Secondary Private Equity Markets No Longer Appear “Secondary!”

As I continue to hunt for my next major article, I thought I’ll focus on a general topic this time. And the subject that I have chosen to write about is an emerging private equity strategy that’s slowly but steadily gaining popularity.

Secondaries or Secondary private equity investments, in very simple terms, can be described as one private equity firm selling a company to another private equity firm. Another interpretation of this term, according to an article in Wall Street Journal, is a strategy through which investors such as pension funds and endowments sell off their investments in private-equity funds before the pools have sold off all their assets.

The secondary private equity market has been growing steadily, and even though it is in the maturing phase, stats have shown that the market is gaining popularity. Moreover, 2014 was indeed a remarkable year   for secondaries. According to a report by Preqin, $13 billion was raised in capital commitments by the end of June 2014. Figure 1 shows the comparison of annual secondaries fundraising since 2006.

According to an article in Wall Street Journal, secondary advisory firm Cogent Partners predicted that the secondary market could witness above $30 billion worth of transactions by the end of 2014, that is, almost twice the transaction value of 2013 ($15 billion).

Figure 1. (Source: Preqin Special Report June 2014)

 An overvalued stock market, a record amount of un-invested capital ($1.1 trillion) committed to private equity funds, and gaining popularity could imply that 2015 would be no different for this young maturing market. Expect more investors to flock to the secondary market this year resulting in greater aggregate capital raised.

Cybersecurity: The Next Meal for “Activ”ist Hedge Funds

It has been nearly a fortnight since the Sony Hack saga, but it is an event that is likely to haunt the business world for weeks, if not months. The entire episode underlies the importance of stringent cyber-security measures in today’s business world. According to a recent article in Wall Street Journal, the US Government and companies are involved in desperate attempts to find a solution to fortify their cyber defenses to prevent similar attacks in the future.

However, in addition to governments, there is one entity, which can ensure that cyber-security is at the forefront of company agendas. And that entity, which also happens to be my favorite superhero of the corporate world, is none other than the typical activist hedge fund!

2014 was the year of hedge fund activism. The growth has been so rapid that some have gone as far as saying that the world is witnessing activism on steroids. These activists are known to use a variety of tactics to force companies to undergo changes, which result in improved performance and stronger bank balances for the target companies’ shareholders.

In one of my earlier articles in my blog, I have mentioned how forcing the target company to be acquired has been the most successful and profitable hedge fund activist outcome. However, last year, we also witnessed a number of company splits as a result of hedge fund activism. Acquisitions and Spin-offs continue to be the popular activist outcomes even today.

However, in my opinion, 2015 should be the year where hedge fund activists shift their focus to strengthening the cyber defenses of their targets. The Sony incident was an eye opener to the corporations worldwide. However, corporations are known to be forgetful and it is precisely why the focus of hedge fund activists needs to be in the area of cyber-security. Activist investors like Carl Icahn and David Einhorn are capable of being quite forceful when required and are known to bring about positive changes in companies, which they target.

In today’s world where hackers have become increasingly sophisticated and where there are entities that are willing to use the cyberspace to inflict maximum destruction to their adversaries, it is extremely crucial that companies fortify their cyber defenses. And hedge fund activists are the perfect catalysts to speed up the process. 

Hedge Fund Activists: “Corporations, Its Time to Hit the Gym”

Carl Icahn, Trian Fund Management, JAT Capital Management, and Third Point are all hedge fund activists. More importantly, they are hedge fund activists who seem to love spin-offs. And I am not talking about television shows; I am talking about giant corporations being forced to spin-off their businesses into separate entities by hedge fund activists.

Hedge fund activist Carl Icahn is said to have played a major role in eBay’s decision to spin off its PayPal business from its Marketplace business early next year. According to a recent article by Wall Street Journal, Mr. Icahn is said to have proposed the split as early as January this year. He had to wait as late as September before eBay, with a little push from Apple Pay, finally caved in and decided to split. Moral of the story: patience pays, even for hedge fund activists!

The trend seems to be fast catching up. In the month of October alone, a number of companies have decided to split, whereas some are exploring a split. Hewlett Packard and Symantec Corp. have already voted yes, while DuPont Co, Madison Square Garden Co and Amgen Inc are currently in the maybe (soon-to be-yes) phase. And in most of these cases, the driving forces seem to be hedge fund activists. Trian Fund Management is pushing DuPont and Madison Square Garden, and according to an article in Wall Street Journal, it was only a few days ago that Third Point LLC took a stake in Amgen and started pushing it for a split.

So what could be the reasons, which prompt hedge fund activists to take stake in companies and urge them to split? It could be because post-split, the individual entities could become potential M&A candidates. Or it could simply be because hedge fund activists believe leaner companies would be easier to operate.

The reason my vote would go for M&A is because takeovers seem to be the most popular activist outcome, according to a recent research by professors Marco Becht, Julian Franks, Jeremy Grant and Hannes F .Wagner. In their working paper titled “The Returns of Hedge Fund Activism: An International Study”, they studied almost 1800 hedge fund activist cases across Asia, Europe and North America, and found out that takeovers were the most popular  activist outcomes in North America. Michael Schor and Robin Greenwood of Harvard Business School, in their paper, “Investor Activism and Takeovers” also support M&A after they found out that it is the ability of a hedge fund activist to force the companies to get acquired that generated abnormal stock returns for the respective shareholders.

Academic research, therefore, seems to be pointing out that hedge fund activists could urge giant corporations to split so that the individual entities could become ideal M&A candidates and get acquired, thereby generating maximum  returns for the shareholders.  And for eBay, that seems to be the motive. PayPal is tailor-made as an acquisition candidate and when the split happens next year, I would expect companies like Google and Alibaba to swoop in and bid. And as for other candidates, we will have to adopt a wait-and-watch approach.

 Hedge fund activists are on the rise. In an earlier article, I had pointed out that the number of hedge fund activist launches this year jumped to 28 from only 12 in 2013. And as the number of trainers keeps increasing, expect more corporations to join the gym and start losing weight, courtesy of spin-offs.

Has Obama Successfully “Inverted” Inversions?

Corporations and their “cunning” methods of avoiding taxation have been a talking point for a long time, with many being targets, recently, for governments worldwide. One such method, which has been brought to light, in event of recent developments, is Inversion.

Inversion deals are a way for companies to lower their tax burden by acquiring companies based in regions with low tax rates, and re-domiciling post the acquisition. Corporate tax rates in the US are currently set at 35%, and this has prompted several corporations to resort to inversion deals.

In fact, inversion deals in 2014 have soared to new highs. According to a recent news article in CNBC (which has derived the figures from Dealogic), M&A deals related to tax inversion had a combined total value of $315.3 billion (13 deals in total) by the end of the 3^rd quarter of 2014. For the same period in 2013, the number of inversion deals was to the tune of $71.7 billion.

A four-fold increase in attempts to escape taxes has clearly upset Uncle Sam, and this was evident when the Obama administration introduced new tax rules, which limited the economic benefits of inversion deals, on September 22. And the US government has ensured that any deals, which close on or after September 22 will be affected by these new rules, thereby sending a strong message to corporations.

Some of the key elements of the new rules are as follows:

•  A U.S. company will be prohibited from reducing its size pre-inversion by issuing extraordinary dividends just prior to launching an inversion.
• U.S. firms will be prevented from transferring assets to the newly formed foreign corporation that it spins off to its shareholders. 
• Companies will be prohibited from counting passive assets, such as cash & marketable securities, to inflate the foreign target's size, though financial institutions would be exempted.

Source: The Street (23/09/2014)

The repercussions were immediate. Upon hearing the news, AbbVie decided to terminate its $54 billion planned acquisition of Shire Pharmaceuticals, which would have been the biggest inversion deal in U.S. history, and which would have allowed AbbVie to relocate to the UK, thereby reducing its tax bills. AbbVie will now have to pay Shire approximately $1.6 billion in penalties as a result of the termination. Yet another US pharma giant, Salix Pharmaceuticals decided to terminate its acquisition of Italy’s Cosmo Pharmaceuticals SpA citing “changed political environment” for its change of heart. The new rules have also resulted in an increase in activity on K-Street. According to a recent report in Bloomberg, 41 companies have hired lobbyists on the issue, compared to a mere 14 in the previous quarter, a “desperate times call for desperate measures” situation.

So, now the pertinent question arises: Has the Obama Administration successfully killed Inversion M&A? Answer: Not Really!

Although the new tax rules successfully thwarted attempts by which MNCs can utilize cash stacked in their foreign subsidiaries without having to pay taxes on it, a method known as “hopscotch loan”, there are other ways through which corporations can still dodge taxes. One such strategy is the reason why banana giant Chiquita decided to go ahead with its acquisition of Fyffes and relocate to Ireland, according to a recent news article in the Huffington Post. This strategy, on which Chiquita will rely upon, is called “earnings stripping” whereby ChiquitaFyffes, the proposed parent company will provide loans to the US based Chiquita, and then write-off most of the US profits as interest payments on loans, which will remain tax deductible even under the new rules. Long story short, mission inversion still successful!

So although some trends, such as AbbVie’s case, indicate that Obama might have won round 1 in his fight against inversions, I have a feeling that with intense corporate lobbying, it would be the corporations who would deliver the final knockout punch! 

Hedge Fund Activism: Proof of Why Speech, and not Silence, is Gold in Business!

Last week, Darden Restaurants Inc. underwent a complete makeover of its board, where the current board, in its entirety, was asked to step down after an election. Yahoo Inc. is considering a merger with AOL after its shares began to tumble as an aftereffect of the Alibaba IPO. And last month, eBay decided to spin off its PayPal division into a separate public company in 2015.

These companies may appear to have nothing in common except perhaps the fact that they are undergoing dramatic shifts in their operation and/or management. However, the truth is that these companies, and many others, have one thing in common; they are all targeted by hedge fund activists.

Hedge fund activist Starboard Value was responsible for the removal of the entire board of Darden, as well as pushing Yahoo towards a merger with AOL. Billionaire hedge fund activist investor Carl Icahn was responsible for pushing eBay to spin off PayPal.

Activism has, in recent times, become an extremely popular investment strategy among hedge funds, so much so that the number of activist hedge fund launches jumped from 12 in 2012 to 28 in 2013, according to a report by Preqin. 

Number of Activist Hedge Fund Launches by Year 

Source: Preqin Special Report: Hedge Fund Activist Report

So what is hedge fund activism? Professors April Klein and Emanuel Zur, in their working paper, ‘Hedge Fund Activism’ define hedge fund activism as “a strategy in which a hedge fund purchases a 5% or greater stake in a publicly-traded firm with the stated intent of influencing the firm’s policies.” The policies include buybacks, spin-offs, acquisitions, and/or the sale of the firm itself.

How do we know whether a firm has purchased a 5% or greater stake? The answer lies in the Schedule 13-D filing, which has to be filed by the hedge fund with the Securities and Exchange Commission (SEC) when it purchases a stake of 5% or more in a firm. The SC 13-D filing reveals the identity of the buyer, the target firm, the stake in the company and the “purpose” for the purchase.

Now that we have got the boring definitions out of the way, it is time to focus on the performance of hedge fund activists. Hedge fund activists, have in recent times, been outperforming the traditional hedge funds. A recent news article in Wall Street Journal indicated that the returns of activist hedge funds gained 6.5% in the first half of 2014, almost twice the returns of traditional hedge funds. A similar pattern was seen in 2013 too where activist hedge funds generated average returns of 11.82% when the broader hedge fund industry generated only 7.88%.

Performance Comparison of Traditional and Activist Hedge Funds

Source: Wall Street Journal

So how do hedge funds become such successful activists? Studies have shown that the unique organisational structure of hedge funds makes them effective activists. Activist hedge funds hold few positions, although large in value, focusing on as few as 10 to 30 companies at one time, and thus, they are able to engage with the management and successfully implement changes in firm policies. According to Christopher Clifford, Assistant Professor at the University of Kentucky, it is the hedge fund’s freedom to lock-up investor capital and the power to use leverage and options, to increase effective ownership stakes, which make them reliable and effective activists.

Whatever may be the reasons and whatever the future may hold, one thing is clear: hedge fund activists have clearly proved that in business, speech, and not silence, is gold!

Yahoo’s Shopping Spree: Tactical Brilliance or A Sign of “Desperation”?

On a Friday morning (September 19, 2014), when China’s biggest online commerce company, Alibaba, filed for, what turned out to be a blockbuster IPO at the New York Stock Exchange, a certain technology company was yelling “Yahoo! Yahoo!” in jubilation. This chant, coincidentally, was its name too.

Yes, Yahoo had sold about 122 million shares of Alibaba in the IPO, and had coolly netted the proceeds, which amounted to $5.1 billion after taxes. And it continues to maintain a 16.3% stake in Alibaba, which is valued in the region of $37.7 billion. In short, the bet Yahoo made when it bought a 40% stake in Alibaba for $1 billion has paid off big, so big that it has shifted the focus from the struggles of its core business to its acquisition strategy in general.

Yahoo has acquired 41 companies in the last two years, according to a recent article in Business Insider. And CEO Marissa Meyer and M&A & HR Chief Jacqueline Reses have no plans of slowing down. Last month alone, it acquired advertising start up Luminate, and document handling start up BookPad. We are barely a week into October, and Yahoo has already announced its acquisition of MessageMe, a mobile messaging service that competes with Whatsapp Inc. And according to a recent article in Wall Street Journal, Yahoo is planning to re-invest some of the proceeds from Alibaba into Snapchat, which is valued at $10 billion. The figure below shows the number of acquisitions per year by Yahoo.

Source: CB Insights

Some would say Yahoo’s shopping spree has been nothing short of tactical brilliance. And they would happily point their fingers at Alibaba to make their case. Furthermore, post Alibaba’s blockbuster IPO, I would expect Yahoo to adopt an even more aggressive acquisition strategy.

However, a word of caution: there is a possibility that Yahoo’s shopping spree could lead to purchase of overvalued companies, which could prove hurtful to the company in the long run. There are two theories, which could explain this possibility: the Hubris Theory and the Desperation Theory.

The Hubris theory was put forward by Richard Roll in 1986, and it states that hubris on the part of individual decision makers in bidding firms can explain why they overpay for the acquisition. The windfall from Alibaba’s IPO could make Yahoo a victim of hubris, and it could end up overvaluing targets and paying lofty premiums for them, a scenario that would hurt its investors.

The Desperation theory can provide a clearer explanation for the possibility that Yahoo might end up overpaying for future acquisitions. The desperation theory was put forward by Ji-Yub Kim, Jerayr Haleblian and Sydney Finkelstein in 2011. According to this theory, there are two drivers of overpayment for acquisitions: low organic growth and high relative acquisition dependence. According to a recent article by Jeremy Quittner in Inc., Yahoo’s market capitalisation stands at almost $41 billion, and its 16% stake in Alibaba is valued at $37 billion. Remove Alibaba, and we have a company whose valuation is only $4 billion, which places Yahoo in the same league as AOL (market cap: $3.5 billion) and online daily deals retailer Zulily (market cap: $4.5 billion). No surprise then that hedge fund activist Starboard Value LP has urged Yahoo to merge with AOL. Its struggling core business could force Yahoo to continue to depend on acquisitions for growth. And this could result in venture capitalists, hedge fund activists, and other target company shareholders demanding lofty premiums, which a “desperate” Yahoo would have to end up paying. 

At present, Yahoo can afford to sit back and continue its shopping spree since it has the cash and a safety cushion in its stake in Alibaba. However, in the long run, whether its shopping spree eventually leads to overpaid acquisitions and a worrisome scenario in general remains to be seen. 

Apple-PayPal: A Match Made in Heaven?

On Tuesday, September 30, eBay Inc. finally succumbed to the demands of activist investor, Carl Icahn, and decided to separate its eBay and PayPal businesses into independent public companies in 2015. However, even before the split has occurred, reports are abuzz on PayPal being an ideal takeover target for companies trying to enter the lucrative mobile payments industry.

The mobile-payments industry is entering into an extremely competitive phase. The latest entrant is Apple, with its mobile payment service; Apple Pay (not iPay!). A host of retail giants, which include McDonald’s, Whole Foods, and Macy’s have already signed up to allow their customers to pay via Apple Pay. Mobile payments in the US alone are expected to touch approximately $118 billion by 2018 from $3.5 billion in 2014, according to EMarketer. This competitive and challenging environment is what prompted the eBay-PayPal split, says John Donahoe, eBay’s current CEO (He is expected to step down as CEO post the split, but will stay as a board member in one or both the independence companies).  

And this is also why companies like Google, Alibaba, and to some extent, Facebook will weigh the opportunity to acquire PayPal. Google is seeking a second chance to enter the online payment industry post the failure of Google Wallet. Alibaba is seeking to enter the United States following its blockbuster IPO, and wants to expand its payment service, Alipay. Facebook has already prized away PayPal’s former President, David Marcus, as it plans to venture into the world of mobile payments.

But the ideal suitor for PayPal, in my opinion, and this might surprise many, is Apple! One can argue that Apple has already launched Apple Pay, and this has become the reason, if many reports are to be believed, for eBay to separate PayPal in the first place.

So why should Apple acquire PayPal? For starters, PayPal has 152.5 million active registered users at present. Secondly, post the split, PayPal is expected to be debt-free as eBay has planned to keep its entire debt, which amounts to $7.5 billion, with its Marketplace business. The acquisition of a debt-free, hugely popular company, who also happens to be an expert in online payments, can help Apple gain a foothold in the industry. Above all, Apple is known to revolutionize every industry it enters (the iPod, iPhone, and iPad being key examples). Investors have been waiting for the “next big thing” for quite a while now. The acquisition of PayPal and its subsequent integration into Apple Pay could take Apple on the brink of revolutionizing the mobile payments industry.

So how much will the acquisition of PayPal cost Apple? PayPal has a potential market cap of $31.5 billion and according to Gene Munster, an analyst at Piper Jaffray, PayPal alone could cost between $50 billion and $62 billion. If Apple can splurge $3 billion on Beats Electronics, then any value in the range of $50 billion and $62 billion for a company that can help Apple leapfrog its competitors in an industry poised for a 34 fold rise in the US alone, will be money well paid.

The question, then arises, as to why PayPal should agree to be acquired by Apple? After all, it sees Apple as a threat, and a direct competitor. Also, Apple Pay is yet to be launched, and still hasn’t been successful, whereas PayPal is hugely popular among consumers. But if were to be successful, then it has the potential to could destroy PayPal. And there is more than one reason as to why the winds are blowing in the direction of Apple. A recent article on ABC news compared both Apple Pay and PayPal. The key takeaway from the comparison is the issue of security. Apple Pay, unlike PayPal, does not store the user’s private information, but makes use of the device account number assigned by the Phone’s Passbook, and a dynamic security code. In short, Apple Pay offers a more secure method of payment, and therein lies its potential success. Therefore, it is only inevitable that the current growth of PayPal declines and eventually it gets usurped by Apple. After all, as the old idiom goes, “If you can’t beat them, join them.”

Apple Pay has still not been launched, eBay still has not split, and it is very early days to even contemplate whether Apple will ever acquire PayPal. Although the more likely candidates for acquiring PayPal, that is, if PayPal does plan to be acquired, are Google, and Alibaba, the thought of Apple acquiring PayPal does sound enticing, and it has all the potential to become a match made in heaven!