Institutions keen on activist hedges

Activist hedge funds have pulled in at least $2 billion in new assets from institutional investors over the past two years, with a marked acceleration in pace in the second half of 2011 and so far in 2012.

In many cases, institutional investors are using traditional long-only equity assets — rather than dedicated hedge fund allocations — to fund big-ticket mandates to equity hedge funds that focus on pushing for operational changes in public companies in order to increase shareholder value.

The swell of assets from institutional investors in the past year led two prominent activist hedge funds to close their strategies to new investors, industry sources said. ValueAct Capital Management LP capped its activist strategy at $8 billion, and Starboard Value LP is holding its small-cap-oriented strategy at $1 billion.

Among the large institutional investors in activist hedge funds:

• The Florida State Board of Administration, which oversees $156.8 billion in pension and other state assets, in 2010 started building an activist hedge fund portfolio that now includes four funds managing about $550 million. The most recent investment was a $125 million allocation in May 2011 to the Starboard Value & Opportunity Fund.

• The New Jersey Division of Investment, which oversees the state’s $70.5 billion in pension assets, has a total of $575 million invested with four activist hedge funds, most recently allocating $150 million to Cevian Capital II in January.

• The $140.3 billion New York State Common Retirement Fund in late 2011 committed $200 million each to Cevian Capital II, Trian Partners Strategic Investment Fund and ValueAct Capital Partners II.

• The Virginia Retirement System last month committed $250 million to Cevian Capital II from the $53.6 billion state pension fund.

STRONG ATTRACTION

For institutional investors, especially public pension funds, the allure of activist hedge funds is their strong, uncorrelated equity returns, Stephen L. Nesbitt, chief executive of alternative investment consultant Cliffwater LLC, wrote in an e-mail.

The average annualized return for the five-year period ended Dec. 31 for a group of eight unnamed activist hedge funds that are of institutional quality was 8.6%, with aggregate risk of 13.8%, according to Cliffwater’s analysis. That compares with a return of 0% for the Russell 3000 Index, with a risk level of 19.6%, and a 1.8% return for the Morgan Stanley Capital International All Country World Index, with a 21.2% level of risk.

“Some investors are opting to replace some of their traditional active equity managers with activist hedge funds that are not afraid to make big, concentrated bets and to emphasize a hands-on, value-added approach,” said Joseph Larucci, a partner at alternative investment consulting firm Aksia LLC.

Because most activist hedge fund managers are classified as long/short equity managers but tend to be net long and rarely short securities, institutional investors are readily inclined to “place these managers in the long-only equity allocation, where traditional alpha has been scarce,” Mr. Nesbitt wrote.

Institutional investors favor activist managers such as Cevian Capital Ltd., Starboard Value LP, Trian Fund Management LP and ValueAct Capital LLC, which generally work behind the scenes with corporate management to effect positive changes.

Some activist firms are more aggressive, including Pershing Square Capital Management LP and Third Point LLC, whose iconic chief executives, William A. Ackman and Daniel S. Loeb, respectively, aren’t shy about waging their battles in the public eye. They also manage money for institutional clients, including the New Jersey Division of Investment. But according to public reports, the sizes of their institutional mandates tend to be smaller than those awarded to activists with a more subtle approach.

Neither Mr. Ackman nor Mr. Loeb responded to requests for interviews.

Jana Partners LLC has had good luck taking a more collaborative approach with corporate boards, said Barry Rosenstein, the firm’s managing partner and co-founder.

Jana’s flagship hedge fund strategy is event-driven but includes up to 25% or 30% of exposure to activist plays. The activist strategy also is available as a stand-alone fund with a three-year lockup and a private-equity drawdown structure.

CONCENTRATED BETS

Jana’s activist strategy takes concentrated bets on undervalued companies when the investment team is convinced that its actions can trigger a catalyst that will “close the gap between fair value and what the stock is trading at when we acquire it,” Mr. Rosenstein said. “We control our own outcome and are not dependent on the good will of the market to increase shareholder value,” he said.

“We’ve conducted 40 activist campaigns over the past 11 years, and we prefer to work cooperatively with management,” he said. “The outcome will be the same if they fight us, and because nobody benefits from a fight, when we show up, the conversation tends to become more constructive.”

The firm has $3.5 billion under management and in commitments, primarily from institutional investors.

Paulson & Co. Inc., an event-driven and merger arbitrage specialist, also has had success over the years with occasional “constructive activist” campaigns, said John Paulson, its founder and president.

In March, The Hartford Financial Services Group Inc. agreed with the hedge fund manager’s recommendation to sell noncore business units to focus on property-and-casualty insurance, group benefits and mutual funds. Paulson & Co. Inc. is the insurer’s biggest shareholder and worked with the firm to improve its share price.

“I would say that our overwhelming preference is to work constructively with management to improve shareholder value. You have a choice,” Mr. Paulson said.

“You can always just sell the stock if you see too much recalcitrance from management, but we had an open and collaborative dialogue with Hartford’s management,” he said.

Paulson manages $22.4 billion for institutional and other investors.

Such corporate campaigns can take years to bear fruit, which makes them especially well-suited for institutional investors with long-term horizons, said Harlan Zimmerman, a senior partner at Cevian Capital.

“A lot of the interest we’ve seen of late from institutional investors is driven by their realization that most investors — and by that I mean money managers — are becoming more and more short-term in focus. Volatility means predicting what markets will do is getting harder,” Mr. Zimmerman said.

“But endowments, foundations and pension funds are in a good position to invest with hedge funds like ours that practice horizon arbitrage, where as activists, we focus on long-term value. When the whole world is moving in one direction, based on short-term motivations, there is greater and greater opportunity to capture alpha by being much more long-term in our approach,” Mr. Zimmerman said.

Cevian Capital manages $6 billion for institutional investors in activist strategies.

Christine Williamson is a reporter for sister publication Pensions & Investments.