Corporate Research E-Letter No. 57, January-February 2006
THE NEW RAIDERS:
HEDGE FUNDS TAKE ON CORPORATE AMERICA
by Philip Mattera
Some scenes from the front lines of corporate control in the United States today: A hedge fund called Pershing Square Capital Management tried to force McDonald’s to spin off its 8,000 corporate-owned fast-food outlets into a separate company. Pressure from hedge-fund investors led to the ouster of two top executives at debt-laden power producer Calpine Corp. and prompted the company to file for Chapter 11 bankruptcy. Dissident hedge-fund shareholders won three seats on the board of Bally Total Fitness and came close to ousting chief executive Paul Toback, who continues to be publicly castigated by the funds. Hedge funds won concessions from Time Warner after pushing for radical restructuring at the company.
In addition, a hedge fund called Cerberus Capital Management was the leader of a consortium that acquired the Albertson’s supermarket chain for nearly $10 billion. Cerberus is also part of a group that is reported to be the leading bidder for a majority stake in finance giant GMAC being shopped around by its parent General Motors Corp.
Hedge funds, investment vehicles for rich people that once were little known to the public, now seem to be on a crusade to shake up corporate America in order to achieve the inflated returns that their clients have come to expect. As happened with the corporate raiders of the 1980s, this upheaval could end up having serious consequences not only in the executive suites but for workers and communities as well.
THE HEDGE-FUND GOLD RUSH
The aggressive moves by hedge funds are a marked departure from the way that these investment pools traditionally operated. Hedge funds have been around for decades, but they customarily were passive investors that rapidly moved into and out of a variety of stocks and other financial instruments in order to achieve maximum profit. Their low profile was not just a matter of the personal preferences of their often idiosyncratic managers. One way that hedge funds escaped the kinds of regulation imposed on mutual funds was that they did not openly solicit investors. You had to travel within certain circles—moneyed circles, that is—to know even where to find them. And once you found one, the fund would usually not even consider taking your business unless you had a minimum of $1 million to invest and were willing to lock up your money for an extended period.
Hedge funds are set up as limited partnerships with no more than 99 investors. They got their name from the fact that they traditionally took short positions on stocks to benefit from downturns in the market. But over the past two decades, a hedge fund has come to mean any kind of unregulated private investment partnership in which the manager takes a hefty share of the profits. Freed from Securities and Exchange Commission oversight—as well as the need to provide detailed reporting to their own clients—hedge fund managers employ not only short selling but also exotic financial instruments such as derivatives that can be highly risky but can pay off big.
During the 1990s there was a hedge-fund gold rush. Hordes of young investment professionals left the stodgy confines of Wall Street and opened their own hedge funds. No longer satisfied with the prospect of becoming a mere millionaire at a brokerage firm, these hotshots saw the chance to become multimillionaires (hedge fund managers typically keep 20 percent of their investors’ profits as well as a management fee of 1 percent of assets). Their heroes were hedge-fund operators such as George Soros, Michael Steinhardt and Julian Robertson, who earned fantastic sums managing billions of dollars in investments.
Hedge fund mania was also seen among investors. Many individuals who were merely affluent rather than truly wealthy clamored to be admitted to the hedge fund club. Institutional investors also jumped on the bandwagon, beginning with university endowments. The nest eggs of Ivy League schools such as Harvard and Yale, large to begin with, grew to unprecedented levels after investing in hedge funds. Soon some pension funds, which were supposed to be cautious investors, started doing the same.
The dream of unlimited wealth was shattered in 1998, when a hedge fund called Long-Term Capital Management—which had used $2.2 billion in assets to acquire financial positions with a value of more than $1 trillion—was on the verge of collapse. Concerned that a failure of this magnitude would weaken the entire financial market, the Federal Reserve intervened by putting together a group of investment banks that bailed out the hedge fund and its rich investors. Two years later, leading hedge funds managed by Soros and Robertson closed up shop after facing huge losses.
Events such as these tarnished the reputation of hedge funds but did not result in a stampede among their clients. In fact, the sluggish performance of the stock market in the wake of the dot.com collapse made affluent investors even more interested in the extraordinary returns that hedge funds seemed to offer. By 2005 there were an estimated 8,000 hedge funds in operation with total assets thought to be in excess of $1 trillion.
Despite the hype in the business press about funds pulling in annual returns of 40 percent or more, many hedge funds have struggled to outperform the stock market. Looking for the big score, some have turned back the clock to the financial maneuvers of the 1980s. Rather than simply engaging in financial plays, they are using their holdings in companies to press for corporate restructuring to pump up the stock price or in some cases are buying out the firm entirely in order to reshape it. Corporate managers find themselves being targeted by a new generation of raiders and buyout artists.
ICAHN REINVENTS HIMSELF
In one instance, it is a member of the old generation who is on the attack again. Legendary corporate raider Carl Icahn—who once used junk bonds to take on the likes of Texaco, TWA, Uniroyal and USX—is now operating as a hedge fund manager. He recently used his client’s money (along with those of other funds that are supporting him) to mount that challenge to the management of Time Warner. Given his reputation, Icahn commands a higher share of the profits (25 percent) and a higher fee (2.5 percent of assets) than the hedge-fund norm.
In the past, Icahn and other raiders sometimes went beyond challenges to management and ended up owning and running companies. One of the first hedge fund managers to pursue this approach aggressively was Edward Lampert, who took over the bankrupt retail chain Kmart in 2003 and a year later combined it with Sears, which he also acquired. Another empire builder is above-mentioned Cerberus Capital Management, a hedge fund with more than $16 billion in assets that has acquired more than two dozen companies. An October cover story in Business Week estimated that Cerberus controls firms “that ring up at least a combined $30 billion in annual sales, more than McDonald’s, 3M, Coca-Cola, or Cisco Systems. With more than 106,000 employees, Cerberus companies have a bigger payroll than Exxon Mobil Corp.” Former Vice President Dan Quayle is a top executive of the fund.
As hedge funds gain control of entire companies, they may begin to exhibit behavior like the previous generation’s corporate raiders and leveraged buyout operators such as Drexel Burnham Lambert and Kohlberg, Kravis, Roberts & Co. These wheeler dealers sold off assets, restructured the remaining operations and did anything else necessary to extract the maximum financial benefit from their holdings. That frequently meant plant closings, mass layoffs, demands for wage and benefit concessions from workers, and seizure of pension plan assets. During the 1980s, such moves resulted in major struggles against the takeover artists by affected communities and union members.
So far today, the response to the hedge-fund maneuvers from outside the corporate suites has been muted. One situation in Canada, however, may be a sign of turmoil to come. The United Steelworkers union has been taking steps to block Algoma Steel from complying with a demand from New York-based hedge fund Paulson & Co. that it pay out C$400 million to shareholders (the largest of which is Paulson). The union argues that the payout would “threaten Algoma’s economic viability.” The issue will soon be heard in Ontario Superior Court.
NOTHING MORE THAN SKULLDUGGERY
Unions (and others) have every reason to be wary of hedge funds. Recent months have seen a wave of scandals involving these investment pools. Last March, the SEC charged Palm Beach-based KL Group with “massive fraud” that included making false statements about its investment record and sending bogus account statements to investors. In September, the founders of the Bayou Group pleaded guilty to federal fraud charges after their $450 million fund stopped communicating with investors over the summer. A few weeks later, the SEC filed suit against Wood River Capital Management, claiming that its manager deceived his investors by failing to disclose that the fund’s holdings were highly concentrated in a single rapidly sinking stock. In December, hedge funds run by Millennium Management LLC and four of the firm’s top executives agreed to pay $180 million to settle charges that they violated trading rules.
Examples such as these suggest that many of the extravagant performance claims of hedge fund managers are nothing more than skullduggery. The ability of federal regulators to address such abuses seems to be limited to the most egregious cases of fraud. The SEC has taken a limited step toward broader regulation by requiring hedge funds for the first time to simply register with the Commission and provide basic information about their managers, but much more is needed. Both vulnerable workers and gullible investors need stronger protection from this latest form of cowboy capitalism.