Delivering Alpha Through Private Equity

The search for returns leads hedge funds to become more activitist in their relationships with the companies they invest in

Tom Price, Counsel, Dechert LLP
Originally published in the September 2006 issue

The search for returns has led hedge funds to become more activist in their relationships with companies they invest in, and to participate in and even take the lead in private equity transactions. Private equity managers recognise the new "competition"; they see more potential deals than they invest in and hedge funds can also be a valuable source of capital.

Although high profile examples such as the takeover of Kmart by funds managed by ESL Investments and the ousting of Rolf Breuer and Werner Seifert from Deutsche Boerse following its attempt to take over the London Stock Exchange garner the majority of attention, less high profile opportunities abound. The benefits must be counterbalanced against the complications associated with such investments – and the ever higher profile of hedge funds in the media increases the risk of such a strategy.

A catalyst for change

Activist investors do not have to take control of a target to generate returns. Most investors are passive, so even a small stake can be an influential catalyst for change. Influence can also be had over an industry – the changes currently underway in the stock exchanges across the United States and Europe mostly feature the same investors.

However being a successful catalyst requires extensive analysis of the advantages and the disadvantages of any particular strategy. Alternatives should be considered and different outcomes contemplated. The business analysis should be flexible, to allow for illiquidity or the target's refusal to cooperate. Support may only come at a price or in exchange for compromising the original plan; and more financial commitment and considerably more time may be required than with a more passive investment. Investors should form advisory teams early, consisting of public relations experts, investment banks, lawyers and accountants to assist. A thick skin may be needed in response to any public criticism.

Sources of information

The first step in any analysis is information. Fig.1 sets out the rules that may be relevant depending on where information comes from.

Insider trading and insider dealing are, broadly, similar in concept (if not in detail or in defences) and, the majority of investors that have previously managed passive funds should be familiar with these. Regulation FD is the relatively recent US rule that requires companies to make fair disclosure of information and not to disclose information to investment professionals (including hedge fund managers) in preference to the market as a whole – even if that disclosure is inadvertent it must be corrected promptly.

Fig 1

Private sources (former executives; investment banks; target) Insider trading and Regulation FD (on fair disclosure) Insider dealing and market abuse
Competitors Market abuse
Other shareholders Proxy rules and group formation Concert parties/market abuse
Public sources Reliability Reliability

The UK's market abuse rules were broad in their scope and the addition of the European Union's Market Abuse Directive have made them broader. They apply not only to sources of information but also the effects on the market of trading (for example where a trade gives a false or misleading impression of the supply, demand or price of an investment). It is also worth noting that in certain circumstances trading in shares of a target on the basis of information from its competitors could constitute market abuse.

If an investor's information is coming from other shareholders, then in the UK the investor and the other shareholders may in certain circumstances find themselves "acting in concert" for the purposes of the UK's Takeover Code, either immediately or at a later stage. "Acting in concert" is when pursuant to an agreement or understanding (whether formal or informal), investors co-operate to obtain or consolidate control of a company or to frustrate the successful outcome of an offer for a company. Under the Takeover Code, which prescribe, among other things, when an investor must make an offer for the target, different stakes of concert parties are combined.

Insider trading and insider dealing are, broadly, similar in concept (if not in detail or in defences) and, the majority of investors that have previously managed passive funds should be familiar with these. Regulation FD is the relatively recent US rule that requires companies to make fair disclosure of information and not to disclose information to investment professionals (including hedge fund managers) in preference to the market as a whole – even if that disclosure is inadvertent it must be corrected promptly.

Fig 2

Target USCustom security; resale restrictions Market abuse, concert party issues with directors, fiduciary issues for target board
Open market purchases Resale restrictions upon becoming an affiliate Insider dealing, market abuse, concert party issues
Founder/insider PResale restrictions and fiduciary issues for target board Resale restrictions on IPOs, market abuse, concert party issues


Sources of shares or stock

Once the analysis of information has been completed, the investment could be acquired from a number of different sources. Many of the same rules that apply to where the information comes from are likely to apply again. However, there are additional issues that need to be considered (see Fig.2).

Two of these points are worth expanding on. First, if an investor acquires significant amounts of outstanding voting securities of an issuer, that investor may be deemed to be an "affiliate" under US rules and become subject to restrictions on re-sales (pursuant to Rule 144 unless another exemption is available). In addition, privately placed securities may not be resold in the markets for a one-year period and thereafter may only be resold in the public markets in limited amounts (depending on issues such as the volume of trades in the issuer's stock). These rules may limit an investor's ability to dispose of the stock in the public markets or to private placements only.

If a board of directors of a target company is involved in the disposal, then they will need to consider the fiduciary duties that they owe. Although these are principally the board's issue, rather than an investor's, they restrict the negotiation opportunities of an investor, so an investor will need to consider them when structuring any particular transaction.

"Short-Swing Profits"
An investor cannot benefit from "short-swing profits" under US rules. This Securities Exchange Act of 1934 rule requires officers, directors and 10% owners of an issuer's securities that engage in a purchase and sale (or sale and purchase) of the issuer's equity securities within a 6 month period to disgorge any profits to the issuer. The rule imposes a strict liability standard and does not require proof of intent. This prohibition covers all types of equity securities of the issuer, and therefore a purchase of common stock can be matched to a sale of preferred stock made within six months prior to or after the purchase of the common stock. These restrictions on short-swing profits may restrict or have an impact on an investor's investment program.

Notification limits

Activist investors will normally acquire more substantial stakes in companies they are seeking to influence than passive investors. A number of rules exist that require investors to disclose their interests – depending on the amount or percentage of the target company acquired.

From a UK perspective, the main rules we are concerned with are the Takeover Code and the Companies Act rules on notification of interests. The Takeover Code bites twice: first if a target company is already the subject of an offer, then every 1% bought or sold has to be notified; secondly, if an investor and anyone "acting in concert" with that investor (see above) acquire 30% of a company, the Takeover Code requires them to offer to buy the whole company. The Companies Act requires investors to notify a company when they have an interest of more than 3% in it (and when they acquire or dispose of another 1% thereafter). In the US, there is no compulsory obligation to offer to buy the whole of a company. However, the detailed notification requirements remain somewhat more complicated.

Hart Scott Rodino

Prior to an investor acquiring more than (currently) $56.7 million of the voting securities and assets of a target company, then Hart-Scott Rodino filings with the US Federal Trade Commission and the Department of Justice may be required. The exemption applicable to those who are making an investment only (i.e. not to take part in business decisions) is unlikely to be available to activist investors. When the rules apply, the investor will be precluded from making acquisitions (but not dispositions) of the voting securities of the target issuer until after expiration of a waiting period (30 days but which may be terminated earlier).

SPACS – Opportunities in publicly traded acquisition vehicles
SPACs are special purpose acquisition corporations that are formed around a proven management team. A SPAC has no operations until a "business combination" is effected through the acquisition of an operating business or assets. They start with an IPO consisting of a mixture of ordinary stock and warrants (combined into units). The units, stock and warrants are publicly traded, in the US usually over the counter and the UK on AIM. The IPO will usually raise money from institutions, and hedge funds have become significant investors. A fraction (say 8%) of the IPO proceeds pay for transaction costs, and the remainder is placed in trust with an established commercial bank. Sharehold-ers then approve a business combination (within a defined time period, say 12 to 18 months) and the trust funds are then released. Management usually receive a "carried interest" through different equity instruments. Hedge funds are already seen investing in SPAC IPOs. But there are also opportunities for effecting exits through SPACs, as it can be a useful vehicle through which to obtain operational control of the target and leverage returns. Although traditionally SPACs were target non-specific, the right combination of investor and management team are generating the potential for launching SPACs with specific targets in mind.
Coexistence, not Competition?

Private equity funds and other private buyers need capital and hedge funds have capital and an appetite for risk. Using a judicious combination of different instru-ments, including subordinated debt, unsecured debt, paid-in-kind (PIK) notes and bridge finance, can increase the chances of acquisitions being successful.For the equity investor, the risks are increased, but the flexibility gained in pricing can be substantial. Can the target finance the offer, what are the prospects for refinancing and should the PIK convert into equity and when? A hedge fund buying the debt may find itself holding the equity if the acquisition fails, so it would need to consider whether it has the right skills to manage the target and plan any potential exit.

Schedule 13

Schedule 13 of The Securities Exchange Act of 1934 requires various filings to be made with the SEC if an investor acquires more than 5% of publicly traded US registered equity securities of the target. The principal notification is a Schedule 13D. This report identifies, among other things, the amount and source of funds used for the acquisition, the parties involved and the purpose of the acquisition; it also typically includes the material agreements used in the transaction (which are filed as exhibits to the Schedule 13D). The Schedule 13D must be filed with the SEC promptly following the acquisition of the securities and is publicly available. Amendments for material changes to the information provided on Schedule 13D must be filed promptly.

Sometimes an investment may turn from being a passive investment to an active investment. There is some flexibility under the US rules for qualified institutional investors and certain passive investors to file a Schedule 13G (rather than a Schedule 13D), which contains less information. This can only be filed if there is no intent to change or influence control over the target. If an investor having taken the advantage of filing a Schedule 13G, then changes its intent, i.e. it becomes activist, then a Schedule 13D must be filed within 10 days (and then is subject to a 10 day "cooling-off period" during which it cannot vote its securities).

Finally, quarterly Schedule 13F filings are required for registered and unregistered institutional advisers with investment discretion over $100 million or more in certain publicly traded US equity securities (the list is updated quarterly by the SEC). The Schedule 13F contains the following information: the equity securities under the discretion of the manager and the type of voting authority exercised by the manager.

Forms 345

Reports of beneficial ownership are initially made on Form 3 (following the appointment as director or officer or the acquisition that results in the owner exceeding 10%) and updated on Form 4 (to reflect for example, purchases of additional securities, sales of securities held or the exercise of options). An annual statement of beneficial ownership on Form 5 may be filed by persons who have not previously reported transactions otherwise reportable on Form 4 or who engagedin certain exempt transactions during the relevant period. These reports generally identify the reporting person's relationship to the issuer of the securities, the type of securities held and the purchase or sale of equity securities during the relevant period. These forms are publicly available. Once an investor becomes a 10% owner of an issuer's securities, it will be required to make filings on Form 4 (or if applicable Form 5) whenever it engages in a sale or purchase of the issuer's securities (until the investor ceases to hold 10%).

Fig 3

$56.7m (as of 17.02.06 & adjusted for inflation). Additional thresholds at $113.4m and $567.0m Hart Scott Rodino filing unless investment-only exemption applies (which requires no participation in business decisions)
1% When target is already subject to an offer (under the takeover rules)
3% Must notify when reached and each 1% bought or sold
More than 5% to 20% Schedule 13D/G/F filings
10% Forms 345 filings and short-swing profit disgorgement (Section 16); maximum for H-S-R investment-only exemption
15% Delaware § 203 business combination limit
15% or 20% Typical poison pill thresholds
30% Takeover Code (Rule 9) requirement to make cash offer for balance of shares


Influencing management and other Investors

Company directors are usually more amenable to listening to shareholders than might at first be thought. They have limited time – and that includes limited time to develop strategy – and the majority of shareholders are not activist. Conciliatory approaches can be more successful, as if directors feel threatened, they may object or become uncooperative.

The principal drawback of discussions with management is if the investor acquires inside or non-public information. Prohibitions on insider dealing/trading, market abuse rules and Regulation FD (on fair disclosure of information) may all affect or restrict an investor's ability to trade, more so if the discussions with management are productive.

An investor may wish to remove unresponsive or uncooperative directors – but the individual director you are targeting needs to be chosen with care. Numerous rules also have an impact, not least the bylaws or the articles of the target company, as in many cases it will be put to a shareholder vote (and will be in the UK). In the US, the proxy rules will apply and it may be difficult to remove a director without "cause". In the UK, an investor will need to requisition an EGM (or "Extraordinary General Meeting" of shareholders) for which they will generally need more than 10% of the voting shares, a "special resolution" will be required, of which 28 days notice must be given, and at the EGM a director will have the opportunity to "protest".

Attracting the support of other investors is attractive: management may be more inclined to listen; the cost and expense of increasing your stake will be avoided if they do. But there are pitfalls. In the UK, investors may find that they are acting in concert under the Takeover Code and in the US, an investor may find themselves part of a group with a ten person limit under the solicitation rules without issuing a proxy statement.

Merger Remedies and Business Opportunities
Divestiture is increasingly the preferred anti-trust/competition law merger remedy. This allows an investor to acquire a business for half or less of what would otherwise be its fair market value. When an anti-trust or competition situa-tion arises, the time to divest is limited. There are three options:

  • POST-ORDER BUYER – divestiture follows closing of underlying transaction; subject to regulator's approval. This is the least unfavourable situation for sellers. Depending on the regulator, the timetable to effect the disposal can be between 6 and 12 months.
  • UP-FRONT BUYER – divestiture must occur at or very near the same time as the underlying transaction; subject to regulator's approval. The European Commission sometimes requires an up-front buyer if it has concerns about the prospects of achieving any disposal. The timing is tighter, so the buyer and seller may prefer to opt for a "fix-it-first" buyer.
  • FIX-IT-FIRST BUYER – divestiture occurs prior to consummation of underlying transaction: it makes it far more difficult and risky for regulator to withhold approval or to negotiate, so for that reason regulators dislike it. The regulator is prevented from determining which assets are to be divested (for example, the takeover of Safeway by Morrisons, the UK supermarkets), approving the buyer and having a final say over the disposal terms. The timing is therefore the tightest of the three and so most favourable to the third party investor. To date, challenges by regulators have been rejected by the courts every time.

As always, but perhaps even more so in exploiting these opportunities, planning and preparation remain the key to exploit such opportunities.

Taking control

Investors becoming activist should all be aware of when they might be in a position to control the target. This is not just if they actually want to achieve control, but because it may have significant and even unintended consequences for any investment strategy. Fig.4 looks at the key levels of investments which determine what an investor can (or must) do with its stake.

Fig 4

30% Presumed control, in the absence of proof to the contrary Takeover Code (Rule 9) requirement to make cash offer for balance of shares
50% + 1 May elect directors and pass ordinary resolutions; and full consolidation of financial results Ability to appoint and remove directors; pass ordinary resolutions; and full consolidation of financial results
75% Ability to pass special resolutions; ability for target to grant lawful security as a private compan
85% results-Delaware: Waiver of bar on business combination with interested stockholder within three yea
90% Short-form (squeeze out) merger Ability to squeeze out following takeover offer

To obtain control, an investor could make a public offer (required in the UK if the target is a plc), a tender offer (in the US – depending on the pattern and objective of the acquisition, the "Wellman" test) or via a sale or purchase agreement. It is also possible, but more complex, to take control of a distressed target through buying debt – in which case care needs to be taken to review the whole capital structure of the target and the different positions of each group of investors throughout the capital structure.

If an investor wants to avoid control, the key UK rule is in the Takeover Code that requires a cash offer to be made for UK companies (and potentially those in other jurisdictions) when an investor (and those acting in concert with it) acquires an interest in shares carrying 30% or moreof the voting rights or moves up a whole percentage point between 30% and 50%. It is very important to monitor closely the conversations being had with other investors, as an investor may find that it is presumed to be acting in concert (even if the investor thinks otherwise). If the plan is to form joint arrangements, then a "concert party agreement" should become part of the plan.

Common pitfalls in taking control

The first serious drawback in taking control is that the extent of due diligence that an investor might want to make may well be constrained. Any release of information may impact on an investor's ability to trade and may have to be given to other competing bidders. The prospect of any protection through warranties and/or indemnities will be limited.

The very fact that an investor is taking control of a target may affect numerous agreements that the target has entered into. All of these will need to be considered, and will include put options in debt documents, employment contracts, joint venture and other investment agreements, pre-emption rights and dissent and appraisal rights and other US state law rights.Regulation of and political interference in the target may also need to be considered. Some industries are highly regulated (e.g. financial services) and others are considered strategic (and some countries may regard more industries as strategic than others).

Delivering firepower: structuring issues for hedge funds

Hedge fund managers typically have more flexibility in their investment mandate than a private equity manager. They can invest in public and private companies; at all levels of the capital structure; do not need to control their investments; often have no sector or geographic limits; leverage the fund's portfolio for specific investments; and can act very quickly. In addition, they arguably have greater flexibility in attracting investment professionals. But a number of structural features of hedge funds make private equity investments more complex.Therefore alternative models have been used by hedge fund managers to make private equity investments – even though they can reduce the attractiveness of the fund to investors.

The best known is a "side pocket". This usually operates by converting some fund shares into a new class, which is solely attributable to the illiquid investment in the target. The side pocket class will usually have restricted redemption rights and a different fee structure, all of which are designed to overcome the structural complexities. If created for a specific target, issues such as shareholder consent, how to provide additional capital for the target and termination of the side pocket will need to be considered. If a fund is structured when set up to allow for the creation of side pockets, additional issues arise, such as how much of the fund can be put into a side pocket and whether shareholders can opt out.

Evergreen capital raising
  • Valuing illiquid investments is hard
  • If valued at cost, then new investors benefit from any
    increase in value since the position has been acquired
Frequent redemptions permitted
  • Sort term investment horizon
  • Liquidity mismatch
  • Valuing illiquid investments is hard
Fees – annual incentive fee calculated on both realized and unrealized gains
  • Misalignment of interests
  • Investors do not recoup capital on a priority basis
  • No clawback
  • Fees paid on unrealized gains

Other mechanisms have also been used: gates restrict the maximum percentage of redemptions permitted on any one date; lock-ups that are fixed or "roll", so that investors come in and cannot leave for a pre-set period of time; and more fundamental changes, such as co-investment funds, hybrid funds and one-off club deals.

Finally, additional compliance issues for fund managers may arise if a fund holds a private equity investment. To make a success of an investment in such a target, a fund manager will need access to material non-public information – which may then prevent the fund from trading in that target or, under market abuse rules in the UK, its competitors; holding a board seat may subject the fund to blackout periods and pre-clearance procedures applicable to insiders; multi strategy hedge funds may have information that precludes other managers within the firm from trading in other parts of the target's capital structure; and finally, irreconcilable conflicts can arise if other funds or managed accounts in the same stable are planning to invest in the same target.


Activist investing certainly has its advantages. An investor's ability to influence management or other investors opens up the possibility of precipitating greater returns on underperforming investments, through giving investors a greater say in strategic planning and ensuring that investors' views cannot be ignored. The market tends to prefer companies that do listen to investors.

There is, really, only one paramount maxim: plan, plan and plan again. Activist investors have to be prepared to cope with criticism, drawn out battles, complex rules and regulations that can prevent trading or even require an investor to offer to buy the target outright or disgorge profits.