Dave Simonds

In 2017, the world’s biggest and most-expensive proxy fight took place at Procter & Gamble. Mr. Peltz, whose hedge fund (Trian) is a shareholder in Procter & Gamble, was trying to obtain a seat in the board in order to influence the company’s strategy. There are estimates that the board spent over $35 million defending itself against the hedge fund’s attacks. In March 2018, GKN (a British multinational automotive company) lost its battle to stay independent from Melrose, an activist hedge fund that is known for its asset-stripping strategy. Shareholder activism is on the rise again and hedge funds are re-entering the game.

Hedge funds

Nowadays, there are around 9000 hedge funds operating worldwide. In total, these funds have approximately $3.6 trillion of assets under the management. This is a huge amount of money, which even exceeds the 2017 GDP of Germany ($3.7 trillion) and United Kingdom ($2.6 trillion). Around 5% of the hedge funds employ activist strategies.

In order to be allowed to invest in a hedge fund, you need to be eligible by law and make a minimum investment of $250,000 to $1 million. This is however not the biggest obstacle to invest nowadays, simply because some funds are no longer accepting new clients. So if you get to be an investor, you are promised to have an unbelievably high return of 15-25% each year.

The basic idea behind hedge funds is investment pooling. Investors buy shares in these funds, which then are invested in the pooled assets on their behalf.

The standard investment textbook usually talks about three categories of strategies used by the funds. Directional strategies are bets that one sector will outperform other sectors of the market. Nondirectional strategies are usually designed to exploit temporary misalignments in security valuations which are constructed to be market neutral, or hedged with respect to the direction of the market. The last strategy is statistical arbitrage. It uses quantitative and often automated trading systems that seek out many temporary and modest misalignments in prices among securities. There is a countless number of statistical arbitrage strategies as the algorithms differ among the funds. The typical example can be pairs trading. The strategy pairs up stocks based on an analysis of either fundamental similarities or market exposures. After finding similar stocks the profit is simply made by selling more expensive and buying cheaper one, therefore, achieving market neutrality. Data mining takes a special place in statistical arbitrage as it refers to sorting through huge amounts of historical data to uncover systematic patterns in returns that can be exploited by traders.

We would expect that the most profits are made from statistical arbitrage strategies as we are living in the 21st century of technology and innovations. But even with current technologies it is hard to believe that hedge funds can persistently overperform the market and deliver those high returns.

We should be careful trusting high numbers. The returns stated by the funds are usually the internal rates of returns since inception. This specific method is commonly used to make the returns seem higher. The hedge funds made fortunes during the dot-com bubble and the discounting of those profits to the present times drives up the IRR significantly making funds looking profitable now while in fact, those are returns made 15 years ago.

“The competition drives profits down” that’s what we were taught and it makes sense to expect that while the market is booming new hedge funds will be popping, tightening the completion, and driving returns down. But it seems not to be the case as the funds are now doing better than ever.

Market efficiency hypothesis tells us that the price of the stock is reflecting all publicly available information and is rapidly adjusting to the news. Therefore, the profit opportunities vanish fast unless you possess the private information or even create it.

It seems that the hedge funds found a way to do so by getting inside the company and engaging in shareholders’ activism. Their game plan is as follows: they are buying a significant stake in the company and trying to get into the board of directors to influence decisions.

World biggest proxy fight: Procter & Gamble (2017)

In February 2017 Mr. Peltz, the CEO of Trian Partners (a multi-billion-dollar investment management firm) paid $3.5 billion for a 1.5% stake in P&G consumer goods group. Since that time he was trying to get into the board of directors “to bring changes and modernize the company.”

Mr. Peltz biggest concern about P&G is that is it slow, closed-minded and too focused on its big brands. Millennials are attacking an old-fashion way of production by focusing on sustainability, exclusiveness, and customized products. Small companies are using the e-commerce to bypass traditional retailers and sell directly to consumers. Consequently, the industry observers that small companies are growing three times faster than their larger counterparts. Mr. Peltz also noted that the P&G culture is also not helping it to innovate because there is no pride in working on small brands in the basement of the buildings. It’s still really cool to work on Tide.

Mr. Peltz wants to simplify P&G’s corporate structure from 10 business units to 3. To make his vision being implemented, Mr. Peltz entered the biggest and most expensive proxy battle ever. The fight for a sit in the board between Mr. Peltz and Mr. Taylor (CEO of P&G) resembled a political contest. Weeks before the P&G’s shareholder meeting carefully crafted videos, lengthy white papers, mass mailings were sent and tens of thousands of phone calls were made urging shareholders to vote blue (P&G) or white (Trian). And the strategy succeeded as in October 2017 400 shareholders showed up to the meeting. Although, not everything went as Mr. Peltz was expected because he lost to Mr. Taylor who spent at least $35 million furiously fighting to prevent him taking sit in the board.

However, taking into account all valid points made by Mr, Peltz about the weaknesses of the company, wasn’t it logical to give him a sit in the board to modernize and make the company better? The concern is that today Mr. Peltz stopped of demanding more extreme measures, like a change of leadership or spin-offs but what can he proposes tomorrow?! And even more importantly is Mr. Peltz really thinking about bringing gains to all company’s stakeholders or is he concerned only about profits of Trian Partners investors?

GKN hostile takeover (2018)

Let’s have a look on similar actions by the hedge fund. GKN (a British multinational automotive and aerospace components company) was not doing so great for past 5 years and, frankly, the overall situation in the British aircraft industry is not very optimistic. GKN along with both Rolls-Royce, the next-biggest, and Cobham have issued five profit warnings each in recent years. The latter two are specializing to survive while GKN was offered £8.1 billion by Melrose in January 2018. Melrose is known for buying up struggling engineering firms, streamlining their operations and selling them on for profit a few years later. It wants to repeat this trick at GKN.

GKN lost its battle to stay independent as Melrose won the backing of 52% of GKN shareholders in March 2018. ADS Group Limited (trade organization representing the aerospace, defense, security and space industries in the United Kingdom) was concerned about losing GKN as it is an important part of the UK industrial landscape. Mr. Everitt (the CEO) stressed that “it is important that its owners continue to invest for the long-term and support high-value jobs both directly and throughout its UK supply chain.”

Melrose’s announced strategy in which it proclaimed to keep the company together “to improve all of the businesses in GKN, only realizing their value once they have reached full potential.” Judging from Melrose’s actions it did not take long for GKN “to reach its full potential” as already in June of the same year Melrose announced £1.5 billion sale of Powder Metallurgy arm (one of its most valuable divisions) as soon as this autumn.

So let’s make some conclusions based on the facts. The hedge funds are doing whatever it takes to make profits: engaging in the hostile takeovers, spending millions in the proxy fights, and making promises they never anticipated to fulfill. Looking at this fast, especially the last one, there are no doubts why the CEOs and the board are trying to keep the hedge fund away from the decision making.