Will the SEC Trim the Hedges?

News that the Securities and Exchange Commission gave a Wells notice to a hedge fund because of its actions in the failed merger of generic drug manufacturers MylanLaboratories (NYSE: MYL  ) and King Pharmaceuticals (NYSE: KG  ) is sending out tiny ripples in the hedge fund community. The regulators have sent notice that they don't want hedge funds influencing mergers if they don't risk losing any money in the deal.

Private investment partnerships, otherwise known as hedge funds, can serve as a counterbalancing influence on corporate management. Because they seek to maximize returns for their investors, hedge funds many times take large positions in companies and then make a lot of noise to force actions that increase the value of that position. Individual investors like you and I can enjoy the ride as the value of our shares increases alongside those of the fund.

Good vs. evil
For example, Motley Fool Hidden Gems selection FlamelTechnologies (Nasdaq: FLML  ) possesses some great nanotechnology but was mired in place, losing deals, and looking like it was beholden to the ego and whim of its founder, Gerard Soula. Dissident shareholder Oscar Schafer, who leads hedge fund OSS Capital Management, chafed at the inertia Flamel was seemingly caught in and subsequently moved to oust Soula and install a new management team. While no new deals have been signed just yet, the stock has moved up about 12% since last June.

Conversely, because hedge funds are primarily interested in their investors and not other long-term shareholders, their actions can work against the interests of individual shareholders. Another Hidden Gems pick is a case in point. Analyst Bill Mann selected Fairmont Hotels & Resorts (NYSE: FHR  ) because he recognized the undervalued assets the company had. Apparently those assets also attracted the attention of corporate raider Carl Icahn, who purchased a 9.3% stake in the chain and seeks to maximize shareholder value through "strategic alternatives." That's all well and good, but management at Fairmont had already been implementing plans to maximize value and was doing just fine without Icahn. In this instance, all shareholders are not necessarily being helped by his maneuvers.

In both cases, regardless of whether their actions were for good or ill, the hedge funds had an economic interest in the outcome. We might not like the plans Icahn has laid out for Fairmont, but at least he also stands to lose should they not pan out.

The empty trade
Perry Capital is a $10 billion hedge fund that had acquired a sizable 7-million-share position in King Pharmaceuticals. Interestingly, Carl Icahn was the largest shareholder in Mylan Labs, with a 9.8% stake. When Mylan made a merger bid for King, Perry supported the deal while Icahn opposed it: He had been rebuffed in his own bid to buy Mylan.

To ensure that the deal went through, Perry Capital then bought more than 26 million shares in Mylan, or 9.9%, thus unseating Icahn as the largest shareholder. But at the same time Perry bought the shares, it started a complicated equity swap with brokerage houses Bear Stearns (NYSE: BSC  ) and Goldman Sachs (NYSE: GS  ) that had the effect of negating any of its risk of loss. Perry kept full voting rights, and thus could vote in favor of the merger, but would not have suffered any fallout if the merger fell through. It's a situation that's been referred to as an "empty trade."

One way an equity swap achieves this is by one company -- in this case a hedge fund -- buying shares in a company and then agreeing to pay another party -- the brokerage houses -- the total return on the stock (depending on how high the shares have risen and what dividends it paid) at a set interval, usually annually. In exchange, the brokerage pays a fixed or floating rate on a fixed principal amount to the hedge fund.

The only risk for the fund would be if the other party defaulted, but in this case, the chances of Bear Stearns or Goldman Sachs, both exceptionally well-capitalized, reaching such dire straits are virtually nil. Perry Capital fully hedged its position by shorting an equal amount of stock, as well as being able to sell back to the brokerage firms the shares it had purchased for the same price it had paid. Sweet deal.

The fallout
The Mylan-King merger fell apart, however, when Perry Capital disclosed its position in Mylan and Icahn filed a civil suit. The SEC picked up the ball, telling Perry that it was investigating its transactions in the merger and was considering bringing a civil enforcement action against it, and saying that Perry might have violated the anti-fraud provisions of securities law, which require large shareholders to disclose applicable financial information about their holdings. For its part, as is often the case with such notices, Perry denies any wrongdoing and will "outline (its) strong defenses to the proposed action."

Foolish final thoughts
Hedge fund activism can often be an agent for change at companies that have failed or are failing to unlock or create shareholder value. Oscar Shafer is seen as a respected voice, as is Whitney Tilson, who runs T2 Partners and used to write for The Motley Fool. Carl Icahn is seen as something less savory, though he has been undeniably successful for himself and his investors. Billionaire financier George Soros, who runs the Quantum Fund, stands somewhere in between.

As hedge funds are immersing themselves even more in mergers and acquisitions, a field that is fast approaching $1 trillion a year, it's not surprising that they will now also find themselves under closer scrutiny by regulators. I see little reason for the SEC to conduct a full-frontal assault here. In general, hedge funds are operating lawfully to maximize returns for their investors, even if we don't always like their methods. That's a goal we can all support.

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Fool contributor Rich Duprey owns shares in Flamel but does not own any of the other stocks mentioned in this article. You can see his holdings here. The Motley Fool has a disclosure policy.


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