Activist Investing Has A Size Problem
Activist investing is no longer a dirty word. The financial crisis was a huge stimulus for cleaning up the public perception of activist hedge funds.
Hedge funds ran by investors like Carl Icahn and Daniel Loeb quickly became heroes as the housing crisis brought to light a gambit of company executives mismanaging their own companies. Finally, minority shareholders felt like they had a much-needed voice.
With that, there's been a big push toward rebranding. We've moved from calling Carl Icahn a corporate raider to an activist investor, and it appears the days of green mailing and corporate raiding have been replaced with constructive criticism.
However, with the bull market running long in the tooth, is activist investing peaking? The Hedge Fund Research Activist Index is up 0.9 percent year-to-date through mid-June, underperforming the S&P 500 return of 2 percent.
Universities are changing their corporate finance curriculum to make dealing with activist investors a core competency. There are historically passive hedge funds getting in on the action by trying their hand at activism.
All this comes as assets under management for activist hedge funds has gone from less than $40 billion in 2009 to over $120 billion today.
There's been plenty of academic studies on how performance starts to fall as a fund's size grows. Finding investable opportunities when you're managing a multi-billion dollar portfolio becomes tough. Warren Buffett famously said in a 1999 Businessweek interview that with less capital he could make more money, noting, "it's a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that."
Many activist investors are doing the exact opposite, boosting their assets and taking on larger companies. Mega-cap companies like General Electric (NYSE: GE), American International General (NYSE: AIG) and General Motors (NYSE: GM) have all found themselves in the activist crosshairs over the last year.
But too big to succeed is real.
One of the largest activists by assets, Carl Icahn, saw his publicly traded investment vehicle, Icahn Enterprises (NYSE: IEP), cut to junk by S&P earlier this year. It's lost over 35 percent of its market value in the last year.
Icahn is not alone. Bill Ackman had a dismal year in 2015, with his Pershing Square Capital losing 20 percent and already being down another 20 percent in 2016 as of mid-June.
By default, activists look to take a sizable stake in companies to have enough influence to effect change. When you're forced to invest in companies with massive market caps, your options for unlocking shareholder value is limited - a break-up isn't as simple, a buyout isn't as easy and rallying fellow shareholders becomes tougher.
One of the biggest issues is group think. The rise of hedge fund protégés is only exacerbating this issue. Bill Ackman's most prominent protégés include the likes of Mick McGuire and Scott Ferguson. Scott Ferguson runs Sachem Head and has co-invested with Pershing Square in the likes ofZoetis (NYSE: ZTS) and Air Products (NYSE: APD).
Meanwhile, Marcato Capital ran by Mick McGuire has had to change its investing strategy after growing assets under management to over $3 billion. So instead of taking on companies with hidden real estate value, which is McGuire's speciality, his fund is largely invested in Bank of New York Mellon (NYSE: BK).
Carl Icahn's most well-known protégé is Keith Meister, who started Corvex Management in 2010. Corvex has moved on from investing in smaller companies in the services sector to pushing for a buyout of Pandora (NYSE: P).
With more money and fewer opportunities, we're also seeing a lot more overlap when it comes to targets. Multiple activists are showing up as shareholders of the same company.
Embattled healthcare stock Valeant Pharmaceuticals (NYSE: VRX) calls both activist investors Pershing Square and Jeff Ubben's ValueAct Capital as shareholders.
Corvex Management pushed ConAgra (NYSE: CAG) to buyout Ralcorp in 2013, only to see Barry Rosenstein's JANA Partners get involved last year and convince the company to sell off the very business it purchased just a few years ago.
Yum (NYSE: YUM) was being targeted by both Dan Loeb's Third Point and Meister's Corvex Management last year, unbeknownst to the both activists.
The list goes on, but part of what's being overlooked by activist naysayers is that there's still plenty of opportunity in the smaller-cap space, where corporate mismanagement runs rampant.
Wynnefield Capital, a small-cap activist that targets stocks under the $500 million market cap mark has managed to generate an annualized return of 14 percent since inception in 1992. Wynnefield is currently in a battle with Omega Protein (NYSE: OME) for a board seat and has previously pushed for the company to sell itself.
Then there's Engine Capital, which manages right at $100 million. The fund was up 8 percent in the first quarter as they've recently pushed Sparton (NYSE: SPA) to explore strategic alternatives.
Smaller funds, which inherently focus on small-cap stocks, are still putting up strong numbers. It'll be interesting to see exactly how a bear market flushes out many activists that have gotten too big for their own good. But, for now, hedge funds that have kept their asset growth in check are having inherently more success than their mentors.