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The dark cloud of the international credit crunch caused by the United States’ subprime mortgage defaults may yet have a small silver lining for public companies: the real possibility of a decline in hedge fund activism. In recent years, hedge fund activists have leveraged themselves into large stock positions and used that platform to maximize their own short-term gains. Ignoring the long-term interests of public companies and the interests of traditional shareholders, hedge fund activists often have pressured companies to sell themselves, in whole or in part, or to incur significant debt to fund large scale stock buybacks. Now that funding for leveraged buyouts is difficult to obtain and the corporate credit market has made it significantly more onerous for companies to incur additional leverage, it should be much harder for activist hedge funds to acquire or profit from the degree of influence that they have enjoyed in the recent past. It is important to note that not all hedge funds are alike and that the term is frequently overused by the media. Activist hedge funds need to be differentiated from the type of hedge funds that a company ought to view as friendly, long-term investors that appear to be genuinely committed to value creation for all shareholders over a significant period of time (as opposed to short-term speculators). In addition, activist hedge funds, unlike long-term investors, often hedge their economic risk by using derivatives and other trading strategies that effectively allow them to vote shares over which they have little or no economic interest. There have been many signs that hedge fund activists are finding themselves in trouble. One example is the aptly named Pirate Capital’s Jolly Roger Activist funds, which used to be prominent in the world of hedge fund activism. Pirate Capital announced on Aug. 31 that it has barred withdrawals from its two Jolly Roger Activist funds in the wake of an almost 80 percent decline in the firm’s assets under management. It is not only activist hedge funds that are suffering. Hedge funds generally are facing significant difficulties in the current credit crisis; even firms such as Bear Stearns, Goldman Sachs, insurer AXA and BNP Paribas have had to freeze, shut or bail out problem funds. In Bear Stearns’ case, a massive investment of $1.6 billion in loans to a troubled fund was not sufficient to provide stability. It is clear that for the foreseeable future, lenders will require more collateral to secure hedge funds’ borrowing as well as tighter covenants on borrowings generally; this should significantly curtail hedge funds’ ability to obtain large stock positions in target companies. Once established as significant shareholders in target companies, hedge fund activists typically have pursued a limited range of outcomes: a sale of the target company or a breakup of the company with a piecemeal sale or spin-off of significant operations, significant stock buybacks financed with company debt or payment of a special dividend to shareholders. At one point, funds were so successful at forcing buybacks that they reached $117 billion in the second quarter of 2006, compared with a quarterly average of $87 billion in 2005. Indeed, one commentator observed that the activist shareholders who caused companies to increase their debt to undertake massive buybacks inadvertently created at some companies a class of angry, activist bondholders. These massive buybacks are less feasible in an environment of higher borrowing costs with tighter covenants. Similarly, sales or partial sales of target companies are more difficult to consummate in the current environment. It is no longer as easy to take companies private because the typical model used by the private equity industry has come under significant pressure with the weakened credit markets. Even though many private equity firms have significant equity available to deploy, with significantly reduced availability of credit, fewer private equity firms are able or willing to buy assets for large multiples; as a result, companies that activist funds might have wanted to put into play would, if pursuing a sale, be negotiating with strategic buyers or otherwise more cautious buyers generally. One estimate is that $225 billion in debt from private equity deals currently requires refinancing; this overhang depresses the ability to offer the typical LBO premium in the current market. A new study from Harvard Business School indicates that without the ability to get target companies sold, fund activists will be less effective in pushing companies to make changes. The authors found that large numbers of hedge funds took on an activist role in recent years, hoping to maximize their investments by pressuring companies to take actions that would improve the hedge funds’ positions. According to their study, the number of public companies targeted for poor performance by hedge funds grew more than tenfold between 1994 and 2006. Despite the prevalence of hedge fund activism, however, the study identified the apparent contradiction in the notion that a hedge fund portfolio manager with a short-term financial goal would have the time, energy or expertise to improve the performance of a public company. When examining the effectiveness of fund activism in producing value for shareholders, the study found that, in fact, when a target company did not get sold, there was little change (during the 18 months following the first activist filing) in the company’s stock price or financial results � even when the company took other steps urged by the activists, such as replacing the chief executive officer, changing the composition of the board or buying back stock. The study reveals two other important facts about fund activism: first, that investments by activist funds increase the likelihood that target companies will get sold; and, second, that activist funds earn high returns for shareholders only when they succeed in getting the company sold; at that point, share prices rise and all shareholders reap the same benefits. In an environment where private equity is relatively weak and the ability to leverage is severely constrained, corporate managers may be emboldened to fear hedge fund investors less and resist activist intervention more. Even pending leveraged buyouts are having difficulty reaching completion in the current credit crunch. Some market-watchers have gone so far as to say that the market for LBO-related debt is effectively closed. Notably, in August, Pershing Square Capital gave up its efforts to find a buyer to outbid a $5.3 billion offer for Ceridian Corp. Other private equity transactions also appear to be in trouble as well. The symbiotic relationship between activist hedge funds and buyout firms will be less intimidating as LBO money becomes scarce. Despite the hard times that have recently befallen hedge funds and private equity investors, potential target companies nonetheless should stay on the alert. Hedge fund activists may reinvent themselves as “event-driven investors,” or, as Carl Icahn calls the new group to which he intends to belong, “distressed activist investors,” that target struggling companies in order to attempt to extract maximum profits from their remaining assets. According to Eurohedge, European event-driven funds, which tend to be dominated by activist investors, doubled in number in 2006 thanks to increased leveraged buyout activity over the past couple of years. This increase comes despite European politicians’ public disapproval of shareholder activism on the European continent. Even if there is a decline in hedge fund activism, public companies need to remain vigilant and carefully monitor changes to their shareholder base. They also need to be proactive in rationalizing their capital structure and taking advantage of market conditions to repurchase shares and engage in appropriate acquisitions when the opportunity presents itself. Corporate defenses should be reviewed regularly and updated as appropriate. Effective communication between the board and senior management team is essential, especially in the context of focusing on corporate strategy. By being proactive, public companies can reduce their vulnerability and be better prepared should they be targeted by a hedge fund activist in the future. Indeed, notwithstanding the visible effects of current market conditions on hedge fund influence and activism, it is important not to overestimate the importance of the recent credit crisis. The situation in the markets fundamentally is a liquidity crunch due to a crisis of confidence, rather than a crisis of credit. Estimates of the total damage due to subprime mortgage defaults range between $45 billion and $100 billion, approximately 1 percent or less of the total market capitalization of the S&P 500. Once confidence is restored, business as usual could more or less resume, with a bit more caution and a bit less exuberance. Though credit market conditions are expected to be difficult in the near future and high volatility also will be a factor, private equity deal making � and its partner, hedge fund activism � are certainly not over. The question is how long the holiday will last. DAVID A. KATZ is a partner at Wachtell Lipton Rosen & Katz. LAURA A. MCINTOSH is a consulting attorney for Wachtell Lipton Rosen & Katz.

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