence is found in
firms that are less exposed to takeovers.
52

47
Hahn, Avital Louria. Retaking the High Ground Investment Dealers Digest.

http://www.iddmagazine.com/idd//NYTSStories/nytsstories.cfm?id=12644&issueDate=current. J une 5,
2006.
48
As of mid-2006.
49
Faleye, Olubunmi, Cash and Corporate Control. J ournal of Finance 59, pp2041-2060. 2005.
50
Cremers, K.J . Martijns and Vinay B Nair. Governance Mechanisms and Equity Prices. Yale
International Center for Finance, Working Paper No. 03-15 & New York University Center for Law and
Business Research Paper Series, Research Paper No. CLB 03-09. April 2004.
51
Gompers, Paul A., J oy L. Ishi and Andrew Metrick. Corporate Governance and Equity Prices. The
Quarterly J ournal of Economics 118, pp107-155. 2003.
52
Gillan, Stuart, J ay Hartzell and Laura Starks. Explaining Corporate Governance: Boards, Bylaws and
Charter Provisions. University of Texas Working Paper. 2003.
39
RECOMMENDATIONS

It is recommended that the SBA allocate capital to an activist investment program. A
significant amount of capital should be allocated to effect the overall performance of the
total fund.

Whereas it is standard SBA practice to analyze external investments at the manager level,
it may be best to view the activist governance program as one holistic portfolio of many
stocks rather than a program of fund managers, with the fund managers occupying a slot
and contributing stocks within the holistic portfolio.

Many of the activist funds are highly concentrated, with managers holding as little as one
name in their portfolio, but often with as few as three to five names. Such individual
manager returns will, by nature, be highly volatile. To mitigate this risk, the SBA should
allocate a smaller amount of capital over a larger number of managers rather than a larger
amount of capital over a smaller number of managers.

However, to capture the benefits of a fairly concentrated yet well diversified portfolio, it
is important such a program not concentrate risk, intended or unintended. Thus, such a
program should be diversified along the lines of market capitalization, industry specialty,
geography, and so on.

The biggest risk to the strategy is that it tends towards companies that are small and
undervalued. It takes much more capital to initiate change at large companies than it
does at small companies, and one would not expect an activist manager to be an
aggressive growth or momentum fund manager. Thus, returns will be most correlated to
small-cap value stocks.

Small cap value has generated the highest returns in the US stock market by far this
decade, with the Russell 2000 Value index advancing 142% to the end of October 2007
compared to a 13% gain for the Russell 3000. Historically, periods of outperformance or
underperformance for small cap stocks tend to occur over periods of time measured in
years. The most recent duration of small-cap outperformance has been one of the longest
on record. Thus, it is reasonable to assume reversion to the mean will occur for small-cap
stocks and thus underperformance relative to broad market indices for an extended period
of time. Periods of relative performance of value and growth stocks also occur, but tend
not to be as persistent as the small-cap effect. However, with small-cap value
outperforming small-cap growth by 120% since the beginning of the decade, one would
expect this trend to reverse. This reversal may have already begun as the Russell 2000
Value index has fallen 4.9% from May through October 2007 while the Russell 2000
Growth has risen 8.4% and the Russell 3000 is up 4.3%.

The inherent small-cap value bias poses an interesting benchmark dilemma. Should
activist portfolios, which tend to invest in small-cap value stocks, be benchmarked
against a broad market benchmark? Doing so would create systematic problems in
determining manager skill. How much of the activist managers return depends upon
40
style of market capitalization bias, or does the commitment to the strategy imply an
acceptance that activism represents an opportunity cost of capital which could be
allocated elsewhere in the fund and thus should be benchmarked based on a risk-adjusted
total asset class benchmark?

How do we adjust the risk for the individual manager? Would the SBA hold the same
standard as we would for a broadly diversified manager? For example, is the information
ratio the appropriate risk metric for a manager who holds one stock, or should the
benefits of risk diversification be measured at the portfolio level rather than the manager
level? The information ratio measures both the management of active return and risk
diversification. If the strategy of the manager avoids risk diversification, the information
ratio is an inappropriate metric by which to measure the manager. This problem,
however, can be mitigated by viewing the program as a portfolio of stocks rather than a
portfolio of managers.


CONCLUSION

There is substantial evidence that activist investing generates statistically significant
excess returns. Until recently, there was little academic research regarding activist
investing as a strategy. However, in 2006 and 2007, at least four studies concluded that
activist investing generates returns above the market averages. Though it cannot be used
as a definitive data set, returns supplied by activist managers and a consultant to the SBA
at least suggests that managers can add value using the strategy.

In a survey of other public pension funds that have allocated funds to activist investing,
all were pleased with the results so far, with all saying the managers in aggregate had
beaten their respective benchmarks. However, they also noted the high volatility of
manager returns, which reinforces the notion of hiring several managers when building a
program.

There are few public pension funds engaging in an activist governance strategy. There
may come a time when activist investing becomes popular amongst large pension funds.
Certainly, the new academic evidence supporting the strategy should increase interest
amongst pension funds. If the strategy becomes popular, the risk adjusted returns may
eventually be arbitraged away. There is some evidence that, though returns remain
positive, this is already occurring. Thus, the opportunity for the SBA is probably sooner
rather than later.

CalPERS, which has been a pioneer in activist investing, recently announced it would be
doubling its allocation to the strategy to $10 billion. CalPERS funded several activist
managers as part of its incubator program. Because activism is in its nascent stage, there
are relatively few established dedicated activist fund managers. Thus, the SBA should
consider the activist strategy as part of an incubator program.

41
Given the academic evidence and the experience of other pension funds, it is likely our
consultants would be supportive of an activist strategy. The strategy is fairly new to the
consultants but most of the pension plans surveyed had at least some input from the
consulting community. Though the SBAs consultants have little experience with the
strategy, they have done work on activist investing and have participated in searches.


42
Appendix

US Broad Market
Return Russell 1000 Active Observations
1994 -6.49% 0.39% -6.88% 2
1995 73.64% 37.77% 35.87% 2
1996 25.99% 22.45% 3.54% 2
1997 36.05% 32.85% 3.20% 2
1998 -14.36% 27.02% -41.38% 2
1999 48.31% 20.91% 27.39% 3
2000 18.33% -7.79% 26.12% 4
2001 40.03% -12.45% 52.48% 4
2002 -0.76% -21.65% 20.89% 4
2003 68.84% 29.89% 38.95% 5
2004 22.08% 11.40% 10.68% 6
2005 6.92% 6.27% 0.65% 3
2006 9.29% 15.46% -6.17% 1
US Broad Market Composite includes Bayou, Lawndale and Relational, as well as those managers not
specifying a specific market capitalization benchmark, which were Barrington, Pirate, Riley and RLR.

US Small-Cap
Return Russell 2000 Active Observations
2002 32.47% -20.48% 52.96% 1
2003 59.14% 47.25% 11.88% 2
2004 24.15% 18.33% 5.82% 2
2005 21.32% 4.55% 16.76% 1
2006 12.09% 18.37% -6.28% 4
US Small-Cap Composite includes Adam Smith, Blum, MLF, RCG and Shamrock.

Europe
Return MSCI TR Europe Active Observations
1999 17.26% 16.24% 1.02% 1
2000 8.42% -8.15% 16.57% 1
2001 -18.70% -19.64% 0.93% 1
2002 -32.28% -18.09% -14.19% 1
2003 45.89% 39.14% 6.75% 1
2004 19.10% 21.39% -2.29% 4
2005 17.77% 9.93% 7.84% 5
2006 31.45% 34.36% -2.91% 5
Europe Composite includes Absolute, Arlington, Go, Hermes Europe and Knight Vinke. Arlingtons
returns are measured as IRR.

UK
Return FTSE All-Share Active Observations
2000 17.77% 20.98% -3.21% 1
2001 73.70% -9.12% 82.82% 1
2002 7.89% -11.88% 19.77% 1
2003 0.55% -22.12% 22.67% 1
2004 40.77% 28.69% 12.08% 1
2005 16.49% 10.87% 5.62% 1
UK Composite includes Hermes UK.

43
Japan
Return MSCI TR J apan Active Observations
1994 17.09% 21.62% -4.53% 1
1995 21.51% 0.86% 20.65% 1
1996 12.82% -15.38% 28.20% 1
1997 48.45% -23.55% 72.00% 1
1998 18.06% 5.25% 12.81% 1
1999 38.97% 61.80% -22.83% 1
2000 15.29% -28.08% 43.37% 1
2001 6.40% -29.28% 35.68% 1
2002 10.00% -10.11% 20.11% 1
2003 17.66% 36.15% -18.49% 1
2004 25.40% 15.95% 9.45% 3
2005 32.97% 25.63% 7.35% 3
2006 7.65% 6.33% 1.32% 3
J apan Composite includes Sparx, Steele and Taiyo Pacific.

Returns are net of fees.
44


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