DOES HEDGE FUND ACTIVISM FACILITATE MORE EFFICIENT CAPEX REALLOCATION?

7/28/2019 DOES HEDGE FUND ACTIVISM FACILITATE MORE EFFICIENT CAPEX REALLOCATION?

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DOESHEDGEFUNDACTIVISMFACILITATEMOREEFFICIENTCAPEXREALLOCATION?

MagdalenaSmithMagdaleneCollege

TheCambridgeJudgeSchoolofBusiness

EMBAIndependentProject

March2013

ABSTRACT

In2007therewereover75hedgefundsintheUSalonethatwerededicatedtoaneventdrivenactivist-styleofinvesting.Togethertheymanagedmorethan$50

billioninassets.SincethattimehedgefundswiththistypeofinvestingstylehaverapidlybeengrowingacrossEurope,Asia,SouthAmericaandAustralia.Intheperiodof2007and2008aloneUScompanieswereconfrontedwitha30%

increaseinthenumberofdemandsfromactivistinvestors.Howevertheknowledgewepossesastowhataffectsthesetypesofinvestmenthaveonfirms

islimited.

Weaimtoaddtothedebateastowhetherhedgefundeventdrivenactivist-styleofinvestingcreatesvalueinthelongtermbyfirstlylookingatwhetherhedgefundsthroughtheiractivitiesfacilitateachangetofirmsCAPEXreallocationbetweendivisions,andsecondlyatwhatthisdoestoreturnsandCFROI.By

doingsowearenotsimplylookingataccounting-basedmeasuresofoperationalefficiency,butanalyzingtheefficiencyofcapitalallocation.

Ifhedgefundswereindeedshort-termfocusedonewouldexpecttheshareprice

toimprove,butnooperationalimprovement.

ByshowingalackofimprovementinCFROIasaresultofhedgefundCAPEXreallocation,weareaddinganargumenttotheclaimthathedgefund

interventionsdonotcreateanyadditionallong-termvalue.

*WethankCreditSuisseHOLT,andinparticularBryantMatthews,forprovidinguswithaccesstotheHOLTdatabaseandcontinuesmoralsupport.FurthermorewethankProfessorWeiJiangofColumbiaUniversityforsharingherandherteamsdataon2001-2007Scheduled13Dfilings.TheauthorhasbenefitedfromdiscussionwithNicky

FergusonofCambridgeUniversity.AfurtherthankyouisespeciallydedicatedtotheadviceandsupervisionofAssistantProfessorPeterSzilagyi,ofCambridgeUniversity.


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INDEX

1.Introduction

2.LiteratureReview

2.1Whatismeantbyhedgefundactivism?

2.2Doeshedgefundactivismcreatevalue?

2.3InternalCapitalMarkets

3.Datacollection

3.1Sampleofactivismcasesandpeers 3.2Operatingperformancemeasurement

4.Examplesofactivism

4.1RowanCompanies

4.1.1History

4.1.2Activism

4.2TempleInland

4.2.1History

4.1.2Activism

5.Methodology

5.1CapitalResourceAllocation

5.2CFROIandStockReturns

5.3RegressionAnalysis

5.4CompanyCharacteristics

5.5ActivistCases

6.Analysis

6.1CapexReallocationFindings

6.2RelationshipbetweenDLCandCFROI

6.3RelationshipbetweenDLCandReturns

6.4TargetCharacteristics

6.5Limitations

7.Conclusion

8.Bibliography

9.Appendix


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1.INTRODUCTIONIn2007therewereover75hedgefundsintheUSalonethatwerededicatedto

aneventdrivenactivist-styleofinvesting.Togethertheymanagedmorethan$50billion in assets. Since that time hedge fundswith this type of investing style

haverapidlybeengrowingacrossEurope,Asia,SouthAmericaandAustralia.In

theperiodof2007and2008aloneUScompanieswereconfrontedwitha30%

increase in the number of demands from activist investors1 . However the

knowledgewepossesastowhataffectsthesetypesofinvestmenthaveonfirms

islimited.

Recentresearchshowsthatthesharepriceperformanceintheimmediateperiod

following hedge fund activism announcements produce significant abnormal

returnsofaround7% for thetargetfirms(KleinandZur,2009) (Tirole,2006)

(Clifford,2007)(GreenwoodandSchor,2009)and(Bravetal.,2008).Thesame

cannot be said for other forms of activism, in the case of large institutional

shareholderactivismforexampleKarpoff(2001)andRomano(2001)goonto

showthatlittleimpactismadeonfirmperformance.

Yet thedebate astowhetherhedge fundsthrough theiractivismcreate value

overalongerperiodoftime,orwhethertheirinterventionsonlygeneratevalue

intheshorttermis stillthrivingwithClifford(2007),Bravetal.,(2008)and

Brav, Jiang and Kim (2011) showing some slight improvements to operating

performanceintheyearsfollowingintervention.GreenwoodandSchor(2009)

on the other hand go on to argue that the outperformance that hedge funds

generatedepends on their success atgetting targets firms takenover.This in

turnproviding adouble benefit to the hedge fundby firstlygeneratingahigh

premiumandsecondlyallowingthehedgefundtoexitincashorstockinamore

liquid company, however no further value creation was shown. Others even

argue that this short-term outperformance is at the expense of long-term

prospectsforthefirms.

1DamienPark,CEOofHedgeFundSolutions,http://www.finalternatives.com/node/3808


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In this researchwe aimto add to thedebate as towhether hedge fund event

drivenactivist-styleofinvestingcreatesvalueinthelongtermbyfirstlylooking

at whether hedge funds through their activities facilitate a change to firms

CAPEXreallocationbetweendivisions,andsecondlyatwhatthisdoestoreturnsandCFROI.Bydoingsowearenotsimplylookingataccounting-basedmeasures

ofoperationalefficiency,butanalyzingtheefficiencyofcapitalallocation.

Lookingatthetypeofobjectivesandactivitiesthathedgefundactivistsengage

inmanyof them look to implythat they facilitate changeswithintarget firms

that that in can turn lead to internal capital reallocation. These include the

following:

UsingameasureGuedj,HuangandSulaeman(2009)callDeviationfromLagged

Capital allocation (DLC) and defined as a deviation in fractional capital

allocation across business segments relative to a passive benchmark our

researchlooked toseewhethercompanies targetedbyhedgefundactivismin

2007 did in deed re-allocate more capital between divisions than peer

companiesnottargetedbyhedgefundsinthesameperiod.

Furthermore,we looked atthe relationship betweenDLC and CFROI, andDLC

andReturns.Ifhedgefundsareindeedshort-termfocusedonewouldexpectthe

sharepricetoimprove,butnooperationalimprovement.

Our results did not show any evidence of hedge funds improving capital

allocation efficiency. When investigating the relationship between DLC andCFROIusingpooledordinaryleastsquareregressionswithaone,twoandthree


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year lagged DLC our findings imply that every $ that target companies

reallocated resulted in lower CFROI improvements for each of the three

individualyearsfollowingthereallocationincomparisontopeers.

By showinga lack of improvement in CFROIas a result of hedge fund CAPEX

reallocation,weareseeminglyaddinganargumenttotheclaimthathedgefund

interventionsdonotcreateanyadditionallong-termvalue.

Furthermore, taking market conditions of the period 2007-2009 into

consideration, which exhibited a pattern of continues reduction in both the

number ofM&A deals occurring and the value of the completed transactions,may in turn give support to Greenwood and Schors (2009) claim that the

outperformancethathedgefundsgeneratedependsontheirsuccessatgetting

targetsfirmstakenover.

Whenlookingatreturnsourfindingsshowedthatfirmstargetedbyactivistsalso

performed worse in terms of annual returns for the period 2007-2011 in

comparisontopeers,withtheaverage2007-2011returnforthetargetsample

resultingin27.49%,whilepeerswereshowedreturnsof0.74%.Thisisnotto

saythatwewouldoppose(KleinandZur,2009)(Tirole,2006)(Clifford,2007)

and (Brav et al., 2008) findings, which claimed that not only did hedge fund

activismannouncementsproducesignificantabnormalreturnsofaround7%for

the target firms in the short term, but that no reversal was foundduring the

subsequentyear.Insteadwewouldarguethatduringtheperiodof2007-2011

andtheextrememarketconditions,companyspecificriskplayedasmallerrole

thansystematicrisk,leavingourtargetpeergroupmuchmoreexposedtoshare

pricepressure,giventheircompanycharacteristics.

2.LITERATUREREVIEWThis section introduces theoretical research that is relevant to this paper,

includingresearchrelatingtohedgefundactivismbylookingatwhatismeantby

hedgefundactivismandwhatroletheyplayincreatingvalueforshareholders.


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Secondlyitwillreviewliteratureoninternalcapitalmarketallocation,asthisis

of great interest when looking into whether hedge funds do in fact facilitate

capital redeployment, and if so why theymight bemore or less successful in

doingsothanCEOsorinternalmanagers.

2.1Whatismeantbyhedgefundactivism?

There isa number of interventions that shareholders have at their disposal if

theyaredissatisfiedwiththeperformanceofafirmrangingfromshareholders

votingwiththeirfeetandsellingtheirholdings(Parrino,SiasandStarks,2003)

toforcingthroughtakeovers.Earlierformsofinvestoractivismwouldperhapsbe best explained by Jensen and Rubacks (1983) definition as investors or

institutions holding largedebt or equitypositions in a company and actively

participating in its strategic direction. The argument for why this definition

would best explain earlier forms of investor activism is because it does not

significantly highlight the part of investor activism that not only actively

participates in a companys strategic direction, but directlyopposes it and its

management. Jensen and Rubacks definition might best define the type of

activiststhatBethel,LiebeskindandOpler(1998)lookatincludingasampleof

money managers, banks, pension funds and insurance companies that held

larger blocks in firms and wouldactivelywork towards asset divestiture and

share repurchases, andwhich are sometimes seen as the closest ancestors to

todays hedge fund activists (Brav et al . 2008). Cliffords (2007) further

contributestothedefinition,byincludingthepotentialthreatoftakingoverthe

target,bringingusclosertothetypeofactivismthatweshallbelookingatinthis

paper.

So what type of events might such hedge fund activist get involved in? The

classificationofeventsasinitiallystatedbyhedgefundsprovidedbyGreenwood

andSchor(2009)andBravetal.(2008)areverysimilar.Theseinclude:

EngagementwithManagementasaresultofthestockbeingundervalued. CapitalRestructuring,includingrestructuringofdebt,recapitalization,

dividendsorstockbuybacketc.


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ChangestoBusinessStrategysuchasbusinessrestructuringandspinoffs,operationalefficiencyandM&Aactivity.

Governanceissues,includingoustingCEOorChairman,addressingBoardindependenceandchangestoexecutivecompensationstructures.

SaleofTargetCompany,eithertothirdpartyorthroughabuyoutwithasignificantproportionofthefirmsbeingtakenprivate.

Itisworthnotingthatnotonlydotheactivistoftengetinvolvedinmorethan

onetypeofactivityinagivenfirm,buttheyalsooftenchangetheirinitialplanas

they gain further information about the organization and depending on

managementsresponse.

Hedge funds use a variety of both non-confrontational and confrontational

tactics toachieve the objectives stated above, suchas; bycommunicatingwith

boards/managementsonaregularbasiswiththegoalofenhancingshareholder

value;byseeking boardrepresentationwithout aproxyorconfrontationwith

theexistingmanagement/board;byformalshareholderproposals,orpublicly

criticizingthecompanyanddemandingchange;usingthreatorlaunchingproxy

inordertogainboardrepresentationorevenbytakingcontrolofthecompany

throughtakeoverbids.Whenhearingofhedgefundactivismmanyassumethat

mostuseconfrontationaltacticstoachievewhattheywant.Thiswouldinbethe

wrongassumptioninaccordancewithBechtetal.(2007).Bravetal.(2008)go

ontoshowthatonly13.2%ofhedgefundsgoontolaunchaproxyand4.2%go

ontotakingthefirmover.

Beitthatthereisnoformaldefinitionofwhatconstitutesahedgefund,Partnoy

and Thomas (2006) present four characteristics by which hedge funds are

generallyidentified.Thefourbeingthefollowing:(1)theyarepooled,privately

organized investment vehicles; (2) they are administrated by professional

investment managers with performance-based compensation structures and

significant investments in the fund; (3) they are not widely available to the

public; and (4) they operate outside of securities regulation and registration

requirements.


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Forthesakeofthispaperwewillnotbelookingatbywhatgeneralmeanshedge

fundsoperatedifferentlytootherinvestmentinstitutions,butforoneaspect

thefeestructure.Themostcommonfeestructureamongsthedgefundsinvolvesa 2% fixed annual fee based on assets under management and a 20%

performancebasedfeedependentonthefundsannualreturn.Thisfeestructure

will prove to be of significancewhen later looking at motivational factors in

relation to CEOs and line managers in the companys targeted by the hedge

funds.

WhenresearchinghedgefundactivismmanyhavechosentogodownthepathoflookingatmandatorySchedule13Dfilingsinordertoidentifycasesofactivism,

theseinclude;KleinandZur(2009),Tirole(2006),Clifford(2007),Greenwood

and Schor (2009) and Bravetal. (2007). This is also thepath chosen for this

paper. Scheduled 13D reports must be filed with the SEC by any investor

exceeding 5%ownership in a publically traded company. This must be done

withintendaysoftheownershipexceeding5%,butonlyiftheinvestorintends

toinfluencethemanagementofthefirm.Thereportalsorequirestheinvestorto

identify their reason for acquiring the shares. Exactly how the scheduled13D

filingsareusedinthispaperwillbeexplainedinthesectiononmethodology.

2.2Doeshedgefundactivismcreatevalue?

Opinions as towhether hedge funds through their activism create value vary

greatly.Therearealsofutherquestionastoforwhomandwhattypeofvalue

theymightcreate.Theopinionof themanonthestreet ismoreoften thannot

thathedge fundsare short termed and onlyhave theirown interestsatheart

(Anabtawi,2006)(Bainbridge,2006),whichoftengoesdirectlyagainstwhatisin

thebestlongterminterestforthecompany.

Incontrasttoresearchdoneon largeinstitutionalshareholdersactivism,which

went to show little impact on firm performance (Karpoff, 2001 and Romano,

2001) or improvement in their operations (Wahal, 1996 and Gillan & Starks,

2000),Bravetal.(2008),foundthatcompaniestargetedbyhedgefundactivism


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showed a share price outperformance of 7% shortly following activist

announcements, and that this did not reverse in the year to follow. Similar

findingshavebeenshownbyClifford(2007)andKleinandZur(2007).Target

firmswerealsoshownexperiencealimitedincreaseinoperatingperformance.However,thisalonemaynotbeenoughtopersuadetheskepticsastothevalue

thatthehedgefundcreatestoothersbutshort-termshareholders.

There isalsoaparalleldebate,whichnotonlylooksatvaluein termsofshare

priceorfirmperformance,butincludestherolethathedgefundsplayasauseful

toolofcorporategovernanceandasvaluablemonitoringagents.Majorityofsuch

researchisfocusedaroundissuesrelatingtousageofshareholderproposalsandproxyprocesses.Bebchuk(2005);HarrisandRaviv(2008)andRenneboogand

Szilagyi, (2009) go on to show that there is indeed a benefit to begained by

hedge fund intervention of this form. While the main arguments against as

provided by Woidtke (2002), Anabtawi (2006), Prevost, Rao, and Williams

(2008)goontoclaimthattheproposalsthatsuchinvestorsmakeonlyenhance

theirownself-servinggoals.

Unfortunately, very limited quantitative research has been done as to show

explicitlyhowhedgefundsmightgoaboutandcreatevaluebyothermeansthan

proposals and proxies. This ismainly due to the limiteddata that is available

throughdatabasessuchasCompustatandthefactahighproportionofhedge

fund targets are taken private resulting in these also being taken off such

databases.However,someresearchhasbeendoneontheseissuessuchasfor

example Greenwood and Schor (2009) arguing that limited if any value is

created, as activists are primarily concerned with having the target acquired.

Theirresearchhoweverislimitedbynotlookingatthevaluethatmaybecreated

in these companies once they have been taken over by a more suitable

management.

On the other hand, Brav, Jiang and Kim (2011) using plant-level information

showedthatatypicalfirmimprovesitsimprovesitsproductionefficiencywithin

twoyearsofactivism.Furthermorebyfollowingplants thatweresold ofafter


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the entry of the hedge fund activist they also found that efficient capital

redeployment is one important channel through which activists can and do

createvalue.

Thislastpieceofresearchmaybeofmostrelevanceto thispaperasitaimsto

lookatcapitalredeploymentbylookingatchangestoCAPEXandwhetherthis

maybeageneralchannelbywhichactivistcreatevalue.

2.3InternalCapitalMarkets

InaMcKinseyarticle (March 2012)Hall,LovalloandMusters claimthatmost

companiesallocatethesameproportionofresourcestothesamebusinessunitsyearafteryear leading tounder-performance.However,companies thathad a

higherrateofcapitalredeploymentwouldoverafifteen-yearperiodoutperform

theirpeersbysomefortypercent.

Whymightthisbesignificant?Whentalkingaboutcapitalre-allocationmostof

usassociatethistothebillionsre-allocatedthroughthecapitalmarkets.Guedj,

HuangandSulaeman(2009)showedthatforeveryyearoverthelasttwenty-five

yearsUScapitalmarketshaveissuedabout$85billionofequityand$536billion

incorporatedebt.However,duringthesameperiodtheamountallocatedorre-

allocatedwithinmulti-businesscompanieswasapproximately$640billionper

year.

Furthermore, they find that when looking at conglomerates that firms that

activelychange theircapital allocationacross industries have a loweraverage

industry-adjustedprofitabilitythanfirmsthatfollowpassivestrategies.Thisis

duetotheinefficiencywithwhichthistypeofre-deploymentisdone.

Althoughsuchefficiencyhasbeenquestionedforaconsiderableamountoftime

(Alchian1969andWilliamson1975),notallresearchwouldclaimthatinternal

capital re-allocation tends to destroy value. Williamson (1975), Stein (1997,

2002) arguing that in a well functioning internal capital market more active

allocationmayinfactcreatevalue.


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However,alotoftheliteraturelooksatwhethersuchawellfunctioninginternal

capitalmarket is in fact possible. What may stand in itsway are the power

struggleswithinafirmandpersonalincentivesthatCEOsanddivisionmanagers

mayhold(Rajan,ServaesandZingales,2000),(Wulf,2008),(Ozbas,2005).

In his 2002 publication Stein looks at the type of information that might be

available todecisionmakers and divides these into softandhard information.

Softinformationbeinginformationthatcannotbedirectlyverifiedbyanyone

otherthantheagentwhoproducesit,whilehardinformationbeingverifiable

information.CEOsmainlyhavehardinformationattheirdisposaltounderpin

theirdecisions. Although it ismost likely true thatCEOshavemore access toinformation relating to the prospects of internal business opportunities than

outsideinvestors,theyseemtopossesslessthantheirdivisionalmanagersdue

tothelackofsoftinformation.Ifhedgefundsdidinfactfacilitatemoreefficient

Capexreallocationitwouldbeinterestingtoseehowthiswasdoneandhowit

overcamethehard/softinformationproblem.

3.DATACOLLECTION

3.1Sampleofactivismcasesandpeers

Oursampleofactivismcasesfirstresultedfromalargecollecteddatasetfrom

2001-20072based on Schedule 13D filings. These are mandatory filings in

accordancewithSection13(d)ofthe1934exchangeactandwhichstatesthatall

investors must file with the SECwithin ten days of acquiring a 5% stake, or

above, in a publicly listed company provided that they have intentions of

influencingthemanagementofthecompany.Investorsarealsorequiredtostate

their given objective for buying the stake as part of the filing. The sample

included 236hedge fund activists and 990 independent activist cases for the

period2001-2007.

Therecanbenodoubtthatwearemissingsomesignificanthedgefundactivism

activitybyonlyfocusingonScheduled13Dfilings inourresearch. Apartfrom

hedge funds that sit under the 5% ownership thresholdwe are also missing

2AskindlysharedwithusbyBrav,Jiang,PatrnoyandThomas


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cash-settledderivativetransactions,whichareknownasswapagreementsand

situations where activist are teaming up with other investors to reach their

objectives.

Inthecaseofswapagreementstheactivist investorenters intoamultifaceted

swaparrangementwithaninvestmentback(mayeveninvolveseveral)whereby

thebankbuyssharesonbehalfoftheinvestor.Howeverfullownershipisnot

transferred.Insteadtheactivistagreestorepurchasethesharesfromthebankat

andagreedtimeandprice.Itisnotuntilthispointofownershiptransferthatthe

hedgefundneedstodisclosetheirpositiontotheSEC3.

Investorsteamingupisanalternativeapproachthatisincreasinglygrowingin

popularity. Here we see activists co-operating with not only other activist

investors,butalsowithprivateequitygroupsaswellaswealthyindividualswho

may own a large stake in a company. Together they work towards offering

buyoutsorotherinitiatives.However,suchdataisextremelyhardtoobtain.

Hence, using Compustat we identified all US listed companies in the above

sample that providedsegmentCAPEXdata for aminimal of two divisions4for

eachofyearsthroughouttheperiodfiscalyears2006-2011inclusive.Thisperiod

waschosenduetothelimitedsegmentdatapublishedinCompustatpre2006

thatcontinuethroughoutourgivenperiod,giventhatprovidingsegmentdatais

voluntary.5

Focusing on activism that had been announced in 2007 the above figures

provided us one year of clean data to identify CAPEX re-allocation patterns

withinthefirms,priortohedgefundintervention.Italsoprovideduswithdata

fouryearsafterannouncementtoseeanydevelopmentinCAPEXre-allocation

within the target firms, changes to share prices and changes to target firms

CFROI. Our final sample group of target companies being restricted to 31

3DamienPark,CEOofHedgeFundSolutions,http://www.finalternatives.com/node/38084Thosedivisionsbeingthesamedivisionsthroughouttheperiod2006-20115InaccordancewithSFAS131asissuedbyFSABin1997


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companiesofthe225hedgefundannouncementsin2007duetothelimiteddata

available.

Thereisaclearbiasinthissampletowardssmallercompanies,withonlyoneofthetargetsSprintNextelCorp,havingamarketcapbigenoughtobeincluded

in the S&P 500. Themedian market cap of the sample group being $892.25

million,whichiscomparabletotheRussell2000smallcompaniesindexhavinga

marketcapmeanof$787million.6

Apeergroupwasidentifiedforthetargetcompanysamplegroupbymatching

firmsofsimilarsizeandtwo-digitSICcodesusingCapitalIQ.Againweensuredthat thesecompanieshad the samerequiredsegmentCAPEXdataavailable as

the target sample. This was followed by a manual search in SECs database

EDGAR to ensure that the peer companies were not themselves targets of

activismatanypointduringtheperiod2006-2011,resultinginapeergroupof

95companies.

3.2Operatingperformancemeasurement

For our operating performancemeasurement for both target and peer sample

groups we used CFROI from Credit SuisseHOLTs database. CFROI cash flow

basedreturnmetricisacompetingmetrictoEVA.It'smaindifferencetoEVAis

that it is in the form of an internal rate of return. HOLT has a proprietary

methodologythatconvertsincomestatementandbalancesheetinformationinto

anannualCFROI.

ThekeycomponentsofaCFROIareGrossCashFlow,GrossInvestmentandasset

life.TheGrossCashFlowisaninflationadjustedmeasureofthecashflowtodebt

and equity capital owners. The Gross Investment is the current value of the

assets.Bycomparingthesetwooverthelifeoftheassetsandrecognizingthe

final realizable valueof the non-depreciating assets an IRR can be calculated.

ThereareimportantadjustmentsfromaccountingtoCFROI,suchascapitalizing

leasesandR&Dexpenditures.Consequently,CFROIhasmuchbetterexplanatory

6Source:Bloomberg


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powerthanROE.TheUSdatabasegoesbacktothe1950sandsincethattimethe

averageCFROIhasbeen6%real.Themeasurementisavailableasalong-term

time series for firms and is directly comparable across time and across

companiesregardlessoftheirsectororgeography.

4.0EXAMPLESOFACTIVISM

Inthissectionwepresenttwocasesofhedgefundactivismshowingwhatmay

actuallyoccurinthesecircumstances,lookingatbothhowtheactivistsoperate

and how target companies respond. The cases presented are those of Rowan

Companiesvs.SteelPartners,andTempleInlandvs.Icahn.

4.1RowanCompanies

4.1.1History

ArchandCharlieRowanfoundedtherowandrillingcompanyin1923withone

land-based steamrig. In1954Rowanwas the firstcompany todoperforma

platformmounteddeepwaterdrillingoperation.RowanCompanies(RDC)went

publicin1967andin1970beganjack-uprigdrilling7.

In 1978RDC fended off a hostile take-over,whichmay have still been in the

corporatememoryasthisstoryunfolded.

By 2004 Rowans primary business was the leasing of offshore jack up rigs,

producing60%oftheirrevenues. Atthis timethecompanyowned20Jack-up

rigs,whichaccountedforaround11%marketshareofthe187rigsinthetotal

marketplace8.Theyhadareputationforhighqualityassets.

Rowansfleetexpansionhadbegunin1995afteracquiringthecompanythathad

designed and built all their rigs: Marathon LeTourneau. LeTourneau was

vertically integrated,having amini-steelmill. Apart frombuilding jack-ups it

alsobuiltheavyequipmentfortheminingandforestrymarket9.

Through2004RDCalsohadanaviationbusiness,Eraaviation,possessingafleet

of more than 100 helicopters and fixed wing aircraft servicing the industry.

Theseassetsweresoldforcashattheendof200410.

7Source:www.rowancompanies.com

8Source:BernsteinresearchFeb9,20049Source:www.rowancompanies.com10Source:200410Kfiling


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Furthermore, RDC also operated six towboatsunder lease agreements during

2000-2005thatweretobesoldorterminatedduringtheendofthatperiod11.

Rowandoesnothavea greatCFROIhistory,it isclearlyverycyclical anduntil

2005 it had only achieved a return above its cost of capital in 199712

whileconsistentlyincurringnetlossesthattotaledmoretan360mduringtheperiod

1985-199513. The boom in energymarket in the period 2005-2008 produced

significantexcessreturnspeakingcloseto11%butthissoonfadedaway.14

OverthetwelvemonthsendingJune2007RDChadlaggedtheOSXPhiladelphia

Stock exchange oil service sector by 22%15. A Credit Suisse report on the

company,published14June2007entitledWhatsLeTourneauworth?stated

thatLeTourneauwasworth$1.2-1.3bnandwithRDChavinganenterprisevalueof $4.7bn at$39per share, perhaps thiswas enough toattract Steel Partners

interest.

4.1.2Activism

SoitwasinJuly2007thatWarrenLichtensteinsSteelpartnersdiscloseda5.5%

stake inRDC (6,121,827shares)making it the largest shareholder. Itdid not

makeanyspecificdisclosuresonitsintentionsinthe13Dfiling16.

InashareholderletteratthetimeSteelPartnersstatedthat:

Whentryingtoidentifyanundervaluedcompanyorsecurityweusuallylookfor

companies with inefficient capital structures, companies that have allocated

capitalpoorly,orcompaniesthatcanuseoperationalimprovements.

...our real home run of long term sustainable returns comes from the

implementation of operational excellence that can change a culture and

transformacompanyintoaworldclasscompanywithcompetitiveadvantages

andhighreturnoninvestedcapital.

IntheirSeptember2007lettertoinvestors,Steelpartnershadasmallsectionon

Rowan. It said that it began buying shares in April 2007 and owned a6.6%

11Source:200610Kfiling12Source:CreditSuisseHoltDatabase13Asperthe200410K

14Source:CreditSuisseHoltDatabase15Source:Bloomberg16Edgar


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stake. Itpointedoutthatdespitethevolatilehistoryandlimitedvisibilityofthe

businessthatemergingmarketdemandwasresultinginrecordpriceincreases.

Theyendedbystating:

The drilling business generates significant free cash flow, currently at 50%EBITAmargins and the manufacturing business is expected to report record

resultsinthe3rdquarterof2007.Withnetdebtof$128m,EBITDAof$648m,

increasedvisibilityinrevenuesandbacklogdemandforitsrigcomponentparts

Rowanisanattractiverisk/rewardinvestmentwhichwevalueatasignificant

premiumtomarket.

The same letter included a comment on another driller they owned namely,

Pride International. Pride hadmade recent asset sales and focused on deep-waterdrilling. The letter hinted at the need for consolidation. Steel partners

statedattheend...theunderlyingvalueinpridehasyettoberealizednowasit

ismoreofapureplayoffshoredrillingcompany.

On8January,2008SteelpartnersfiledaNoticeofintentiontonominatedirector

candidatesattheRDCscompanys2008AGM17.Managementrespondedtothis

inan8Kfilingon8January2008.DanielMcNease,ChairmanandCEOstated:

"Wehavealwaysmaintainedanopendialoguewithallofourstockholdersand

havelistenedtotheviewsexpressedbySteelPartnersinourconversationswith

them. We are prepared to have a continuing and constructive dialoguewith

SteelPartners. TheBoardofDirectorsregularlyreviewsthevalueinherentin

the Company's business plan, and will continue to do so in a decisive and

measuredway.Whilealengthyanddisruptiveproxycontestisnotapreferable

courseofaction,theCompanyispreparedtodoeverythingnecessarytoprotect

the interests of stockholders consistent with our goal of delivering high

performanceandlong-termstockholdervalue."

Inthe2008AprillettertoSteelpartnerinvestorsitwasmentionedthatthere

had been continuous discussions with Danny McNease, CEO of Rowan the

resulting inthepreventionofanelectioncontestonthebackofanagreement,

whichwas reached on 30March 2008. In return for thewithdrawal Rowan

agreedtomonetizeLetourneau(LTI)bytheendoftheyear.Ifthiswouldnot

17SECEdgardatabase


17/39

happenthenSteelpartnerswouldgetadirectorontheboard.Itwasalsostates

thatifLTIwasmonetized throughanIPOthena$400msharebuy-backwould

occur.OnthedaytheagreementwasannouncedRowansharesmovedup8%.

The next Steel Partners investor letterswas in September 2008. At this timeSteel partners owned a 9.45% stake. Since our negotiated settlement with

Rowaninthefirstquarterof2008,theCompanyhasannounceditsintentionto

sell or spin-off its wholly owned manufacturing subsidiary, Letourneau

technologies,Inc.(LTI)andtorepurchase$400mofstock.TheCompanyhas

reportedstronginterestfromseveralpotentialstrategicbuyersandtheyexpect

toannounceadefinitivedealinthecomingweeks.

Thenthelettercommentsthatdespiteoilbeingup56%sincetheytooktheirstakethestockhassoldoffaggressivelybacktowheretheypurchaseditdespite

afundamentallyimprovedbusinessmodel.Thesectionendsbycommenting

thattheycontinuetoworkwithmanagementtounlockvalue.

ContinuingtofollowthisstorybySteelPartnerslettersbringsustoMarch2009

inthemidstofthefinancialcrisis.SteelPartnersissufferingredemptions,and

gatedthefundinDecembertostabilizeit.SteelPartnersnowdeclaresan8.7%

stakeinRowan,presumablydownduetoredemptions.Onthisoccasionthey

statethatWeinitiallyinvestedinRowan,inpart,becausewebelievedthesale,

spinoff,orothermonetizationofLTIwouldunlocksignificantvalue.

DuetothecrisisRowanwasunabletocompleteitssideofthebargainandSteel

partnersplacedJohnQuickeontotheboard,soontobefollowedbyLarryRuisi

attheMayshareholdermeeting.

InfurthercommunicationwithinvestorsSteelPartnersstate:

We were successful in convincing the company to cancel or postpone

additionalcapitalexpenditureandtheyhaveagreedtolimitthenumberof

newrigstheyarebuilding(cancellingoneanddeferringtwoothers)asthe

demandsideoftheequationhasbeengreatlyreduced.

This followed a surprise announcement by Rowan in November 2007 of six

additionalnewbuildrigsdespiteconcernsofglobaloversupply(therewere80


18/39

jack-upsunderconstruction).Theorderwasfor$1.1bnandadded$645mtothe

backlogofLTIwithanestimated15%savingversusoutsourcing18.

Furthermore,SteelPartnershadbeensuccessfulingettingRowantoadoptlean

practiceutilizingtheSteelPartnersLeanmethodology19

.DannyMcnease,theCEOhadretiredattheendof2008andnowsteelPartners

wasdealingwithW.MattRalls,whowasCOOatGloablSantaFeCorp.

On 15 July, 2009 Steel partners disclosed that its stake had been reduced to

3.8%. The agreement that got Lawrence Ruisi onto the board stipulated a

minimumstakeof5%.Ruisiquittheboard

Jumping ahead toMarch2010, Steel Partnershas restructured into a holding

company. Rowan only gets mentioned in a section saying its stake has beenreduced.

The sale or spin of LTI was still on the cards. W. Matt Ralls in the 2011

shareholderlettersaidthatitexpected2011tooffersuitableconditionstobegin

the process. Later that year the company realized $1bn from the sale of its

manufacturing operations (quitea lot less than Steel partnershad estimated)

anditalsosolditsonshoredrillingoperationsfor$513m.

JohnQuickeremainsontheboard.

SeeAppendixforHOLTchart

4.2TempleInlandcasestudy

4.2.1History

BothTemple and Inland have longhistories, but Temple and Inlandwereput

together inside Time Inc. (TIN) in 1978 and then spun off in 1983as Temple

Inland Inc. The combined firms created a conglomerate that offered financial

services,banking services, includeda real estate portfoliobut also operateda

packagingandforestproductssegment20.

In themid-1990's, though,Mr Temple stepped down from his duties on the

boardofdirectors,and Ithinkweall realizedthatsomethingbighadchanged.

Likeaboatthatlosesitsanchor,thecultureofthecompanybegantodrift,to

18Source:DavidSmith,JPMorgan(2/11/07)19SteelPartnerslettertoinvestorsNov200820Source:TempleInlandwebsite


19/39

changeintoonethatplacedlessemphasisonthelong-termsustainabilityofthe

companyandmoreemphasison quarterly,and thenmonthly,profitsand loss.

Theculturechangedslowlyfromfamilialcompetitivetocorporatecompetitive,

andtherewasadifference21

.

4.2.2Activism

Activist involvement in Temple Inland actually dates back to the start of the

decade when in March 2000 LENS Investment Management made a filing

pushing for TIN tospin-offits bankingand financial servicesdivisionwhich it

claimedwouldimproveitstransparencyandaccountability22.

As a sign of the change at TIN they announced in 2003 Project TIP the

Transformation,InnovationandPerformanceinitiativeisrolledouttoimprove

organizationaleffectiveness,reducecostsandstreamlinecorporatefunctions.23

Afewyearslater,inFebruary2005,Icahnwhohadbuilta2%stakethreatened

tonominatedirectors ina proxybattlebutnothinghappened24.Postedonthe

temple Inland website in 2006 was: "Our technology-driven, low-cost systems

keep our plants operating in the lowest cost quartile, delivering a 37%ROI for

2006."

Twoyearsafterannouncinghis2%stake,Icahnincreasedhisstakethroughthe

5%thresholdandthereforeappearedonouractivistlistfor2007witha13D

filing as at 22/01/2007 and a stake of 6.7%25. On this disclosure the stock

jumped8%to$4526.

Inthe'PurposeofTransaction'sectionofthe13DfilingIcahnstated:

21Source:Changeisintheair...andonthegroundforTempleInlandbyChuckRay,http://gowood.blogspot.co.uk/2012/03/

22Source:BloombergBusinessweekFebruary26,2007

23Source:TempleInland2003AnnualReport.

24Source:BloombergBusinessweekFebruary26,200725Source:BloombergBusinessweekFebruary26,200726'Icahn'sbadbet'byHerbGreenberg,WSJ8thNov2007.


20/39

"TheReportingPersonsacquiredtheirpositionsintheSharesinthebeliefthatthey

wereundervalueddueto,amongotherthings,theconglomeratestructureofthe

Issuerinwhichvariousdisparateandnon-complementarybusinessesarecombined

under onecorporateumbrella.TheReportingPersonsbelieve thatthisstructureobfuscatesthetruevalueoftheIssuer'sassetsandnotethatvariousanalystshave

issued sum of the parts analyses that imply a value for the Shares that is

significantlyhigherthantheircurrentmarketprice.TheReportingPersonsintend

toseektohaveconversationswithmembersoftheIssuer'smanagementtodiscuss

ideas that management and the Reporting Persons may have to enhance

shareholdervalue,whichmayinclude,amongotherthings,thedivestitureorspin-

off of one or more of the Issuer's component businesses (which may includeGuaranty Bank, the corrugated packaging business, timberland holdings, the

buildingproductsbusinessand/ortherealestatedivision).TheReportingPersons

may consider engaging in a proxy contest to attempt to replace one or more

membersoftheIssuer'sstaggeredboardofdirectorswithpersonsnominatedby

theReportingPersons,buthaveasyetmadenodefinitedecisiontodoso."

From the 2006 10K one can see the significance of the financial services

operations:

Inthepreviousthreeyearscapitalexpenditurehadbeen fairly stable ($221m,

$222m, $208m) although 2006 did include a fairly sizeable acquisition in

January of $196m for Standard Gypsum. The company disclosed divisional

assetsandinthe2005/6periodassetshadincreasedinRealEstateandFinancial

servicesby$41mand$90mrespectivelyto$422mand$1,017m.Thereported

GAAPassetsintheForestandtheCorrugateddivisionswereshrunkby$53m


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and$141mto$866mand$2,318mrespectively.Itwouldappearthatthereal

estate and mortgage boom was seducing management to grow these

businesses27.

Icahns13DfilingwasquicklyfollowedupbyannouncingonFriday16February,

thathewouldnominatefourdirectorstotheboardattheAGM 28.Itdidnttake

longforthemanagementtorespond,ason26February,2007TINsaidthatit

wouldsplitintothreepubliccompanies(retainingmanufacturingandspinning

financialservicesandrealestate)committingtosellitstimberlandoperationsby

theendoftheyear.

According toS&Pthespin-offbusinessesaccountfor24%ofsalesand33%of

historicEBIT.

Thesharesmovedup13%onthenewsandclosedaround$63 29.Icahnbought

hissharesintherangeof$39to$4730.AtthispointIcahndroppedhisproxy

threat. He was quoted saying "Temple-Inland's management and board of

directorsshouldbecommendedforlisteningtotheconcernsthatweandother

shareholders have expressed and for announcingplanstotake the actionswe

suggested".

Thestockreachedahighof$65inJuly31andthenasthecreditcrisisemerged

therealestateandlendingbusinessescameunderpressure.

On 10th September Icahn announced hisownership of9.4m shares, an8.65%

stakeresultinginthesharesmovingup4%to$55.6.

Onthe3rdofOctoberIcahnagainannouncedanincrease.Thistimehisposition

hadincreasedfrom8.8%from8.65%,sendingtheshares6%higher.Inthefiling

Icahndeclaredhehadusedderivativeswithnovotingpowertogainanexposure

of5mshares.

27Source:2006annualreport28Source:13Dtracker31/1/07

29Source:BloombergBusinessweekFebruary26,200730Source:www.bloggingstocks.comFebruary26,200731Source:Bloomberg


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The timberland assets of 1.55m acres were sold in October for $2.38bn, the

proceedsinloannotesdue2027.Proceedswereexpectedtobe$1.8bnandTIN

wouldpaya specialdividendof$10.25pershareor$1.1bnand the remaining

cashusedtopaydowndebt32

.

Andyet,thestocksoonfellbackto$45onFriday16November2007,thesame

priceasafterthe13DfilinginJanuary.

Temple-Inland completed the spin-off of its Guaranty Financial (GFG) and

Forestar(FOR)realestateunitson31December.TINclosedtheyearjustunder

$30 and after the spin ownership of one share of TIN including the spun

companieswaswortharound$3233.

Icahncontinued touseoptionsandreportedon15February2008 thathehad

approximatelya9.77%stake.

ByhisQ4200813FfilingIcahnhadsoldoutcompletelyoftempleInlandbut

remainedowningthespincompanies.Icahnownedcloseto10%ofthespun-out

Guaranty Financial trading at $12 per share which ended badly as Guaranty

declaredbankruptcyin thesummerof2009,just fifteenmonthsafterthe spin

off.AtthetimeitwasthetenthbiggestbankbankruptcyinUShistory 34.Itisnot

clearwhetherIcahnmadeanymoneyfromhisinvestmentinTempleInland.

Forestar(FOR)has beenmore successful, although ithas underperformedthe

marketasitsCFROIhasfallenfrom6.5%in2007to3.6%in2011.Todayithasa

sharepriceof$22,amarketcapitalisationof$720mandexpectationsthatCFROI

has troughed and the shares have started outperforming recently35. The final

chapter for Temple Inland story was entered as of the 6th June, 2011when

International paper (IP) made an offer of $3.3bn for TIN. The shares jumped

42%ontheopenandInternationalPaperrose4%.

32Source:2007annualreport33Source:WSJ3/1/2008,Seekingalpha,byHerbGreenberg

34Source:A Time-Ripened Tale of Toxic Assets, a Corporate Spin-Out & a Failed Bank, Nov. 14,2011byK.LaCroix,www.dandodiary.com

35Source:CreditSuisseHoltDatabase


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AdealwasfinallysettledinSeptemberwithafinalofferintheorderof$3.7bn

includinga$105mbreakclause.Atthepointofsaletherewasnoongoinghedge

fundactivisminthefirm36.

SeeAppendixforHOLTchart

5.METHODOLOGY

We are attempting to identifywhether hedge fund activists facilitate internal

capital reallocationthrough their interactionwith firmsand look atwhat this

mightdotothetargetsreturnsinordertoaddtothedebateonwhetherhedge

fundscreatevaluethroughtheirintervention.Wealsolookattwoexamplesof

hedgefundactivitywheretheinitialstatedobjectiveincludedmeasureseffecting

capitalreallocationinordertoseehowthismightbedone.

5.1Capitalresourceallocation

Inordertoseeifhedgefundsdoinfactfacilitateresourceallocationwestartby

lookingatwhetherfirmswherehedgefundshaveopenlystatedtheirintention

to be activeby filling a SEC 13D aremore active in their CAPEX reallocation

betweenbusinesssegmentsthanfirmsthatarenottargeted.

Wemakenoassumptions astowhether aboveorbelowaverage reallocation

activity provides higher operating efficiency (Guedj, Huang, Sulaeman, 2009)

(HarrisandRaviv,1996)(Ozbas,2005).Neitherdowelooktoidentifywhether

anyoneexplicitformofcapitalallocationismoreefficientthantheother(Billett

andMauer, 2003).We aim to identify whether firms targeted by hedge fund

activismin2007aremoreorlessactiveintheirCAPEXreallocation thantheir

peersfortheperiodrunningupto2011.

UsingCAPEXasaproxyprovidesuswiththemostreadilyavailablesegmentdata

togetaquoratethatisavailable throughCompustat.Italsoallowedus tolook

acrossallindustriesunlikeifweweretolooktomeasureimprovementontotal

factory productivity Brav, Jiang and Kim. (2011), which would only allow

36Source:NYTimes6/9/11,MichaelMercedandJeffreyCane


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analysis of firms that have their own production. Ideallywewouldhave also

likedtoincludeananalysisofotherformsofresourceallocationsuchaschanges

toR&D,PPE,humancapitalandfixedassets.Howeverthelackofsegmentdata

wouldhaverenderedthesamplegroupunfitforpurpose.

TomeasureCAPEXreallocationbetweendivisionsweusedacapitalallocation

activeness measure (DLC)37 showing change in fractional capital allocation

acrossbusinesssegmentsovertheperiod2006-2011.

The formula below shows the activeness of CAPEX allocation by looking atfractional allocation by division against the prior year. A firm is active if it

changesrelativepercentageallocationsfromyeartoyear.

ThisisforalldivisionsiinthesetFofdivisionsoffirmfinyeart.Theresulting

DLCisthereforebetween0and1.Themeasurementiscomparedtoapassive

benchmark of the previous year's allocation. If a company adds a division or

removesadivisionwehaveleftthesedatapointsinandcountthemasactive

allocation.

ThisisdifferenttothemethodologyinthepaperbyGuedj,HuangandSulaeman

(2009).TheygiveanexampleofacompanyhavingdivisionsA,BandCinyeart-

1 andB,C,D in year t. In this case they only includeB andC in set F for the

calculationofDLCf,t.

WehavechangedthecalculationtoincludeAasazeroinyeartandDasazero

int-1.Theeffectofthisistoshowthiscaseasactiveallocation.Thereasonfor

37AsintroducedbyGuedj,HuangandSulaeman(2009)whenlookingatinternalcapitalallocationandfirmperformanceamongstconglomerates.


25/39

doingthisistoallowforM&Aandspin-offstobeincludedasresourceallocation.

Thedownsideof thismethod is if the company has simply reclassified rather

thanmadeanactivedecision.Wehavelookedattheexamplestoseewherethis

mightbethecaseandwherefoundwewouldnotcountitintheDLC.

They also state that in case of no common divisions the DLC is defined

missing.Inourdatasetthiscasedoesnotarise.

SuchDLCcalculationsweredoneforeachofthe31firmsinvolvedinhedgefund

activismand95peersfortheperiod2007-2011,allowing for5datapointsfor

eachofthetargetsandpeers.

5.2CFROIandStockReturns

To identify the extent to which a firm creates value through their decisions

related to capital allocation we looked at year-end CFROI as our operating

performancemeasurement,andyear-endStockReturnsforalltargetfirmsand

peersalikethroughouttheperiod2006-2011.WegatheredtheCFROIdatausing

Credit SuisseHOLTs database and thestockreturnsusing closing shareprice

datafromBloomberg.

ThekeycomponentsofaCFROIareGrossCashFlow,GrossInvestmentandasset

life.GiventhelackofsuchinformationonasegmentbasistheCFROIcanonlybe

calculatedonacompanylevel.

Combiningallofthedataaboveprovided499observationsforeachvariableto

beincludedinfurtheranalysis.

5.3RegressionAnalysis

Inordertoformallyinvestigatetherelationshipbetweenfirstly,DLCandCFROI

and secondly, between DLC and returns, I use pooled ordinary least squares

regressions.ThefirstusingCFROIasascalardependentvariableandtheDLCas

an explanatory variable, and the secondusing Returns as a scalar dependent


26/39

variableandDLCasanexplanatoryvariable.Furthermoreaoneyear,twoyear

andthreeyearlaggedDLCwasincorporatedtopredictCFROI,asonewouldnot

expectaneffectonCFROIintheyearoftheintervention.Thesamelageffectwas

addedtoreturnsinordertoseeifchangestointernalcapitalallocationmayhavebeendiscountedinthesharepricepriortotheactualeffectontheCFROI.

Time fixedeffects were included in theregression specification to control for

timevaryingaspectsofthevariationintheindependentvariablenotassociated

with changes in DLC due to activism or otherwise. This being of particular

significance given the turmoil in 2007-08 leading to $8 trillion of US stock

marketwealthbeinglostbetweenOctober2007whenthemarketwasatandalltimehighandOctober200838.

As importantly, the US M&A market has had a very rough ride during the

observedperiodwiththevalueofM&Adealscomingdownfroma$500bnhigh

inQ22007to$100bninQ32009.DuringthesameperiodthenumberofM&A

dealswent down from justunder3000deals inQ2 2007 to 1700deals inQ1

2009. Since then the stockmarket and the number of deals have returned to

theirearlierhighs,butthevalueofthedealsinQ42012hadstillnotreached

above$300bn39.

ThiscouldhaveespeciallyaffectedhedgefundactivistsifGreenwoodandSchor

(2009)areaccurateinclaimingthathedgefundreturnsarelargelyexplainedby

the ability of the activist to force target firms into a take over. A dummy

identificationvariableisincludedintheregressionspecification,whichisequal

tooneifthefirmwastargetedbyahedgefund,andequaltozeroifthefirmwas

not targeted by a hedge fund. This variable controls for any difference is

performancemeasurebetweenthetargetandpeerfirmsnotduetochangesin

DLC.

38Brunnermeier,200939M&AandstockmarketperformancedataascollectedfromBloomberg.


27/39

Interactiontermsarealsoaddedtotheregressionspecificationbymultiplying

theDLC variables and the target firm dummyvariable in order to isolate the

effectofDLCoverandabovepeers.

y!" = b!DLC!" + b!DLC!"!! + b!DLC!"!! + b!DLC!"!! + b!DLC!"!! + b!TD!"

+ b!TD DLC!" + b!TD DLC!"!! + b!TD DLC!"!!

+ b!"TD DLC!"!! + b!!TD DLC!"!! + v! + !"

WhereyitiseithertheCFROIorannualstockreturnsoffirmiattimet.TDisthe

targetdummyvariable.v!arethetimefixedeffectsand!"istheresidual.

5.4CompanyCharacteristics

Characteristicsofthetargetfirmsandpeersrespectivelyarealsoindependently

taken into consideration and the analysis includes looking at averages and

medians of DLC, market caps, debt leverage, CFROI, Returns and Price/Sales

ratios.AWelsht-testwasfurtherperformedontheDLCaveragesandmedians,

whichunliketheStudentst-testisnotbasedonapooledvarianceestimate.

5.5Activistcases

Thereportalsoincludesthedescriptionofthreeactivistcasesandfollowactivity

fromwhen thehedge fundmakes their activist intentions public and through

their period of varying intervention. The information for these cases was

collectedusingFactiva,BloombergandHolt.


28/39

6.ANALYSIS

Aspresentedinsection1thereisavarietyofsituationsinwhichhedgefunds

dedicated toaneventdriven activist-style of investing find themselves,which

couldleadtoCAPEXreallocation(Table1.).Thisbeingthecase,ourpapersets

out to investigate whether companies targeted by hedge fund activism do

reallocateCAPEXdifferently,andwhethertheyseeanybenefitinprofitabilityor

shareholderreturnsasaresultofthisactivistengagement.

Table1.

6.1CAPEXreallocationfindings

Bearinginmindtheaimpresentedabove,wefirstlylookatwhetherhedgefund

eventdrivenactivist-styleofinvestingcreatesvalueinthelongtermbyfocusing

on whether hedge funds through their activities facilitate a change to firms

CAPEXreallocationbetweendivisions.

UsingameasureGuedj,HuangandSulaeman(2009)callDeviationfromLagged

Capital allocation (DLC) and defined as a deviation in fractional capital

allocation across business segments relative to a passive benchmark our

researchlooked toseewhethercompanies targetedbyhedgefundactivismin

2007didindeedre-allocatemorecapitalbetweendivisionsthancompaniesnot

targetedbyhedgefundsinthesameperiod.

When looking at a sample of 31 targeted firms and some 95 peers our DLC

measuresshowedthatthetargetedfirmsre-allocatedlesscapitalthantheirnon-


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targetedpeersforeachoftheyears2007throughtoanincluding2011.Thiswas

particularly statistically significantatthe1% level for the years2008 through

2010 during which time the target firms re-allocated on average 9-10% less

acrossdivisions(Table2).

Table2.

Furthermorewewentontodivide thetargetcompaniesandpeers intoactive,

neutral and passive groups by dividing average DLC for each company and

sorting into the three groupsmentioned abovewith the highest third of DLC

coming into the activegroup etc. (Table 3.)40. This data shows slightlybetter

CFROIperformancefromtargets,butworsereturnsalthoughthesedifferences

were not statistically significantwhen using aWelch t-test. Thereby,we can

neither confirm nor deny Guedj, Huang and Sulaeman (2009) argument that

higherallocationleadstolowerreturns.

Table3.(Thedatawasdividedinto1/3active,neutralandpassiveasdefinedby

averageDLC over2007-2011. The highestbeingthemostactive CFROIchanges.

CFROIChangeiscalculatedasCFROI2011-CFROI2007.Capex/07showsthesum

ofFirmCapexmade2008-2011dividedby2007FirmCapex. Henceusing2007

Capexasabaseyear,above4showsCapexincreasedonaverage,andviceversa.)

40TheconceptfortabletwocamefromGuedj,HuangandSulaeman(2009)


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6.2RelationshipbetweenDLCandCFROI

For the second part of our investigation we were looking to analyze the

relationshipbetweenhedgefundactivistsreallocationofCAPEXanditseffectonCFROI. When investigating the relationship between DLC and CFROI using

pooledordinaryleastsquareregressionswithaone,twoandthreeyearlagged

DLCourfindingsimplythatevery$thatthetargetcompanyreallocatedresulted

in lowerCFROIimprovementsfor eachof the three individualyears following

thereallocationincomparisontopeers(Table4.).However,thedifferenceswere

statisticallyinsignificantforallbutthefirstyearafterreallocation.Whatisclear

is, thatwehavenotshownanimprovement inCFROIasaresultofhedgefundCAPEXreallocation,seeminglyaddinganargumenttotheclaimthathedgefund

interventionsdonotcreateanyadditionallong-termvalue.Wecannothowever

go on to claim that they destroy long-term value due to the statistical

insignificanceofourfindings.

Table4.

Ourfindingsfurthershowthatthetargetsamplehasloweraverageandmedianannual

improvements to CFROI than peers for all but one of the individual years, as well as

throughouttheentireperiodlasting2007to2011(Table5.).Thiswouldgoagainstthe

findingsofClifford(2007),Bravetal.,(2008)andBrav,JiangandKim(2011)allshowing

someslightimprovementstooperatingperformanceintheyearsfollowingintervention

incomparisontopeers.

Table5.


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InBravetal,(2008)theyfindtheaverageholdingperiodforhedgefundactivists

tobe22monthsafterusingform13FholdingsdatafromThomsonFinancial.For

oursamplethatwouldimplythatthehedgefundswerebecomingactiveinthe

companiesin2007andexitinglate2008tolate2009.Thisoverlapswiththeperiod of credit crisis in which share prices saw their low points41. When

lookingatmarketconditionsduringtheseyearsandtheamountofM&Aactivity

intheUS42wenotethatM&Aactivitywasconsistentlygoingdownthroughout

the period starting in Q2 2007, hitting a low in Q2 2009andonly starting to

recoverslightlyinQ32009bothintermsofnumberofdealsandthevalueofthe

completedtransactions.ThismayinturngivesupporttoGreenwoodandSchors

(2009) claim that the outperformance that hedge funds generate depends ontheirsuccess atgetting target firmstakenover.During thisperiod thatwould

have proven significantly harder, as reflected in a total lack of relative

improvementinCFROI.

6.3RelationshipbetweenDLCandReturns.

Whenanalyzing therelationshipbetweenDLCandReturnsthe samelageffect

wasaddedtoreturnsastotheCFROIregressioninordertoseeifchangesto

internalcapitalallocationmayhavebeendiscountedinthesharepricepriorto

theactualeffectontheCFROI.

Again, we found very little evidence to support any statistically significant

increase in returnsas a resultof changes to DLC. However therewere slight

signsofthetargetgroupstartingtoperformbetterthanpeersasaresultofDLC

changes two and three years after the actual change had been implemented

(Table6.).

41Source:Bloomberg42Chart1and2intheappendix.


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Table6.

Furthermorewhenlookingatannualreturns(Table7.)weseethattheaverage

yearonyearreturnswereworsefortargetfirmsin2007and2008bothinterms

of averages and medians. However in 2009 target firms showed a stronger

averageannualreturnof128.69%versusthepeers60.81%andamedianannualreturnof65.52%fortargetcompaniesand39.70%forpeers.Targetedfirmsalso

performedbetterin2010thanpeersonanaveragebasis.Thiswouldlikelyhave

occurredasaresultofthecharacteristicsofthefirmsinwhichhedgefundswere

activeatthetimeandtheextrememarketconditionsduringtheperiod.

Table7.

6.4TargetCharacteristicsAscanbeseeninchart3intheappendix,ourtargetshaveloweraveragemarket

capitalization than thepeers and theirmarket capitalization has a significant

skewtowardssmallercompaniesasshownbythemedians.Italsohasalower

averagedividendyieldwith the same skewasnotedbythemedian company,

whichpaysnodividend.Finally,thetargetgroupdisplaysavaluebiasasshown

bysignificantlylowerpricetobookratio.

Theabovethreefactors,asexhibitedbyourtargetsamplerelativetopeers,go

farinexplainingwhyourtargetsamplegrouphadsuchpoorreturnsin2008and

2011,whilerecoveringin2009.


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Runningup to the credit crisis of2007, stockvolatility and correlationswere

unusually low43,whichwouldhave createdabeneficial environment for stock

picking.That environment abruptlychangedwith the startof the credit crisis

towardstheautumnof2007.Thisresultedincorrelationsandvolatilityreachinglevelsnotseensincethe1930s44,asimilarspikeinvolatilityandcorrelations

wasonceagainwitnessedin2011.$8trillionofU.S.stockmarketwealthwas

lostbetweenOctober2007,whenthestockmarketreachedanalltimehigh,and

October2008alone.

Companyspecificriskwouldhaveplayedasmallerroleintheseextremetypesof

marketsthansystematicrisk,leavingourtargetpeergroupmuchmoreexposedtosharepricepressure,giventheircompanycharacteristics.

6.5Limitations

Therecanbenodoubtthatthemostinfluentiallimitationstoourresearchresult

from lack of segment data, as provided by Compustat and other similar

databases.Asaresultwewerenotabletosubstantiateourargumentbyusing

furtherdatasuchassegmentsales,operatingmarginsandassets,forthesewere

notavailableforenoughcompanieswithinourtargetsamplegroup.

Inordertoseeifsuchdatawouldshowsignificantlydifferentresultfromthose

that we found, we used the Columbia Schedule 13D data goingback to 2001,

matchingthesecasesagainsttheCreditSuisseHOLTdatabase.Wematched51

caseswithdivisionaldata(beitnotdivisionalCAPEXdata).Inordertoanalyse

thesecaseswealsoproducedarandompeersetofcompanieswithdivisional

data matching the data with the year of activist engagement.

Weused the divisionaldataand lookedatoperatingmargin, returnonassets,

asset turns, capex/sales and for the parent company cash/assets and CFROI.

Thetablebelowshows themediansfromthedataon the51activistcasesand

the51matchedrandomsampleofpeers.

43Source:Bloomberg44Brunnermeier,2008


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Source:HoltDatabase

Fromthisitcanbeseenthattheactivisttargetshavehighermargins,lowerturns

andhigherreturnonassetsatthesegmentlevel.However,attheconsolidated

parentleveltheactivistfirmshavelowerCFROI,henceshowingnoimprovement

tothefirm.Thereappearstobelittledifferenceincashheldonthebalancesheet

betweenthetwogroupsthatwoulddistorttheCFROIanalysis.

Theredoesappear tobe someevidencethatthe two-yearchange indivisional

ReturnonAssetsisstrongerfortheactivistgroupbutthisdoesnotshowupin

CFROIimprovements.Therefore,itisdifficulttodrawanyconclusionsfromthis

data. Further work in this area would be beneficial, including statistical

significancetests.

An additional limitation is the lack of segment data pre-dating 2006. For our

researchthismeantthatwecouldnotlookatCAPEXpatternsofthetargetfirm

prehedgefundengagement.

7.CONCLUSION

Weaimedtoaddtothedebateastowhetherhedgefundeventdrivenactivist-

styleof investing creates value in the long termby firstly looking atwhether

hedge funds through their activities facilitate a change to firms CAPEX

reallocation betweendivisions, and secondlyatwhat this does toreturns and

CFROI.Bydoingsowewerenotsimplylookingataccounting-basedmeasuresofoperationalefficiency,butanalyzingtheefficiencyofcapitalallocation.


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Ourfindingsshoweda lackof improvementinCFROIasa resultofhedge fund

CAPEXreallocation, therebyadding anargument to the claimthat hedge fund

interventions do not create any additional long-term value. However, when

lookingatthecasesamplesitisclearthatnotallactivistshavethesamemodusoperandinorobjectives.Assuchitwouldbe interestingto seefutureresearch

lookingatthesedifferenceswhenanalyzingimprovedallocationefficiency.


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9.APPENDIX

Chart1.

Chart2.

Chart3


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DOES HEDGE FUND ACTIVISM FACILITATE MORE EFFICIENT CAPEX REALLOCATION?

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