Hedge funds are lightly regulated private investment funds that use unconventional investment strategies and tax shelters in an attempt to make extraordinary returns in any market. Typically, these funds are structured as limited partnerships and limit investment to business or institutional investors. These factors have given them a secretive and shady aura in the financial community; however, Securities and Exchange Commission (SEC) rules and regulations make it possible for anyone to take a glimpse into their activities. This article will explore how savvy individual investors can profit off of some of Wall Street's most ruthless hedge funds. (See also: A Brief History of the Hedge Fund.)
Step 1: Find a Hedge Fund to Watch
Most hedge funds invest using unconventional strategies, but others take a more active role in realizing the value of their investments—these are known as activist hedge funds. Activist hedge funds not only engage the company's board and management in discussion, but also wage proxy battles, liquidate assets and even force sales of companies. These activities can provide opportunities to savvy individual investors willing to do a little digging!
Those who have spent some time in the marketplace may be familiar with many of the activist hedge funds out there. Some funds are very public when fighting management, while others are extremely quiet about their activities. (See also: Introduction to Hedge Funds—Part 1 and Part 2.)
Step 2: Tracking Hedge Funds
Hedge funds may be mysterious on the surface; however, the SEC mandates a certain level of transparency—particularly when activist hedge funds are involved. It's through these SEC filings that we can get a glimpse into the actions being taken by activist hedge funds.
You can find SEC filings by using the official EDGAR database or other free services like SECFilings, which allow you to set up email and RSS alerts to send notifications when hedge funds make trades.
The most important form filed by activist hedge funds is the Schedule 13D, which is a statement of beneficial ownership (5% or above). There are several sections within this filing that can clue us in to the hedge fund's motivations and possible future actions:
1. Security and Issuer: This contains basic information about the stock and associated company.
2. Identity and Background: This section contains information about the hedge fund acquiring the stock, including disclosure of its criminal record and any pending lawsuits.
3. Source, Amount of Funds and Other Considerations: This section explains where the funds used to buy the stock are coming from (cash-on-hand or debt).
4. Purpose of Transaction: This is the most important section of the 13D; it details exactly what the hedge fund is planning to do with its investment. A hedge fund is required to disclose whether it is holding stock purely as an investment or if it is interested in "seeking strategic alternatives."
5. Interest in Securities of the Issuer: This section discloses the number of shares owned and occasionally the transaction dates for major purchases.
6. Material to Be Filed as Exhibits: This is the second most important section of the 13D; it contains any letters to management or other exhibits that often contain extremely useful information detailing future action.
Combined, this information can give individual investors a lot of insight into what the hedge fund is attempting to do with its investment and whether it will be attempting to take over the company or is simply looking for a good investment.
Step 3: Deciphering a Hedge Fund's Activity
The "Purpose of Transaction" section of the 13D filing with the SEC describes exactly what the hedge fund is planning to do. There are two different types of demands that hedge funds make in these letters:
1. Demands to the Board: These are specific requests made to the board of directors demanding certain changes. These may include management replacements, mergers or acquisitions, capital structure changes, disbursement of cash reserves and other items.
2. Appeals to Shareholders: These are situations in which the hedge fund is looking to take over the company via a proxy battle. This is a situation that requires shareholders to vote to sign-on the hedge funds nominees instead of the company's incumbent directors. Activist hedge funds engage in many activities to unlock shareholder value, including:
- Management replacements or changes
- Potential mergers or acquisitions
- Capital structure changes
- Expenditure or executive compensation cuts
- Disbursements of cash reserves to shareholders via dividends, buybacks, etc.
Altogether, this section of the 13D filing gives you all the information you need to know about the situation. Most of the time, these hedge funds have nothing to hide because they want investors to understand how management is failing.
Step 4: Acting on the Information
There are two types of opportunities that activist hedge funds create: (1) long-term turnarounds or (2) short-term exit strategies. Obviously, the short-term actions are most advantageous to those following hedge fund activities because they provide the largest returns in the shortest amount of time. This is particularly true for buyouts because they always happen at a premium to the market price. Here are some common hedge fund activities and their general payoff times:
- Sale of the company
- Liquidation of assets
- Special dividends
- Replacing board members
- Firing management
- Share buyback programs
- Small dividends
- Capital structure changes
It is important to consider all of these things before following a hedge fund. Remember that in almost all cases, a fund will have averaged in at lower prices than yours, causing the potential for a large difference in breakeven points.
The Bottom Line
Although investing alongside hedge funds isn't a guaranteed way to make money, it is a great way to find opportunities. By carefully analyzing the terms of the deals and proposals, it is possible for savvy investors to find attractive short-term and long-term investment opportunities.