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Alpha maelstrom

In their search for lucrative buyout deals, private equity firms are facing staunch opposition from a new source -- activist hedge funds.

The deal should have been a slam dunk. On October 11, One Equity Partners, the private equity arm of J.P. Morgan Chase & Co., made a $468 million buyout offer for Titan International that represented a healthy 36 percent premium to the tire and wheel maker's market value. Titan's stock had been flatlining for months.

Cue Barry Rosenstein, head of $5 billion hedge fund JANA Partners. In August, JANA, betting on a turnaround at Titan, had bought almost 5 percent of the company. Rosenstein believed that Titan was worth considerably more than the LBO firm had offered, because of improving sales to mining and construction companies, and that its stock would rise. And he wasn't about to give up those gains.

Over the next ten days, Rosenstein bought nearly 2 million more Titan shares, bringing his stake to 15 percent. Then, having loaded his gun for battle, the 47-year-old hedge fund manager fired away. On October 24 he wrote Titan's seven-person board, urging it to extract a higher bid from One Equity or walk. He also highlighted a potential conflict of interest: One Equity's managing partner, Richard Cashin, had been a Titan director since 1994 and served on the board's compensation committee.

Receiving no response, Rosenstein launched another salvo, threatening in a December 20 letter "to hold board members personally liable should any attempt be made to improperly deprive shareholders of the value to which they are rightfully entitled." That got their attention.

In April, after several rounds of back and forth between the parties, One Equity withdrew its offer. Today Titan's business is improving and its shares trade for about $20, up more than 50 percent since One Equity's October offer and higher than its $18-per-share bid.

"Hedge funds are rational shareholders," says a vindicated Rosenstein. "If it's not a fair price, we won't back a transaction."

Battles like the one Rosenstein waged to protect his investment and, indirectly, the interests of Titan's other shareholders, are raging throughout the corporate world as two groups of extraordinarily well capitalized investors -- private equity firms and hedge funds -- home in on many of the same targets. LBO firms, often in cooperation with senior company managers, have long profited by taking companies private, turning them around and selling them after a few years. But now so-called activist hedge funds like JANA, which take big but noncontrolling stakes in public companies and try to influence their strategy, are mobilizing to prevent such deals -- or at least to make sure they get done at higher prices.

"One could argue the private equity game has always been to collude with management to steal companies from deficiently informed public shareholders," says Robert Chapman, manager of $300 million hedge fund Chapman Capital. Activist funds, he adds, are like cops on the beat: "People can still rob banks, but if you add enough security, it makes it a lot harder."

The pitched battle being fought today is ultimately over whether private investors or public shareholders will reap the gains to be had from investing in undervalued companies. And the combatants, whose egos can be as big as their funds, aren't shy about publicly slamming, goading and threatening each other to seize their share of the spoils.

Underpinning this struggle is an influx of capital into alternative investments from pension funds and other investors that aren't content with returns in the stock and bond markets. Cash committed to LBO funds globally doubled in 2005, to a record $134 billion, according to research firm Private Equity Intelligence. This year those funds should be just as flush, with three big buyout shops alone -- Blackstone Group, Texas Pacific Group and Thomas H. Lee Partners -- set to raise more than $35 billion between them.

Specific figures for the amount of money flowing into activist hedge funds are harder to come by, but some who have studied the industry estimate that the ranks of such funds have more than doubled, to about 100, in the past three years. Among the most notable activist funds are JANA, Warren Lichtenstein's $5 billion Steel Partners and Daniel Loeb's $3.8 billion Third Point.

Another catalyst behind the going-private phenomenon is the pressures on companies themselves. They have rarely been more inclined to flee the intense scrutiny and rising costs of being publicly traded. Those with market capitalizations of more than $700 million paid $8.5 million, on average, to comply with mandates of the 2002 Sarbanes-Oxley antifraud legislation during its first year of implementation, according to research firm CRA International. CEOs also are increasingly upset about what they see as the stock market's obsession with short-term financial performance, because they think it hinders companies from managing for long-term success.

That frustration is helping to drive small- and midcap companies into the arms of LBO firms. Some $69 billion in public-to-private buyouts occurred last year, up from $18 billion in 2004, according to Dealogic. Among the most notable were the $11.3 billion acquisition of SunGard Data Systems in March 2005 and a $6.6 billion deal for Toys "R" Us in July.

The flow continues. In March, Wellspring Capital Management took the Dave & Buster's bar and game room chain private for $365 million. Bain Capital took garment wholesaler Burlington Factory Warehouse Corp. off the market for $2.1 billion in April. And last month Leonard Green & Partners acquired sporting-goods retailer Sports Authority for $1.3 billion.

Increasingly, however, activist hedge funds are obstructing this stream of deals. In March a group of shareholders led by Knight Vinke Asset Management refused to back a private equity consortium's bid for Dutch business information company VNU. On May 4 the buyout firms responded by raising their bid by 2 percent, to E8.7 billion ($11 billion), and shareholders approved the transaction. Also on May 4, $3 billion hedge fund Eminence Capital said it would not back a $5.8 billion offer for food services company Aramark Corp. from its CEO and several LBO shops unless the buyers hiked their bid from $32 per share to $40. "This is a gross undervaluation," says Ricky Sandler, managing member of Eminence, which owns 8 percent of Aramark. (The company declines comment.)

More often than not the outcome of such episodes favors public market shareholders. In Titan's case, Rosenstein thwarted a buyout, allowing those who owned the stock to benefit from the company's turnaround. Titan chairman and CEO Maurice Taylor says that he initially regarded Rosenstein as an interloper trying to make a fast buck. But now that the value of his 1.2 million Titan shares has risen from $16 million to $24 million, he has a different view.

"I've never met Barry, but I love Barry," says Taylor, who stresses that the offer from One Equity was fair. "He had enough guts and did enough to say that if it didn't work out, he was going to stay as an investor." JANA now owns 20 percent of Titan. (Cashin and a J.P. Morgan spokeswoman decline comment.)

In other instances, LBO firms simply wind up paying more for their quarry -- giving up, in effect, a portion of their prospective gains to existing shareholders. But things can go wrong for the activists and their fellow stockholders if they nix a deal and the company then performs poorly.

The broader impact of activists' nosing into going-private deals, of course, is greater scrutiny of corporate boards and management, which often participate in buyouts as co-investors with LBO firms.

One of the most hotly contested going-private deals in recent memory was the buyout of discount retailer ShopKo Stores. Many activists hail it as a landmark victory. The following account is based on several conversations with people who were involved in the deal, as well as on public regulatory filings.

In April 2005, ShopKo agreed to be taken private for $1.1 billion, or $24 per share, by buyout firm Goldner Hawn Johnson & Morrison. The deal called for ShopKo's nonexecutive chairman at the time, Jack Eugster, to put up $3 million of the $30 million in equity for the buyout, giving him a 10 percent stake in the company. Goldner managing director Michael Sweeney had approached Eugster about a potential deal in late 2003 before launching an opening bid of $20 per share in March 2004. The parties haggled for more than a year before agreeing to terms, which included a $27 million breakup fee to be paid to the buyers if ShopKo backed out. The company set a shareholder vote on the deal for September 2005.

That's when the activists jumped in. Hedge funds Elliott Associates and John A. Levin & Co.'s Levco Alternative Fund separately began building positions in ShopKo over the summer. Elliott bought 8 percent of the company. Levco amassed 6 percent. Both argued that Goldner's bid substantially undervalued the retailer. Indeed, in a July 2004 report, Deutsche Bank analyst Louis Taylor had suggested that the value of ShopKo's real estate holdings alone -- it owned 80 percent of its more than 150 stores nationwide -- was between $794 million and $1.4 billion, which translated to a share price of $27 to $48. The activists also objected to the low percentage of equity being put up by the buyers -- just 3 percent, compared with 25 to 35 percent for most LBOs -- and the high breakup fee.

Levco portfolio managers Jonathan Reiss and Rosty Raykov struck first, protesting the transaction in a July 21 letter to the board. They suggested ShopKo's true value was as much as $33 per share, or two thirds more than the initial bid, and that the company could do better for shareholders by taking on debt to pay a special dividend.

ShopKo's board, meeting one week later, dismissed Levco's concerns. Then on September 5, Elliott portfolio manager Ivan Krsticevic weighed in with a letter questioning the board's handling of the sale process. And two days later Institutional Shareholder Services, which advises investors on proxy votes, urged shareholders to vote against the deal, citing similar concerns.

"While one can compliment Goldner Hawn on obtaining such favorable terms, one can also reasonably question whether the board could have negotiated a higher price for shareholders," wrote Christopher Young, co-head of mergers and acquisitions research at ISS.

ShopKo postponed the vote and began reaching out to shareholders -- including the activists. Krsticevic, however, turned up the heat by inviting another private equity firm, Sun Capital Partners, to mount a rival bid. On September 30, Sun Capital -- with Elliott and real estate firm Lubert-Adler co-investing -- offered to acquire ShopKo for $26.50 per share.

A bidding war ensued. ShopKo invited the two prospective buyers and a special committee of its board to thrash matters out during a marathon meeting over the weekend of October 15 and 16. Board members throughout the Midwest were linked up with ShopKo executives at its Green Bay, Wisconsin, headquarters; its investment bankers at Merrill, Lynch & Co.; and representatives for Sun in New York. When new bids -- due at 3:00 p.m. central time on Sunday -- arrived, the special committee and its advisers pondered them for several hours.

They discussed them all day Monday and into the following morning. At 2:30 a.m. on Tuesday, Goldner raised its offer to $29 per share. By 8:00 a.m., Sun Capital had matched that price and pledged to pay a penalty of 6 percent per annum per day if they did not close the transaction by December 15.

John Turner, head of the special committee, then called Sun Capital managing director Gary Talarico at his Manhattan home and talked about Sun's plans for ShopKo. Satisfied that the firm would manage the retailer well, Turner -- himself head of a private equity firm, Hillcrest Capital Partners -- recommended that the board accept the offer. It did, a few hours later. (Elliott and Lubert-Adler dropped out of the bid during negotiations because management preferred to deal exclusively with Sun, but they were brought back in as minority co-investors once the deal closed.)

"It is pretty clear that without Elliott's involvement, ShopKo would have been sold at a substantially lower price to Goldner than what the company ultimately received from Sun Capital," says Krsticevic. Adds ISS's Young, "The auction would never have taken place but for the efforts of the hedge funds."

Sun Capital's Talarico tells Institutional Investor he's pleased with how the company handled the transaction. "We feel we paid very fair value," he says. "It was a fair and open process; both parties had an equal chance to win."

Activists aren't altruists, and they're not opposed in principle to buyouts -- they just want to get their share of the spoils. As it happens, that aggressive attitude often benefits the other shareholders as well.

ShopKo's shareholders plainly came out better. But in this case, one LBO shop's loss was another's gain. Last month Sun reaped $815 million in a sale-leaseback of the retailer's real estate holdings to Spirit Finance Corp., a real estate investment trust. ShopKo will continue to operate the stores under long-term leases. Of course, Elliott, instead of derailing the buyout, wound up participating in it.

A similar turn of events occurred when Dave & Buster's was taken private in March. Two activist hedge funds, HBK Investments and Millennium Partners, were among the big shareholders that objected in December 2005 to Wellspring's initial offer of $365 million. But in January, HBK changed its mind after Wellspring offered it a chance to participate in the buyout, according to a Millennium regulatory filing opposing the deal. HBK's vote -- it owned 9 percent of the company -- helped cinch the deal over the objections of Millennium and other investors.

The transaction closed in March, but Millennium and another hedge fund, Newcastle Partners, which also voted against it, have mounted a legal challenge. Exercising the so-called appraisal rights of selling shareholders, the funds have asked a court in Missouri, where Dave & Buster's is incorporated, to conduct an assessment of its value. If the court valuation comes out higher, the buyers will have to fork over the difference plus interest. (Officials at HBK, Millennium, Wellspring and Dave & Buster's did not return repeated calls for comment.)

Activists sometimes overplay their hands. In February 2004, Helen Johnson-Leopold, chairman and CEO of recreation products company Johnson Outdoors, tried to take the company private at $18 a share (it was then trading at $16.78). Some shareholders, including activist hedge fund and 4 percent-owner Dolphin, opposed the deal because they thought the price was too low. Even though the Johnson family increased its bid to $20.10, the company lost a shareholder vote and called off the transaction. The stock traded late last month at $18. "A deal with a significant premium went up in smoke, and the stock has traded below that price ever since," notes ISS's Young.

In some cases, activist hedge funds clamor for companies to sell to LBO outfits. Loeb's Third Point has been pushing plastics manufacturer AEP Industries to repurchase 2 million shares or sell the company, and has suggested that a private equity buyer would make sense.

The relationship between activist hedge funds and buyout firms is in fact "symbiotic," asserts Lee Partners' Scott Sperling. "Activist shareholders have identified situations where full value has not been created, and accelerated the process of those companies' becoming available to the private equity industry," he contends.

Nevertheless, activist investors can certainly diminish buyout funds' returns. Eminence's Sandler estimates that the proposed $32-per-share deal for Aramark stands to yield the LBO-firm consortium -- comprising Goldman Sachs Capital Partners, J.P. Morgan Partners, Lee Partners, Warburg Pincus and Aramark CEO Joseph Neubauer -- in excess of 30 percent.

But suppose the consortium had paid $40 per share, as activist fund Eminence Capital had demanded. That would still result in a strong, mid-to-high-teens return for the buyout group, according to Sandler, while ensuring that the public investors were fairly compensated.

Lee Partners' Sperling counters by arguing that activists underestimate the amount of work and risk shouldered by buyout funds once a company goes private. "We have to be realistic about the price we can afford to pay for these companies," he says. Activist investors might say the same thing, only they would define "realistic price" differently.