Hedge Funds

Their role in M&A

Philip Coggan
Originally published in the April 2005 issue

Wall Street is used to the idea of hedge funds being involved in mergers and acquisitions. But for Europeans, the process has proved something of a shock. The remarkable achievement of some investors in blocking the Deutsche Borse bid for the London Stock Exchange prompted Hans Eichel, the German finance minister, to muse about outlawing short-term trading strategies.

This knee-jerk reaction may simply be part of the general European distaste for the hurly-burly of global capitalism. Herr Eichel made similar comments about the undesirability of short- selling in the wake of the September 11 attacks.

But Eichel and others may have to get used to the influence of hedge funds. Under the old German model, when one shareholder register was a facsimile of another, and a cosy coterie of banks controlled the fund-raising pipeline for the corporate sector, hedge funds were not needed. But the German authorities have let the genie out of the bottle. German banks have been selling their shareholdings in industrial companies and German companies have had to tap the international capital markets. They may not have meant to attract hedge funds but now they have got them.

The battle over the Deutsche Borse bid for the London Stock Exchange showed how far Europeans may have to go before they grasp the concepts of shareholder value. One results conference saw Werner Seifert, the exchange's chief executive, refuse to take questions from dissident investors. In January, a conference call developed into a shouting match between Seifert and TCI, the hedge fund that led opposition to the deal. Initially, indeed, the Deutsche Borse refused to give investors the right to vote on the deal. The exchange argued that, under German corporate governance rules, it was up to the supervisory board to approve the deal, not investors. Historically, of course, this would not have been a problem; the supervisory board effectively were the biggest investors. But as well as the content of the decision, investors were upset by the distinctly patronising tone; "You little people just provide us with the money. We will make all the big decisions." All this was all the more remarkable since it was a stock exchange that was doing this. If any company should be sensitive to the needs of international investors, it ought to have been the Borse. After all, part of its role was surely to attract money to the German corporate sector. How could it hope to do so, if it treated investors so cavalierly? But it learned its lesson as the hedge funds mounted a fightback. Along with Atticus Capital, TCI threated to vote out the board at its May meeting. And they started to line up alternative candidates, such as Lord Rothschild, to take the board's place.

In the end, more than 40 per cent of the Borse's shareholders expressed their unhappiness about the deal. The management was forced to abandon its approach and to promise a return of cash to shareholders, one of TCI's key demands. It even established a committee, specifically to talk to the hedge fund and to improve the relationship. But TCI is still aiming for the removal of Rolf Breuer, the supervisory board's chairman, at the annual meeting in May.

Chris Hohn, managing partner of TCI, has remarked: "Mr Breuer and Mr Seifert have been running the company as if it were theirs. That is rather absurd; we are owners, Mr Seifert is an employee." Of course, that is not the way European companies have traditionally thought about things. Managers traditionally regarded themselves as responsible to three groups of "stakeholders": customers, employees and shareholders, with the latter coming a distinct third in the priority list. Such a system, it was argued, protected businesses from the short-term pressures imposed by Anglo-Saxon systems. A decade ago, when German and Japanese economic performance still looked superior, authors such as Will Hutton, in his book "The State We're In", argued that the stakeholder system created better conditions for economic growth.

The defeat of the bid is certainly an epochal event in the history of the German corporate sector. The nearest comparable event was the takeover of Mannesmann by Vodafone at the height of the dotcom bubble but there at least, the UK telecoms group eventually got the approval of the Mannesmann board. This was a case of shareholders defying a board's course of action.

To be fair to the Germans, they are not the only ones to complain about the influence of hedge funds. As far as capital markets are concerned, Britain is supposed to be the "mini me" to Wall Street. But John Sunderland, president of the Confederation of British Industry and chairman of Cadbury Schweppes, recently railed against the influence of the hedge fund sector. "On roadshows, there is increasing pressure to put us in front of hedge funds rather than traditional long funds" he said in April. "It may be old-fashioned but I view a shareholder as a shareowner – someone whose interest in the success and prospects of the company lasts more than three weeks." Sunderland called on the fund mangement industry, including hedge funds, to be more transparent. "Set up your own self-regulation, declare your conflicts of interest and reveal your remuneration. In other words, do what the markets have required of the corporate sector."

Hedge funds may have become more active because their role has become more difficult.

In the old days, merger arbitrage funds followed a fairly simple strategy; buy shares in the target and short the shares of the bidder. This was based on the old rule, borne out by many academic studies, that shareholders in the target company did much better out of takeovers than shareholders in the predator. Of course, there was always the risk that the bid might fail, or the predator might walk away. In those cases, it would be better to short the target and buy the predator. A hedge fund manager's skill depended on his judgment of which deals fell into which category.

Hedge funds do not always get their way. "There is a perception after the Deutsche Borse affair that hedge funds are coining it from mergers, but hedge funds have lost money from deals on both sides of the Atlantic" says Jamie Kermisch, managing director at Morgan Stanley.

At Marks and Spencer, for example, some 20 per cent of the equity was reported to be in the hands of hedge funds. But in the end the deal did not go through. This was little to do with the activity of the hedge funds themselves. Philip Green, the entrepreneur who wanted to take over the retailer, was unwilling to launch a hostile bid and the M&S board refused to recommend his approach.

Sometimes hedge funds can be on both sides of a deal. When Polygon Investment Partners took a stake in British Energy and tried to get a better deal for shareholders, it faced opposition from the holders of the company's bonds, many of which were distressed debt hedge funds.

That deal illustrated that it is not just merger arbitrage hedge funds that are involved in the bidding fray. The result is that the success or failure of some bids may seem entirely in the hands of the sector. Reports that some 40 per cent of the equity of DFS Furniture was in the hands of hedge funds seemed to have ensured the success of founder Lord Kirkham's efforts to buy back the group. Some institutional investors were unhappy with the bid price but the hedge funds were eager to take their profits and get out.

The increased role of hedge funds in the M&A process has inevitably caused controversy. One particular tactic that has drawn attention is the use of contracts for difference (CFDs) to build up stakes. CFDs give the buyer an interest in the company without the need to buy the underlying shares or, under the present rules, the need to disclose their stake. CFD owners d o not receive voting rights in the company but there has been talk that brokers are making informal agreements to vote in line with hedge fund wishes (a formal agreement would run foul of the disclosure rules and would trigger the payment of stamp duty).

One striking use of CFDs came during the BAE Systems bid for Alvis, the tank maker, when the defence group announced it had received irrevocable support from hedge funds holding 16.2 per cent of the equity through CFDs.

The Takeover Panel put out a consultation document in January suggesting that holders of derivative positions should be put on the same footing as normal shareholders during the takeover process.

Another issue is what happens to a takeover target if hedge funds take a big stake in the group, and the bid fails. The result will be a share register packed with short-term holders of the stock. However, traditional investors must bear part of the blame of such situations; after all, if they did not sell the stock, hedge funds could not buy it.

While the authorities are fretting about the role of hedge funds in bids, the sector has its own reason to worry. So much money poured into merger-related strategies that returns may have been reduced. Hedge funds may accordingly have to find a more creative way of making money out of big deals. This may require them to take a more aggressive, and more public, approach. One age-old tactic is to take a stake in a business and demand that the company improve its performance or put it up for sale. So-called action funds have been pulling off this trick for years.

Events in Europe have not reached the same stage as those in the US, where some hedge funds have moved from taking stakes to taking over whole businesses. An obvious example is Eddie Lampert. The discount retailer KMart went into Chapter 11 in January 2002, having suffered the effects of years of intense competition from rivals Wal-Mart and Target. Eddie Lampert's ESL fund, which specialised in distressed debt, immediately began buying up the bonds of the troubled retailer. He then helped arrange the financial reconstruction of the company, including a sale of surplus stores that focused attention on the value of the group's real estate portfolio. Shares in the revamped KMart soared and Lampert then announced a merger with Sears Roebuck, another US retailing giant that had fallen on hard times.

Another instance of aggressive action by hedge funds was the unsolicited offer by Highfields Capital to buy the retailer Circuit City. Such a bid would create a political storm in Europe. But, judging by recent events, it may be only a matter of time before one occurs.

Philip Coggan is Investment Editor of the Financial Times