Shareholder activism hasexperienced a resurgence over the last few years roughly a decade after first rising to national prominence in the mid 2000’s as a viable hedge fund strategy. While some of the previous denizens of this bountiful territory have long since run aground, in some instances spectacularly (Pirate Capital), many of the largest shops in the space have stayed afloat across the ensuing market cycles, honing their craft. Indeed, of the estimated $120 billion invested in the sector, perhaps 90% can be found concentrated in the hands of a few large investors – names such as Carl Icahn, JANA Partners, and Bill Ackman of Pershing Square.
The sheer size of these capital pools can arguably provide an edge in agitating for positive change at companies targeted by such firms. Often, the mere appearance of the activist itself is the event that catalyzes value creation for existing shareholders because other market participants recognize the past successes of the activist and immediately assign a premium to the stock based upon the name brand of the manager alone, usually the bigger the better.
In fact, recent research published at Vanderbilt University shows  that stocks targeted by large activist hedge funds pop significantly more in the immediate aftermath of the announcement of the activist campaign than do equities targeted by smaller shops. Over the period of 10 days prior to the announcement to 10 days after, the targets of large activist firms jumped 10.9% versus just 5.2% for those of their lesser rivals.
The authors – and they are not alone in this assertion – attribute this success to a few related size factors: a larger pool of capital itself can move a stock price more, larger investors are more visible and hence more likely to attract follow-on investors creating a virtuous self-reinforcing cycle, and larger investments can assist in facilitating engagement with C-suite executives, signaling a higher probability of effectively driving operational or governance changes. And, like most things, the truth is probably some combination of these factors acting in concert.
Perhaps market efficiency is another reason large activism seems to generate better returns. Consider that the same research paper found that bigger activists tended to target larger non-NASDAQ companies with more entrenched management. If activists share the market for public corporation reform and managerial efficiency with private equity funds, it is possible that the larger end of the spectrum is somewhat paradoxically less efficient than the smaller end. We’ll try to establish the former argument before exploring the latter.
One similarity between activists and private equity funds that differentiate both from passive public equity investors is a true owner mentality. Activist managers typically approach acquiring stock in publicly traded companies in a similar fashion to private equity funds. In fact, many activists explicitly tout their “private equity approach to public markets,” a philosophy usually meant to convey not only a tangible book value down-side discipline and sustainable operating cash flow approach to valuation, but more importantly a longer-term focus on business building and operational improvements or turnarounds. This stands in stark contrast to the archetypal viewpoint of equity-focused hedge funds being frenetic traders, myopically focused on quarterly EPS and today’s trading P&L.
Most activists enter a position only after having established a clear playbook for operational or governance changes to unlock shareholder value, as well as steps to ensure such changes are actually implemented. These changes usually span from general governance improvements, such as de-staggering the board or changing compensation structures, to highly focused strategic plans, including divesting or spinning off specific non-core assets. Further, the activist engagement method varies from quiet, behind thescenes “relational” investors to more saber-rattling, headline-grabbing confrontational approaches. Of course, all of this is overlaid with a healthy dose of financial engineering and balance sheet optimization.
Upon further consideration, this activism matrix has a great deal in common with private equity, where general partners employ an investing model that spans from arms-length supervisor to hands-on operator, from control stakes where they can dictate the outcome to minority stakes where they negotiate items and offer advisory input.
One by-product of this longer-term focus on valuations and business building as opposed to short-term price action and quarterly earnings numbers is a necessarily longer holding period, again similar to private equity. Usually, activist hedge funds have a multi-year average holding period and extremely low portfolio turnover. Certainly, they can and do take advantage of investing through public markets by trading around core positions on large price moves, but the name turnover in activist portfolios tends to be far lower than other equity-centric hedge funds. Additionally, and because of the longer-term nature of the investment thesis, activism often displays a J-Curve or initial period of flat to negative returns before the realization of operational objectives and financial metrics results in valuation improvements, similar to private equity. It is also becoming more common to see activist funds with longer-term lock-ups that accompany this holding period, often three years, or even in dedicated private equity style call-down funds.
Given this deep private equity style analysis and long hold periods, it should not be surprising that shareholder activists have ultra-concentrated portfolios, much like private equity funds. It is quite common to find activist funds with eight to 12 core positions accounting for 80% to 100% of long capital, similar to buy-out funds. Certainly some activists have more line items when including toe-hold or on-deck positions, and often mega buy-out funds have to invest in more companies in order to deploy their hefty asset bases. But by and large, a portfolio comprised of eight to 12 companies is quite common for both strategies.
With such concentration, there exists much greater opportunity – and risk – for idiosyncratic or company-specific factors to drive the outcome, as opposed to mere beta – but make no mistake, both have equity beta! In this regard again, activists serve a similar role to private equity, which is one of a return enhancer rather than a portfolio diversifier. In order to investigate this, I constructed an equal weighted index of 15 activist hedge funds dating back to 2000 (including several dead funds in an admittedly quick and dirty attempt to reduce selection and survivorship bias).
As should be obvious in Fig.2, this activist index has outperformed the S&P 500 substantially, annualizing at 16.4% per year (net) versus just 5.3% (gross) for the market. Even more impressively, volatility for the activist basket was a mere 10.9% as compared to 15.0%, an enormous enhancement in risk-adjusted return and alpha. It’s also worth pointing out that this portfolio of activists compares favorably with the Cambridge US Private Equity Index 15 year end-to-end pooled net return over the same time period of 11.9%.
Interestingly, the study above documented strong performance for activist funds overall, but demonstrated that larger activist funds significantly outperformed smaller ones. This is the exact opposite finding that any number of studies have found for other hedge fund strategies and for private equity fundsin general. For instance, PerTrac  showed that hedge funds under $100 million posted annualized gains of 13.6% over a 15-year period, besting funds greater than $500 million, who averaged 10.0% per annum. Similarly, Thomson Venture Economics  provided evidence that over a 20-year period, small buy-out funds generated IRRs of 25.9% while their mega buy-out brethren compounded at just 11.6%.
This anomaly may make sense if we consider the role activism plays in capital markets. I would argue activist investors serve as enforcers of corporate and managerial efficiency, proposing remedies for inefficiently run companies with good products, or sub-optimal capital or governance structures, and so on. In this regard, they may serve a very similar role to private equity, which should not be surprising given some of the characteristics discussed above.
Given the size of the larger end of the publicly traded equity market, it is less clear that buy-out funds can actually serve as a credible governor on management behavior whereas activists arguably can.
Using SEC 13-F filing information for a handful of the largest activist hedge funds, we arrived at an average portfolio company market capitalization of roughly $45 billion, and an approximate average AUM size of $12 billion. Assuming 10 equally weighted positions at $1.2 billion dollars each, these large activists are able to easily acquire 2.7% stakes in their targets, on average. While clearly not large enough to force change, such stakes are big enough to influence management (even more so of late with the increasing tacit support often of other large institutions in the investor base).
On the other hand, it is far more difficult to acquire a control stake in such massive corporations. Indeed, at $45 billion the 2007 KKR-lead acquisition of TXU ranks as the largest private equity deal of all time. Most of the top 10 deals ever also occurred in the go-go days of 2005 – 2007, which seems unlikely to be repeated any time soon. Certainly, large deals are occurring – Dell at $25 billion in 2013 was the largest take private in terms of revenue – and club deals are reappearing a bit, but the factors which lead to the previous boom are not as ubiquitous today. There is less bank debt available, fewer CLOs, and less limited-partner demand for mega funds. $10 billion-plus buy-out funds are still being raised successfully by firms such as Blackstone, TPG and Warburg Pincus to name a few, but in general LPs have been more focused on the middle market opportunity set in recent years. According to information from Pitchbook , fundraising for buy-out funds below $500 million dollars has risen from roughly 60% of total private equity fundraising activity in 2006 to nearly 75% by last year.
Given this fundraising dynamic, perhaps smaller activists simply have more capital competing with them from the private equity sector for opportunities. Conversely, it is far easier for a $12 billion hedge fund to take a 3% stake in a $50 billion company than it is for a $12 billion buy-out fund to club up a deal and arrange enough financing to take the same company private. Given the similar approaches to concentrated portfolio construction, longer-term time horizons required for the investment thesis and/or operational change to pan out, and the higher rates of return, activism is a compelling substitute for or complement to a large cap or mega buy-out private equity portfolio. It’s also worth noting that the comparable returns come with moderate as opposed to complete illiquidity, shortening the effective risk duration of capital deployed.
Finally, activism may have one clear advantage over buy-out funds. Activists get to build their position in the company with little to no fanfare, capturing a significant premium when news hits. Research shows this is less than the control premium mega buy-outfunds typically pay, but given a choice I’d prefer to collect such a spread rather than pay it.
 Krishnan, C.N.V., Frank Partnoy and Randall S. Thomas, 2015, “Top Hedge Funds and Shareholder Activism,” SSRN White Paper 2589992, draft, May
 PerTrac, 2011, “Impact of Fund Size and Age on Hedge Fund Performance,” White Paper, September
 David Bernard, 2005, “Benchmarking Private Equity”, Thomson Venture Economics , September
 Pitchbook, 2015, “2Q 2015 U.S. PE Breakdown,” Presentation