Should you be concerned with hedge funds?

• Author: Ellison, Laurie
• Position: GOVERNANCE

Under current market conditions, hedge funds are likely to be more conservative and have less access to debt. But should you, as a financial officer, be concerned about activist hedge funds? The answer is "yes."

Even hedge funds are not immune from the current economic meltdown. The average fund has lost more than 9 percent this year, according to Hedge Fund Research. While far from a sterling performance, it is noticeably better than the 30 percent drop in the Standard & Poor's 500 stock index.

But, market liquidity will eventually improve and hedge fund managers will be looking for their next targets. So, now is a good time for companies to begin assessing their own attractiveness (and vulnerabilities) to a possible attack from a hedge fund.

By doing the right things, boards of directors and management teams can ensure a company does not attract the unwelcome attention. But, should a hedge fund enter a company's stock, management can take steps to protect the short-and long-term interests of the company and its shareholders.

The 2007 edition of Databook notes that there are more than 9,000 hedge funds with assets exceeding $1.8 trillion. Hedge funds are aggressively managed portfolios of investments, usually structured as private investment partnerships.

They differ from mutual funds in several ways. Mutual funds cannot take more than a 10 percent position in any one company or invest more than 5 percent of the fund's total assets in any one security. Hedge funds, on the other hand, are largely unregulated, aren't required to be diversified and have far more flexibility in their investments strategies. This flexibility allows hedge funds to target companies.

Will Your Company Be a Target?

Activists conduct their own assessments to determine targets, carefully selecting those firms they believe have the best opportunity to create value and the greatest likelihood of success. Hedge funds favor companies that have little debt and lots of cash. They also like companies with stock and/or earnings that have underperformed, especially relative to their peer groups.

Hedge funds typically target small-to mid-cap companies, with restaurants and retailers topping the list. That's because it's easier to amass a larger amount of stock in a smaller firm than a large-cap company. Activists often will target companies that appear attractively valued based on a break-up analysis. They also favor companies with an under-leveraged balance sheet and "hidden"...