Hedging Your Bet - Part 2

Tips for Interacting with Hedge Funds

In Hedging Your Bet, Part 1, we looked at what makes a hedge fund tick, including various strategies employed to protect capital while maximizing investment returns. In Part 2, we continue the discussion, offering tips for interacting with hedge fund managers.

When an IRO is organizing a marketing trip, hedge funds are generally not high on the list of meeting targets. Hedge funds are often pigeon-holed as short-term traders, and have a reputation for using management’s time for their own agenda rather than having a genuine interest in investing in your company. However, research^[1] suggests that hedge funds have an average hold period of 22 months – that’s hardly short term. As well, hedge funds can be opinion leaders and provide interesting insight. Therefore, meetings with hedge fund managers can be worthwhile, although their strategies should be understood before deciding which meetings to take.

For example, a hedge fund pursing a convertible arbitrage strategy will want to understand the terms and conditions under which the convertible can be called, converted or redeemed, as well as factors contributing to the volatility of the underlying stock. IROs whose companies have convertible securities need to be well-versed and able to answer technical questions.

In a merger or takeover bid, the target company’s shareholders will want to know that they are receiving full value, while the acquiring company’s shareholders will need to be assured that the purchase price is not too high. Arbitrage hedge funds, which tend to buy and sell rapidly based on nuances, are particularly hungry for the specifics of the deal and can be quite aggressive in pressing for more details. Review and understand the details of the offer so that you can answer their questions with confidence. However, do not give them more information than you have provided publicly; it is important to ensure that all shareholders have equal access to information.

Distressed securities are usually illiquid, as they are typically below investment grade, and long-term investments; for example, the length and outcome of bankruptcy proceedings are difficult to predict. Given their broader investment mandate, hedge funds in these situations can be buyers when traditional investors are sellers.

Activist hedge funds look for an opening (see warnings signs, below) and work to garner media attention and rally support from other shareholders to put pressure on management and the board to effect change. They tend to target companies that are undervalued (with low market-to-book value) but profitable (with positive operating cash flows and solid assets). Hedge funds are not interested in control; their goal is to get the company to take action to close the gap between the intrinsic value of the company and the market value of the stock. They may propose strategic, operational, and financial remedies to boost the stock price. Although behind-the-scenes dialogue with the board is often accompanied by media and public perception strategies aimed at increasing pressure, hedge funds typically prefer a negotiated settlement to a costly proxy battle.

Warning Signs

There are usually signs that a company is vulnerable. Monitor emerging issues and assess significant changes in:

• Market sentiment – commentary and recommendations in analyst reports, media articles, proxy voting patterns, shareholder proposals, stock performance, short positions, credit ratings and loan covenants
• Financial reporting – restatements, accounting practices, revenue recognition, write-offs, debt levels, dividend policy
• Regulatory compliance – regulatory reviews, inspection reports, health, safety or environmental infractions
• Competition – new competitors, new products, new processes
• Customers – customers’ growth, buying patterns, sales cycles, inventory levels, accounts receivable
• Employees – issues with safety, productivity, turnover, absenteeism, morale, ethical behaviour

Through daily contact with the investment community, the IRO can often act as an ‘early warning system’ in identifying investor concerns. Here are a few proactive steps you can take to ensure you are not caught flat footed:

• Maintain contact with the trading desks to help understand any anomalies in trading activity.
• Understand your shareholder base, including identifying and monitoring hedge fund ownership. A proactive shareholder identification program can yield valuable information about who owns your company’s stock. And an active targeting program can help ensure you have the most appropriate shareholder base. The right investors will support the company’s underlying value and help to moderate volatility.
• Maintain open lines of communications with your major shareholders. Invite direct investor feedback or conduct a perception audit to get feedback anonymously.
• Educate the board about the tactics employed by activist shareholders and hot button issues. Expect any approach by an activist hedge fund to be supported by a thorough analysis and don’t be surprised if the hedge fund knows the company and industry as well as management.
• Identify your experts and advisors so you don’t lose valuable time if the need arises.
• Adopt an advance notice by-law to protect against a surprise attack at the annual meeting. For example, an activist hedge fund can seize the agenda by nominating directors from the floor. An advance notice by-law requires that any person proposing to nominate a director provide the company with advance notice of, and prescribed details concerning, the proposed nominee. This ensures that all shareholders are informed about and have the opportunity to vote for each of the candidates put forward for election to the board.

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