Why were hedge funds developed and what role do they play in the market today? A hedge
fund is a type of open-ended mutual fund and were created as an alternative to the traditional mutual
fund. All mutual funds have managers, that is the person determining the assets that will be contained
in the fund. The fund prospectus will give risk and other important information for the investor to
determine if the asset is based for them. However, with hedge fund it is more of a private investment
and does not require a prospectus nor is the information about the fund made available to the public
because “they do not make public solicitation”[ CITATION BUSI536 \l 1033 ]. One could think of the
hedge fund as a partnership with only sophisticated, wealthy investors. The fund manager is like the
general partner and the investors are the limited partners and all the money is pooled together into the
fund. Within the hedge fund are two subgroups one being the risk arbitrage hedge fund and the activist
hedge fund, and they hedge funds are more relevant to mergers and acquisitions. That is because the
activist hedge fund is designed to seek out undervalued companies that are vulnerable to activist.
Several hedge funds have also sought to export American-style activism abroad, with companies
throughout the world now facing classic activist attacks. Many activist attacks continue to be designed to
force a takeover, sale or breakup of the target, or a change in management, either immediately or over
time. (Liptor, 2018). One way to look at how they play a role today is the idea that the hedge fund does
not seek to take over the company, but the thought is to get the company to make meaningful changes
that will improve their performance. By improving their performance, the value increases and in turn
the hedge fund ROA increases, making the investors more money.
Some of the reasons for deleveraging despite low federal interest rates can be explained by
companies wanting to carry more cash instead of debt. Leveraged buyouts required financing the
purchase with huge amounts of debt. “The lack of debt financing in the years 08-09, at a time when
rates were low, helps explain the big falloff in the number of deals”.[ CITATION BUSI536 \l 1033 ]. After
the economic crisis that occurred in 2008, monetary policy changed drastically. During the recovery
period corporations had more liquidity and could afford to use cash for purchases but even with the
liquidity banks were cautious and did not want to fund all types of deals as they had in the past.
Corporations deleverage is to help eliminate debt without incurring additional debt to do it. By doing so
this reduces the percentage of liabilities recorded on the balance sheet and builds more confidence to
shareholders. According to the Wall Street Journal, investors keep their eye on the debt of companies
and continue to let the amount of debt influence investing habits, mainly because the crisis of 08-09 are
still fresh in their minds.[CITATION Ques2 \l 1033 ]. Corporations used the logic that after the crisis and
due to all the monetary policy, that had been put into place, they would have not choice but to start to
pay off their debt. Consumers face the same issue, and biblically speaking paying off debt is what is
required, so it would make sense for corporations to do this also. Psalm 37:21 says “The wicked borrows
and does not pay back, but the righteous is gracious and gives.”[ CITATION Bible \l 1033 ]
What created the change in the activist acquisition targets? Typically, the fund would target
smaller companies because it was easier to acquire a large amount of those shares because first of all
less shares needed to become major holder and the cost of the shares were less money. Once the fund
was a major holder of the shares they could “bully” the target board and management to get them to do
what they wanted.[ CITATION BUSI536 \l 1033 ]. Although, the fund would have desired to control larger
corporations, it was not possible due to the amount of capital that would be required to accomplish this.
The text gives an example of Carl Icahn’s fund, even if they invested billions into one of these giant
companies, their interest would still only be 5% and not enough to bully the corporation. However,
around 2012-2014 this all changed and larger companies could now be the target for larger funds. As
the funds were able to get more AUM, assets under management, not only was the capital available to
purchase into larger companies, shareholders demanded it. These larger companies offered better
returns and increased wealth. Activist funds were getting more aggressive and diligent about finding
ways to buy into companies such as Microsoft and Apple, which showed that the size of the company did
not matter, and all companies were vulnerable. Shareholders liked purchasing into funds with a variety
of large cap investments and smaller cap one’s too, diversity seemed to be the way to go.[ CITATION
BUSI536 \l 1033 ].
Why is Jeff Smith known as one of the most aggressive activists and what was the result of his
actions? Many people think of aggressive activist hedge fund managers such as Icahn and Ackman but
let’s not forget Jeff Smith and his aggressive take over of Darden Restaurants. Smith’s fund,” Starboard
Value Fund” owned a mere 10% of Darden, however he took 100% control of the companies board. It is
important to note that the board of directors for Darden Restaurants were advised by some of the best,
names such as Morgan Stanley and Godman Sachs and Smith was still able to prevail. Big restaurant
chains such as Olive Garden and Red Lobster were some of the restaurants owned by Darden and started
out as part of General Mills. Smith recognized the failing smaller chains such as Olive Garden and Red
Lobster and called on shareholders to intervene when the board tried to auction off these chains. He
further initiated a proxy along with shareholders to remove the board and once the board was removed,
Smith replaced the entire board with himself and others he chose. This seemed impossible since most
boards should contain outsiders that do not have an interest in the business, however, in this case it
worked out for Smith and the “Starboard Value Fund”. In the end, Smith initiated many improvements
in these restaurants and by micromanaging he was able to make the restaurants profitable again. Smith
is unique, not only because he was aggressive and found a way to obtain these chains, but also because
he found a way to revive them.[ CITATION BUSI536 \l 1033 ].
What is the difference between a leverage buyout and a going private transaction? A leveraged
buyout is when a company purchases another company and virtually uses all debt to buy it. The way the
debt is secured is by using the assets of the company they are purchasing and then the debt becomes
the liability of the purchased company and the assets become the collateral for the loan. Generally
speaking, any major purchase by a corporation will involve some debt, even if the company has large
amounts of cash. However, leveraged buyouts are different than a normal purchase because of the high
debt to equity ratio and the fact the secured debt being used to buy the company is actually the assets
of the company being purchased, this allows them to make acquisitions without committing large
amounts of capital. When a company goes private then are essentially taking a company that was
publicly traded and taking it off the trading market. Shareholders are paid off and the shares are now
owned by private equity firms. Typically, this is done with a struggling company so that they can
restructure and try to make the company profitable again. Going private can be accomplished through a
LBO but going private is not the same as an LBO, instead it is a one method in which a company can go
private.
How have the trends in leveraged buyouts changed since their origination in the 1980’s? In the
1980 the market was experiencing all time highs and was considered a bull market. During this time
many companies were able to go public and have their stock purchased, even lower end smaller
companies were able to see gains. It was also a time when many when LBO firms were forming and
gaining popularity because they were able to find undervalued acquisitions and acquire them quite
easily. Although they were gaining in popularity, LBO, were still small compared to mergers. “For
example, in 1987 there were 3,701 mergers but only 259 LBOs.”[ CITATION BUSI536 \l 1033 ]. The
characteristics of LBO is the use of debt to purchase asset, but it was getting harder to do this because
funding sources were requiring more equity to be used in the purchase. Some of the challenges were
the high degree of failing LBO and the about of competition that were entering the market. During this
time, it was easier to enter a market because capital was readily available then had been in the past due
to the wealth in pension funds and endowments. Many individuals that worked for private equity firms,
the ones that controlled the LBO markets, were now using personal capital and starting new firms out on
their own. With the newfound interest by these individuals to start out on their own, LBOs started to
increase in numbers and by 1999 the number of deals had increase by nearly 50%. The deals were not
as large in dollars, but there were more in numbers. The text attributes this trend to a combination of
factors, including a robust economy, rising stock market, housing bubble, low interest rates, and equity
and debt capital was easily obtainable.[ CITATION BUSI536 \l 1033 ].
RJR Nabisco is ranked as one the largest leveraged buyouts; discuss another recent leveraged
buyout. How does this one differs from what happened at Nabisco? RJR Nabisco was unique in several
ways, first both Reynolds company and Nabisco both carried well known brands that were considered
staples with the average consumer. Prior to the buyout Nabisco had seen slowing sales but it was a solid
company with little debt and the same being true for RJR Reynolds. “The combination of many well
recognized products gave the company a high breakup value that Smith Barney estimated to be in the
85-92 per share range compared to the 56 dollar stock price”[ CITATION BUSI536 \l 1033 ]. Another
unique feature of this buyout was how the bidding started. Ross Johnson low balled the company with
an offer of 75 dollars per share. The problem here was Ross was charged with looking out for the
shareholders and here he was trying to cheat them. Finally, the third characteristic that made this a
unique buyout was the terms that the board presented. They required the company stay intact and not
be sold off in pieces and still have some public ownership. H.J. Heinz turned private in a deal with
Berkshire Hathaway and 3G Capital Partners valued at $23.5 billion in 2013. The ketchup and snack
company went on to merge with Kraft in 2015.
Discuss some of the potential conflicts of interest that take place in a management buyout. A
management buyout is similar to a leveraged buyout with the difference being the entity doing the
purchasing. In this case the management team such as officers, directors, board members are the ones
who pool together to purchase the company and assets of the business they current operate. A
management buyout is appealing because of the potential financial rewards along with control of the
company as an owner instead of an employee. Management buyouts (MBOs) are favored exit strategies
for large corporations that wish to pursue the sale of divisions that are not part of their core business, or
by private businesses where the owners wish to retire. The financing required for an MBO is often quite
substantial and is usually a combination of debt and equity that is derived from the buyers, financiers
and sometimes the seller. In a management buyout (MBO), a management team pools resources to
acquire all or part of a business they manage. Funding usually comes from a mix of personal resources,
private equity financiers, and seller-financing. One of the biggest conflicts of interest can come when
management wants to purchase the company, but their fiduciary duty is to get the best price for the
shareholders. As a result of the fiduciary responsibility owed by management, the buyout transaction by
its nature creates a significant conflict of interest. 18 In the management buyout, management sits on
both sides of the transaction; 19 it acts as the buyer and the seller, or rather as the agent of the selling
shareholders.2 Since the buyer and seller in any transaction have differing goals, there will obviously be
a conflict.[ CITATION question8 \l 1033 ].
How does debt have a lower cost than equity? How does this impact the company’s tax
position? When a business needs to secure funding to operate they can do it in two different ways, can
borrow like a loan or note, or they can sell more stock into the company. The loan is the debt part and
the selling of stock to raise capital is the equity part. When considering which one has a lower cost it
takes into consideration how the interest paid on the loan over the life of the loan will compare to the
profits being sacrificed by having those additional shares out there. The idea of why debt is cheaper is
because the loan will eventually end, and the interest will be paid. However, with selling additional
shares of stock that means the stock will always be out there and the companies’ profits will always be
shared with those additional shareholders, it will never end. The tax system provides a relative
advantage to financing capital expenditures through debt because under current tax law, businesses can
deduct their interest payments on the debt instruments, but dividend payments to shareholders are not
deductible. Thus, equity is disadvantaged because it is double taxed while debt correctly faces only a
single layer of taxation.[ CITATION Cur15 \l 1033 ].
List two ways of financing a leveraged buyout, which method would you chose if you were
brokering the LBO? There are two different methods of debt that can be used when putting together a
LBO, secured and unsecured. Secured debt, which is sometimes called asset-based lending is the money
being secured usually comes from a bank, and the assets of the company are considered the collateral
for the loan. Unsecured debt, which is also considered subordinated debt “lacks the secured debt”
[ CITATION BUSI536 \l 1033 ], guarantee that comes with having some type of collateral in case of default
on loan.
Works Cited
Dubay, C. (2015, September 30). Taxation of Debt and Equity. Retrieved from The Heritage Foundation:
https://www.heritage.org/taxes/report/taxation-debt-and-equity-setting-the-record-straight
Gaughan, P. A. (2018). Mergers, Acquisitions, & Corporate Restructurings. In P. Gaughan. Hoboken, NJ:
John Wiley & Sons.
Goldfarb, S. (2018, August 27). US Companies Begin to Chip Away at Mountain of Debt. Retrieved from
Wall Street Journal: https://www.wsj.com/articles/earnings-boom-helps-tip-u-s-companies-into-
deleveraging-1535365765
Jeremiah, D. (2013). The Jeremiah Study Bible--NKJV. Brentwood, Tenn: Worth Publishing.
Liptor, M. (2019, January 25). Harvard Law School. Retrieved from Dealing with Activist Hedge Funds:
https://corpgov.law.harvard.edu/2019/01/25/dealing-with-activist-hedge-funds-and-other-
activist-investors-2/
Shaw, B. (1990). Resolving the Conflict of Interest in Management Buyouts. Hofstra Law Review, Vol 19,
Iss1, Article 4.
Powered by TCPDF (www.tcpdf.org)
