Hedge Funds as Shareholders

Hedge funds as shareholders

Hannah Keever and Justin Bickle, Cadwalader, Wickersham and Taft LLP

Much has changed since Lord Denning denounced directors as "a self perpetuating oligarchy"1; shareholders have risen up against their old masters and seized power at a rate some commentators find alarming2. Far from humbled subjects, shareholders have shown an increasing determination to use the powers available to them, and the government looks keen to increase these powers. There is every possibility that the extra leverage given to shareholders by government reforms will attract hedge funds and that hedge fund shareholders will participate in financial restructurings through ad hoc equity committees. Despite the scepticism of some observers, there is every reason to look forward to this involvement as a constructive one, albeit one that will affect changes within the financial markets and upon hedge funds themselves.

Shareholder powers

Currently the most important powers in a shareholder's arsenal are:
 

  1. Shareholders together holding over 10% of voting shares may requisition an extraordinary general meeting.3
  2. Shareholders numbering 100 or more, holding shares on which an average of not less than £has been paid up, or shareholders with 5% or more of voting rights in a company, can require the company to circulate a statement regarding the subject matter of a resolution for discussion at a forthcoming general meeting.4
  3. Shareholders numbering 100 or more, holding shares on which an average of not less than £100 has been paid up, or shareholders with 5% or more of voting rights in a company, can require the company to circulate a resolution for discussion at an AGM.5

Reform of the UK listing rules

The UK Government has made calls for more active shareholder intervention.6 To foster this movement the FSA has proposed changes to the Listing Rules so that shareholder approval would be required for a company to de-list. The rules currently require an issuer wishing to cancel the listing of its shares to notify the Regulatory Information Service and send a circular to shareholders giving at least 20 business days notice of the intended cancellation. The circular is solely for information purposes; no shareholder approval is required. British Energy recently used this process to defeat a rebel shareholder, Polygon (a hedge fund), in its attempts to implement an alternative restructuring plan for shareholders.

The FSA is due to introduce an additional requirement, that, save whereit otherwise agrees, de-listing will require the prior approval of at least 75% of total votes cast in a general meeting. In an October 2004 announcement, the FSA stated that there was further work to be done and that consequently the new rules are unlikely to come into effect until July 2005. In a recent survey of hedge fund managers, opinion was divided as to whether these proposed changes will be sufficiently comprehensive to give shareholders a real voice during a restructuring.7

The role of hedge funds in this phenomenon – are we looking forward to ad hoc equity committees?

In an examination of how hedge funds might exploit equity products, it is useful to look at how these funds have evolved. Hedge funds are no longer exclusively the instrument of the wealthy or maverick players on the edges of the financial world, but a tool of pension funds and mainstream financial institutions. British Telecom's pension fund is just one that has recently announced it is to invest in hedge funds and City institutions such as Goldman Sachs now use hedge fund tactics to their own advantage. The appearance of new funds has been dramatic: Merrill Lynch forecasts that by 2010 the industry's capital will reach $2 trillion.8

A rising or falling stock will reach equilibrium more quickly if a large number of investors buy into it. As a result of this a crowded market reduces windows of opportunity for profit as well as heightening competition. Hedge funds thrive on market volatility rather than the stability that has characterised the recent economic climate; this further limits the opportunities for easy profits from traditional means. Hedge funds have also had to look for opportunities outside their traditional sphere of interest, and as part of this process we see them looking at new ways of using equity products.

One tactic open to hedge funds investing in equity, in a stable market, is to move to offering long-only products in a manner more akin to traditional funds, but with absolute, positive returns and more lucrative fees. While long/short equity strategies are still the largest single strategy adopted by European hedge fund managers and are still the strategy exhibiting the fastest growth, many funds are successfully exploring long-only strategies. Hedge funds that have launched or are planning to launch long-only products include Caxton Associates, DE Shaw and Egerton Capital.9 Not only does this strategy make the most of the current economic climate; it also appeals to conservative investors such as pension funds.

Commenting on the way hedge funds have adopted this strategy, Josephine Shaw, portfolio manager for Tower sub-manager, GAM, states, "Equity hedge is now accepted so well that I am not sure that people even classify it as a hedge fund. Most equity hedge managers are basically market neutral or have a certain level of net long."10 Hedge funds have shown that they are prepared to make long-term commitments to investments.

This kind of long-term commitment suggests that hedge funds could play a role in the restructuring of companies on equity committees in the same way as they currently do on bondholder committees. As shareholders, hedge funds can make their voices heard louder than most, and their expertise working with distressed debt would be invaluable. The official committees of equity security holders in US Chapter 11reorganisations indicate what could develop. These equity committees are appointed only where the court finds there is some potential for recovery to shareholders. Such an appointment gives the committee the right to hire outside counsel and investment bankers, paid for out of the bankruptcy estate. This process does offer equity holders meaningful access to the reorganisation process. Emphasis is placed on the committees' negotiation and communication roles. Such committees have become more common in recent years in light of the wave of Chapter cases involving large, publicly traded debtors.

However, a dichotomy exists between the traditional importance of market volatility to hedge funds and the long term commitment that traditionally characterises both equity investments and committees of stakeholders. This would have to be overcome for hedge fund equity holders to have a real and permanent role in the restructuring process. Hedge funds are traditionally characterised by their flexibility and agility; qualities that mean hedge funds are not tied to their stock in quite the same way as traditional holders, since they can make money from any market movement and do not necessarily rely so heavily on a stock's price rising.

The tensions that can arise where hedge funds, who traditionally prosper on volatility, invest in equity, are evident in the opportunities for creating this volatility that are to be found in successfully exploiting shareholders' rights. The results do not always benefit the long term, more traditional, shareholder. Last summer Polygon used its rights as a shareholder to challenge the British Energy restructuring and mobilized support from other shareholders to do the same. The announcement to oppose the restructuring was made on July 26, by midweek the share price had hit a two-year high. Bonds, on the other hand, had fallen by around 15 points.

This example illustrates the advantages hedge funds have over traditional shareholders and the different way in which they work. If a hedge fund manager reads the market well, he can make money when a share or bond price is going down, as well as when it is going up. This means that he will have more freedom than a traditional investor, yet it may be that he will be less committed to his shareholding. In an insolvent company this ability to trade in and out of an equity investment and make money as prices rise or fall creates opportunities for profit that may otherwise be blocked to shareholders. Traditional shareholders will have fewer opportunities to make money since shareholders are traditionally last in line for repayment and ultimately, as was the case with British Energy and Polygon, the threat of putting the company into insolvency is a powerful tool in the hands of creditors.

Another case where agile investors could have profited from equity shareholder activism occurred in May 2004 when Phillip Green waited for dissatisfaction with M&S management to build before he made a bid approach for the company. In the end his offer was not sufficient to persuade management to offer Green and his advisers to perform due diligence. However, for those who had spotted M&S as a bid possibility in the preceding months and purchased shares, Green offered a good opportunity for a profitable exit. By the time that Green abandoned his bid, the hedge funds had control over sufficient stock to determine its fate.

Hedge funds do not need to play the same role in every restructuring deal. In some deals, they may choose to profit through short term holdings. Yet this fact does not mean that in other deals they will not choose to invest and make a genuine commitment to the restructuring process. In situations where equity is concentrated in the hands of a few funds and where sufficient value exists in the company for shareholders to make some recoveries, ad hoc equity committees could have a real role and a genuine long-term interest.

The contradiction between what a hedge fund wants and what is in the interests of the company is not insurmountable. Hedge fund managers understand the industries that they are investing in exceptionally well, and without the weighting requirements that restrict traditional funds, they are freer in their investment approach. Fund managers may buy shares in order to create fluctuations in share and bond prices, but they will not short a well-managed company with good potential for growth as long as the company and the hedge fund have adequate communication and cooperation.

Hedge funds have long been accustomed to playing a constructive role in the recovery of companies in which they hold bonds. This summer, K Capital built up a 25% stake in Jarvis, the PFI specialist. Jarvis' chairman Steven Norris is quoted as saying, "They have been referred to as a vulture fund, but as far as I am concerned they are positive and constructive".

Some doubt exists as to whether hedge funds have the management skills to maintain sufficient levels of regulatory compliance. However this doubt could be surmounted, as in the private equity context, by hiring executives, forming partnerships, or subcontracting out.

Potential consequences and conclusions

Within hedge funds themselves, regulatory requirements pursuant to gaining a stake in a company create tension between money managers who are only interested in whether the share price is going up or down, and corporate governance officers who are focused on compliance with regulations. This tension will only increase with the regulatory requirements that will be imposed upon hedge funds following the SEC's decision that hedge fund managers must register with the agency and the increasing demands on hedge funds to measure their performance against sector indices, in a way more similar to the benchmarks traditional funds rely on. This increasingly rigorous regulatory framework in which hedge funds work will pose challenges to their traditional flexibility, and will have to be worked around, and will potentially change the way hedge funds operate.

Despite reform of UK insolvency legislation, administration still destroys value. Solvent restructuring remains a process of the utmost importance and the rights of equity holders remain a key factor in this process. With an established role in the financial mainstream, hedge funds are well positioned to take advantage of these rights for their clients. Henry Kravis, co-founder of the private equity firm Kohlberg Kravis Roberts, sums up the sceptics' opinion that while hedge funds, "know how to pick stocks and make lots of money that is not the same thing as creating value through ownership of an asset over the long term in a hands-on way."11In December 2004 the Financial Stability Review pointed to "the aggressive search for yield" by hedge funds as a potential threat to stability.

However there is great danger in underestimating the ability of hedge funds to evolve and diversify. Opportunities for profit exist in longer term, as well as short term investments and the level of commitment required in each restructuring will differ. When last year's range bound equity markets saw many hedge funds moving to offer long-only products, some analysts were prompted to predict the disappearance of the gap in management styles between hedge and traditional fund management styles. Ultimately, hedge fund managers have money and have expert knowledge of the fields they operate in. They will find ways of investing for maximum profit, and companies in need will find uses for these funds, even if in the process conventional ideas of creditor committees, shareholders and hedge funds themselves, are challenged.

Justin Bickle is a partner in the Financial Restructuring Department at Cadwalader, Wickersham and Taft LLP, and Hannah Keever is a lawyer in the Global Finance Department. Cadwalader, Wickersham & Taft LLP is an international law firm with over 1000 staff across five offices in London, New York, Washington D.C., Charlotte, NC and Beijing.
 

  1. Lord Denning Northwest Holst Ltd v Department of Trade [1978] Ch 201
  2. Brian MacDowell writing in IT-Director.com
  3. s368 Companies Act 1985
  4. Companies Act s377 (1) (a)
  5. Companies Act s376 ((a)
  6. Myners report 6 March 2001
  7. Debtwire "European Distressed Debt Market Outlook 2005"
  8. "The Growing Hedge Fund Equity Investor Universe" D Pepper April 2004 (Presentation to Investor Relations Society)
  9. "Hedge Funds Raid Traditional Fund Methods " Pratima Desai. Reuters December 212004
  10. Financialalert "Hedge Fund investing going mainstream" Antony Davies December 14 2004. Quoted in Times October 2004<.li>