Private Equity and Activism

Amadeus Moeser is an associate at Sidley Austin LLP. This post is based on a Sidley memorandum by Mr. Moeser and Michael Olaya.

The relationship between private equity funds and activist hedge funds has always been double-edged. While in the past, engagements of activists often led to the sale of a target company or less profitable operations of a company to private equity funds, many go-private transactions have been opposed by activists trying to improve the terms of the deal and companies brought private equity funds in as “white knights” during a hostile takeover. However, tensions seem to be slowly disappearing as the transitions between activist hedge funds and private equity funds become blurred. Private equity funds are beginning to adopt activist tactics and activists are increasingly engaging in private equity transactions.

Private equity firm Waterton Global Resource Management started to use activist strategies in 2018 and pushed for a new slate of directors at Hudbay Minerals after accusing the board of mismanagement. Other private equity firms like KKR, Golden Gate Capital and Sycamore Partners had already applied activists tactics, for instance, by acquiring so called “toehold” stakes in public companies (typically under the 5% public reporting threshold) as a way to approach management and begin a dialogue regarding a buyout. On the other hand, activists started to take private equity opportunities themselves by buying entire companies, alone or with a partner. In 2016, Icahn Enterprises bought auto service and part chain Pep Boys for $1 billion. Elliott Management’s private equity arm Evergreen Coast Capital joined forces with the private equity firm Veritas Capital to purchase Athenahealth for $5.7 billion in November 2018. In December 2018, Evergreen Coast Capital acquired Travelport Worldwide alongside Siris Capital Group for $4.4 billion. In January 2019, the $15 billion buyout of Arconic by Elliott Management and Apollo Global Management just fell apart due to a dispute over pensions obligations.

There are two main reasons for the convergence:

  1. There is too much competition. The private equity industry as well as activist hedge funds have raised and deployed record amounts of capital in the last few years. There are also extremely high levels of dry powder. In addition, traditional asset managers like Wellington Management and Neuberger Berman are putting activists under pressure by applying activist tactics. Pension funds might start to consider moving money from expensive activist funds to cheaper (active) asset managers. Private equity funds are struggling to find attractive new deal opportunities due to high valuations. As both types of investors compete in an increasingly crowded investing world, where huge amounts of capital chase fewer opportunities, private equity funds and activist hedge funds have to look for alternative investments to put their capital to work.
  2. Both investment classes are very similar which makes it easier for them to adapt to each other’s strategies. A company that is seen as a good activist target is also often a good choice for a go-private transaction. Compared to many other investors—especially passive investors—private equity funds and activists have very concentrated portfolios and a true owner mentality. Both have a long-term focus (at least activists focusing on operational changes). Further, both players have the key competencies for the business: a sense for undervalued companies and for the appropriate restructuring measures to drive value creation. Another similarity is the investor base. Private equity funds and activist hedge funds both heavily depend on the favor of public pension funds and asset managers. In order to attract capital, both players must adhere to the same rules as, for example, the commitment to ESG standards.

Private Equity Funds as Activists

There are some factors that make an activist approach quite attractive for private equity investors. Due to their longer-term approach and the complexity of private equity transactions, private equity funds are inflexible to abrupt market changes. By applying activist tactics, more opportunities open up for private equity investors. By being able to buy (minority) stakes of public companies, private equity funds can more quickly seize on dips in the market. In addition, the selection of possible targets is no longer limited to the small circle of companies available for sale. Since the negative perception of activists is slowly vanishing and activists’ endeavors are increasingly backed by entities that invest in both investment classes (e.g. the big public pension funds and asset managers), private equity funds have no need to still be squeamish. They don’t have to be friendlier and more collaborative than the activist hedge funds anymore.

However, there are several impediments that make it difficult for private equity funds to act as shareholder activists. Most limited partnership agreements of private equity funds have provisions in their investment criteria that don’t allow them to participate in “hostile transactions” like takeover bids that are (publicly) opposed by the board of directors of the target. Usually, proxy fights are also prohibited. Many private equity funds have limitations on taking positions in public companies except for the purpose of gaining control of the company or for the purpose of a going private transaction. Also short-term investments are usually prohibited. The only way most private equity investors can engage in activism is to establish a separate activist fund without the aforementioned investment restrictions. In addition, being perceived as an aggressor can limit a management’s willingness to engage in a buyout dialogue. Competitors can take advantage of an aggressive approach of another private equity fund during negotiations with the management of a company.

Activists as Private Equity Investors

While activists previously only emphasized that they take a private equity approach to investments in public companies to help other public investors to share their gains, now it has become very tempting for them to engage in full private equity transactions. To take over a company is a guarantee to implement the changes the activist believes need to be made in order to unlock value. But a private equity arm can also be used to facilitate and support classic activists’ campaigns. Sometimes a takeover offer by an activist can pressure a company’s management to put the company up for sale or encourage potential bidders to consider the benefits of an acquisition. Activists can even pressure potential targets into a private equity deal with the activist itself (e.g. Elliott Management—Athenahealth) or with a company in which the activist has a substantial stake (e.g. Elliott Management—LifeLock). Further, by acquiring a company outright, a time consuming dispute with a reluctant management that can also be harmful to the activists’ reputation can be avoided.

There are also some obstacles for activist hedge funds to engage in private equity. Their investment strategies usually go along with rather short lock-up periods. Unlike private equity investors, activists usually have quarterly or even monthly liquidity. Having assets tied up in a buyout can be problematic in case a significant amount of investors request redemptions. Further, owning the majority of a company that fails to live up to its potential can hurt the fund’s overall performance and its reputation far more than a minority stake that underperforms.

Outlook

It remains to be seen to what extent the two investment classes will converge in the future. Taking into account the highly competitive environment and the latest developments towards long-terminism, sustainability and the revival of club deals, it is not unlikely that many activists will join the trend initiated by Elliott Management and rewrite their playbooks. The failed $15 billion acquisition of Arconic by Apollo Global Management and Elliott Management as co-investors shows that even well-established private equity firms are willing to team up with the most notorious activists. In the current highly valued, and extremely competitive market, private equity firms are keenly aware of the need to examine which strategies can deliver strong returns. As fewer but larger funds dominate the market, especially smaller private equity firms will have to look at different ways to compete. Private equity funds will stop being queasy about being seen as unfriendly to management. Most likely, partnerships between private equity funds and activists and hybrids will become the new normal.

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