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Wall Street Journal MarketWatch, December 2, 2010 article



Hedge Funds

Dec. 2, 2010, 10:04 p.m. EST

Operational activists’ work pays off
ValueAct, Cevian, Barington see big gains as corporate revenue rebounds

By Alistair Barr, MarketWatch

SAN FRANCISCO (MarketWatch) — Operational activist hedge funds, which take long-term stakes in companies and push for strategy changes, are reaping rewards from hard work during the recession.

ValueAct Capital Management, a $4.5 billion firm led by Jeff Ubben, was up roughly 35% this year, through early November. That was on the back of a 40% gain in 2009.


Jeff Ubben, head of ValueAct Capital Management.



Cevian Capital, Europe’s largest activist investment firm headed by Christer Gardell and Lars Forberg, gained almost 30% in the first 10 months of this year and returned 36% in 2009. Read MarketWatch’s profile of Cevian here.

Barington Companies Equity Partners, run by James Mitarotonda, returned almost 11% in September alone. It was up more than 20% so far this year, through the middle of November, after jumping over 52% in 2009.

“Operational activists have accomplished a lot over the past two years with their portfolio companies,” said Tony Lissuzzo of Lakeview Investment Manager, which invests in activist hedge funds. “The market rally and some economic pickup has highlighted the companies that used the recession to rationalize their businesses.”

“As I look at the companies in our managers’ portfolios I see good values and coherent plans to realize that value,” he added. “You cannot discount the work they’ve done through the recession on some of their longer-term positions.”

2008 Losses

Activist hedge funds often take big stakes in companies and push for share buybacks, bigger dividends and sales of divisions or the whole corporation through mergers and acquisitions.

Barington Capital

James Mitarotonda, head of Barington Capital Group.



Operational activists try to differentiate themselves by holding stakes in companies for several years and often becoming directors and even chairing boards. Instead of focusing on buybacks, dividends and M&A, they attempt to change the way companies work and come up with new strategies.

This approach produced heavy losses during the 2008 financial crisis. As stocks swooned in the wake of Lehman Brothers’ bankruptcy, the big positions held by operational activists were hit hard.

Most of these firms don’t short, so they were exposed as other investors panicked and sold stocks indiscriminately. If managers are board members, they are subject to strict trading limits, which may have reduced their ability to maneuver during the crisis.

Barington lost 46% in 2008, while Cevian was down 32% and ValueAct shed 28%.


But the losses masked changes underway at several companies backed by these investment firms.

For ValueAct, the financial crisis was an opportunity to put companies’ cash flow to work, often in attractively priced acquisitions.

ValueAct doesn’t short stocks, but the firm’s hedge is its focus on ten to 15 high-quality businesses that can generate cash in good times and bad.

”Our role in the boardroom is allocating capital,” Ubben said in an interview with MarketWatch. “Down markets are really opportunities. With these companies generating cash flow, we were in the room and we could act when prices fell.”


ValueAct’s largest holding is Valeant Pharmaceuticals International Inc. (VRX 28.05, -0.02, -0.07%), a position the firm has held for a few years.

ValueAct partner G. Mason Morfit joined Valeant’s board and the chief executive was replaced with a former McKinsey & Co. partner J. Michael Pearson.

The company has shifted away from developing new drugs in favor of an acquisition spree focused on manufacturing branded generics, Ubben explained.

Valeant has made at least 14 acquisitions in recent years, helping annual earnings, before interest, taxes, depreciation and amortization, jump from about $150 million to $850 million, Ubben added.

In September, Valeant merged with Biovail in a $3.3 billion deal. Although this was a “big bite,” Ubben reckons the company can make more acquisitions in the industry by focusing on manufacturing, rather than the science.

Valeant shares lost two-thirds of their value from the middle of 2007 to October 2008, in the midst of the financial crisis. Since then, the stock has tripled.

Ubben said part of the company’s success involved a potentially lucrative compensation package for Pearson that aligned the CEO’s incentives with those of shareholders.

“We incented in the hell out of him... Alignment of interests is very important to us,” Ubben said during a presentation earlier this year.

“The stock has tripled. You can’t pay him enough for that shareholder value,” Ubben added. “If he can’t do it, you fire him.”


ValueAct’s second-largest position is U.K.-based software company Misys Plc (UK:MSY 302.20, -1.90, -0.63%).

Misys acquired Allscripts in October 2008, at the height of the financial crisis, then merged its health care software business into the company, which specializes in electronic health records.

The combined business, Allscripts-Misys Healthcare Solutions, bought Eclipsys Corp. for $1.3 billion in stock earlier this year.

Misys sold its 54.6% stake in Allscripts (MDRX 17.94, +0.31, +1.76%) as part of the deal. That raised about $1.3 billion. More than $1 billion of that money was returned to Misys shareholders, including ValueAct.

“We made three times our money,” Ubben said.

“With low-cost debt, willing sellers and cash flowing, it was wonderful,” he added. “The last two years, it’s been as good as it gets.”

‘Sense of urgency’

The deep recession gave other operational activists the chance to push through changes that might have been rejected in better times.

Cevian Capital

Harlan Zimmerman, London-based partner at Cevian Capital.



“The crisis instilled a sense of urgency among all stakeholders — managements, boards, other shareholders, even unions,” said Harlan Zimmerman, a partner at Cevian. “This meant we could walk in the door and start talking immediately about what changes to make.”

In the midst of the crisis, other investors in the stock market didn’t care about such changes, because “they were even more skittish and short-term focused than they normally are,” Zimmerman added.

“Recently, as the world has started to normalize and revenues have started to come back, we’ve been enjoying the payoff for the work that we’ve been doing over the last two years,” he explained.

“The cost structures of our companies have been cleaned up, and the companies have achieved a new level of profitability,” Zimmerman said. “This has driven our strong returns this year, and we expect that dynamic to continue as revenues get back to pre-crisis levels.”

Crane giant Demag Cranes AG (DE:D9C 37.25, -0.46, -1.21%), in which Cevian unveiled a position earlier this year, has been shutting facilities in high-cost countries. As manufacturing recovers, they are opening factories in lower-cost areas, improving profitability, Lakeview’s Lissuzzo explained.

Pep Boys

Barington’s Mitarotonda said the recession forced many U.S. companies to make painful cuts that are paying off now.

Barington has owned a big stake in auto parts and service company Pep Boys (PBY 13.57, +0.61, +4.71%) since at least 2005, before the global financial crisis.

Mitarotonda, who is chairman of Pep Boys’ board, helped bring in new management, while developing a new strategic plan for the company.

Pep Boys has two main businesses: the retail auto parts side and a service business where customers bring in their cars to get oil changes and other work done.

The focus is now on growth through the service side, which has higher profit margins. The auto-service industry is highly fragmented, giving the company room to expand.

Pep Boys’ businesses used to be operated independently of each other, which meant there was always a retail store manager and a service group manager. These were meshed together and the management structure was whittled down to reflect that.

Pep Boys is also opening new service-only locations and these will buy products from the company’s commercial-equipment business.

Pep Boys has also reduced debt from about $600 million to $300 million under Barington’s watch.

“This was done from the generation of free cash as well as from sale leaseback transactions involving some of the real estate assets that Pep Boys has,” Mitarotonda said. “Many of Pep Boys’ stores are owned by the company.”

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Since Barington’s representatives joined the company’s board, Pep Boys has closed four tranches of sale leaseback transactions involving about 100 store properties. The company has also realized over $80 million in cost reductions.

“As a result of changes that were made, the company has become much more efficient,” Barington Chief Operating Officer Jared Landaw said.

“They are more profitable than they were before the recession, and on significantly lower revenue,” he added. “As sales increase, we believe that there’s an opportunity for the company to generate above-market returns for its investors.”

Pep Boys shares plunged more than 80% from the middle of 2007 to early 2009, in the depths of the financial crisis. Since then, the stock has almost quadrupled.

A. Schulman

Barington invested in plastics company A. Schulman Inc. (SHLM 22.46, +0.37, +1.67%) about four years ago. About 30% of revenue was from North America and 70% came from abroad — with all the profit generated overseas.

Mitarotonda joined the board and a new chief executive started in January 2008. A special board committee was set up to oversee the company’s operating budget and business plan.

“Costs were cut and capacity was reduced in North America pretty aggressively,” Mitarotonda said. Now A. Schulman’s North American business is profitable, after roughly a decade of losses, he noted.

A. Schulman also used to operate with about $150 million of net working capital. That represented about 120 days of working capital, a chunk of which was used to finance big inventories.

Rivals had about 60 days of working capital. The company it down to that level, partly by working off inventory. That helped generate cash that could be returned to shareholders or used for acquisitions.

Since representatives of Barington joined the Schulman board, the company has also reduced selling, general and administrative expenses, improved its gross margins, increased cash flow.

“The company is now much stronger,” Mitarotonda said. “We were able to do this during an incredibly difficult economic environment.”

A. Schulman shares lost about 40% from late 2006 to April 2009. But the stock has rallied almost 60% since then.

Alistair Barr is a reporter for MarketWatch in San Francisco.

Copyright © 2010 MarketWatch, Inc.




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