Given the unpredictability of today’s financial markets, many investors are looking to reduce the impact of market volatility on their portfolios. Hedge-fund strategies—a type of alternative investment strategy—may help by potentially offering additional diversification, new sources of return and reduced risk. K2 Advisors seeks to add value through active portfolio management, tactical allocation and diversification across four main hedge strategies: long-short equity, relative value, global macro and event driven. Here, K2’s Rob Christian discusses why the team favors activist hedge strategies as a subset of the event-driven strategy, and how attitudes toward activist investing have changed.

When describing hedge-fund performance—and more specifically hedge-fund alpha1 —words like “generating,” “producing,” and “creating” are often used. These expressions are somewhat misleading, in my view. They imply that hedge funds, by their own sheer will and determination, can somehow conjure alpha on demand. For the majority of hedge funds this is not the case. Technically speaking alpha is not generated, nor is it produced, manufactured or built. Indeed, for the majority of successful hedge-fund managers, the most that can be expected of alpha is that a fair amount of it may be captured over the course of an investment horizon. That is the key—alpha is largely captured. A good market day for a hedge fund means that the fleeting alpha ghost has had the misfortune of stepping into a cleverly constructed trap—if only momentarily. The nature of alpha is elusive, and that is why investors will pay for it.

The Exception to the Rule

Like all good rules however, there are exceptions. In my view, activist hedge funds represent one such exception. It could be said that activist managers in some ways represent the only strategy that generates alpha to some degree. While not always successful, activist funds seek to unlock “hidden” value in the companies they invest in.

They look for stocks that are trading at a discount to intrinsic value, and then instead of waiting passively for the market to recognize this perceived hidden value, the activist hedge fund will proactively work to expose—or elevate—that value to the market. In this way the strategy quite literally attempts to generate or harvest alpha proactively by promoting the catalysts that may increase stock value.

Activism: A Primer

Briefly, the strategy of activist investing involves taking a minority position in a public company, with the goal of helping unlock said company’s value by influencing management to modify its capital allocation activities. That is, run their businesses in a more efficient and profitable manner. Tactics include financial restructurings, operational turnarounds and/or strategic initiatives.

Implicit in the strategy is the notion that the targeted company is undervalued and generating earnings below its potential (based on the hedge fund manager’s assessment) and the activist has a plan to help unlock this potential.

More than three decades ago, some of the same players in the activist space today may have grabbed headlines under different—perhaps less flattering—characterizations as part of the leveraged buy-out (LBO) frenzy of the late 1980s and early 1990s. Indeed, some of the same iconic names that today are held up as defenders of the average investor, often praised for holding management teams accountable, were in days of yore condemned as “robber barons,” “corporate raiders” and “barbarians at the gate.”

Not anymore. The “barbarians” of the 1980’s no longer crash the gates as much as they wish to repair them.

The game today is more about diplomacy than aggression, as activist investors have found it easier (and clearly more profitable) to work with corporate management to help implement positive change, versus trying to take full control of a company and possibly liquidate its prized assets. In this way, the spoils are shared among many.

Today it is about building venerable brands versus destroying them, and activists no longer need to take over a company to influence action. Often it is possible for a hedge fund with a minority stake (perhaps just over 5%) to initiate change with cooperation from management, possibly by nominating a member of the hedge fund’s team to the company’s board of directors.

As a high-profile activist stated to Bloomberg, “the least effective way to do activism these days is to come in with a big club. The best result is to have a board hear your ideas, realize they are good and then acquiesce…we prefer to work with management in making changes that increase shareholder value, but sometimes you have to go to the mat.”2