Activist hedge fund returns all over the map

The gap between the highest and lowest returns of activist hedge fund managers so far this year is more than 23 percentage points, a range that institutional investors will have to get used to as they continue their activist investment spree.

Sources said the unique investment approach of activist hedge fund managers — whose raison d'etre is to persuade public companies to make operational or balance sheet changes to increase shareholder value — consistently produce a wider dispersion of returns than is typical among a small group of hedge fund managers.

Analysis by Chicago-based Mesirow Advanced Strategies Inc. found that the spread tracked by its hedge funds-of-funds research team averaged 25 percentage points per calendar year back to 2005, said Terra Fuller, vice president and head of hedged equity.

Pensions & Investments' comparison of year-to-date returns of eight of the largest activist hedge funds used by institutions showed a 23-percentage-point difference. For calendar year 2012, the difference was 34 percentage points; 2011, 24 percentage points; and 2010, 33 percentage points.

The best performing hedge fund in P&I's ranking was Trian Partners Ltd., managed by Trian Fund Management LP, which returned 24.3% year-to-date through Aug. 31. The worst activist hedge fund performer was Pershing Square International Ltd., managed by Pershing Square Capital Management LP, which scraped by with a 1.1% return year-to-date Sept. 13. (Activist hedge fund returns are difficult to come by and reporting dates tend to vary widely.)

“There always is a lot of dispersion in the returns of activist hedge funds because of their idiosyncratic investment styles,” said Ms. Fuller.

The idiosyncrasies arise from the corporate targets in which individual managers choose to take stakes and the degree to which each campaign for change is successful.

Well-publicized activist hedge fund campaigns, both collaborative and aggressive, that have been waged or still are ongoing this year include Pershing Square's large bets on J.C. Penney Co. Inc. and Herbalife Ltd.; JANA Partners LLC's entanglement with Canadian fertilizer giant Agrium Inc.; Third Point LLC's push for changes at Sony Corp.; and ValueAct Capital Management LP's engagement with Microsoft Corp.

Activist hedge fund investment styles broadly incorporate four tools to increase value for shareholders of public companies:

• executive and board-level leadership changes;


• financial engineering focused on improving a company's capital structure through stock buy-backs and other transactions;


• operational and process changes to cut costs or raise efficiency levels; and


• corporate investment banking to facilitate acquisitions, spinouts and other structural changes.

“Activists all use every one of these tools to push a company to do what's needed to raise the share price,” said Alex Da Costa, director, hedge fund research and consulting, in Pavilion Advisory Group Ltd.'s Montreal office.

“Activists will do whatever they can to win, and because their strategies are event-driven, the extent to which they are successful explains the lumpiness of their return streams,” Mr. Da Costa said.

“A lot can happen in a very short time in activist hedge fund campaigns and that characteristic brings with it the potential for high, erratic volatility,” said Stephen L. Nesbitt, CEO of alternative investment consultant Cliffwater LLC, Marina del Rey, Calif. Because of that risk, “we size activist investments for our (institutional) clients differently — at just half the size of a normal hedge fund allocation,” he said.

Mesirow's Ms. Fuller said portfolio construction also plays a huge role in driving activist hedge fund returns, hinging on the investment concentration in individual corporations; whether the portfolio is net long or hedged with short bets; and the capitalization and geographic ranges of the investment strategy.

“There have been tremendous headwinds against short-sellers this year, with performance on the short side being driven down by the bull market. Activist hedge fund manager returns have benefited from market beta — a bull market raises all boats,” she said.

Returns of the top three managers in P&I's universe of activists were above the 16.2% return of the S&P 500 index year-to-date Aug. 31, but most of the managers lower on the shortlist still benefited from beta production in their investments.

“Activist returns this year are not that differentiated from those of the S&P 500 this year. It's not a good time to take a top-down look at activist hedge funds because quite a bit of their returns can be attributed to the market,” Pavilion's Mr. Da Costa said.

“Because they invest in public companies, there naturally is a lot of beta embedded in activist hedge fund strategies,” Mr. Nesbitt from Cliffwater stressed.

While hedge fund managers occasionally collaborate on campaigns, Mr. Da Costa said “there is little commonality in activist portfolios,” which further contributes to differentiation in returns.

But even as activist hedge fund managers tend to eschew each other's holdings, hoping to score most of the profits from their campaigns, other money managers “often follow an activist manager into a stock” because of the growing credibility of the activist space, Mr. Da Costa said.

“There can be phenomenal pops in share prices within a single day's trading when an activist investor reveals a big stake in a company. The market recognizes the value of activist shareholder involvement,” Mr. Da Costa added.

The reputational advantage of the surviving group of activist hedge funds — many firms got out of the space after the financial crisis in 2008 — creates a huge barrier for would-be entrants, agreed Ms. Fuller and Mr. Da Costa.

“Success begets success” as activist hedge fund managers gain experience, build up an enviable track record of campaign wins and returns, and find themselves with a wider sourcing network for the companies they target, Ms. Fuller said.

“Reputation, size and track record: these three criteria are so important to manager selection,” Mr. Da Costa stressed.

“For a space that's done relatively well for a long time, there are few new entrants and new fund launches,” said Harlan Zimmerman, senior partner at hedge fund activist manager Cevian Capital, London.

“There are big barriers to entry,” Mr. Zimmerman said, primary among them the need for “a big base of stable capital right from the start in order for the manager to begin to take large enough stakes in a company to have sufficient influence.”

“It's a simple fact that bigger activist investors get better deals, larger stakes and higher returns,” Mr. Zimmerman said.

Cevian Capital manages $12 billion in its second activist hedge fund, Cevian Capital II, which is closed to most new investment. “We are in the mode of accepting only replacement capital now,” Mr. Zimmerman stated. n