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A hybrid formula entices investment funds

Sunday June 3, 2007

In August 2005, Blue Harbour Group, a small fund based in Connecticut, began buying shares in Laidlaw (NYSE:LI), operator of America’s largest fleet of yellow school buses and Greyhound coaches.

The company was weighed down by Greyhound, which was struggling to compete with other forms of transport such as low-cost airlines, but the school bus business was doing well, churning out healthy cash-flow from a series of recurring long-term contracts.

More importantly for Blue Harbour, Laidlaw’s management was receptive to change, including buy-backs and the possible separation of Greyhound.

The fund earned a 40 per cent return on its investment in February 2007, when Britain’s FirstGroup agreed to buy Laidlaw for $35.25 per share – well above the $23 per share Blue Harbour paid for its stake.

The success of that deal highlighted Blue Harbour’s unusual strategy, which combines elements of both private equity investing and shareholder activism, and is becoming increasingly popular on Wall Street.

Sageview Capital, a fund based in Greenwich and Silicon Valley, founded by KKR alumni Scott Stuart and Ned Gilhuly also puts money to work this way.

Loosely called “private equity-style investing in the public markets”, the strategy has been employed by US investors such as Warren Buffett and Eddie Lampert.

But Wall Street investors say it has gained traction thanks to a greater openness to outside ideas in US boardrooms in the wake of the Enron and WorldCom scandals. “There has been a sea change in the attitudes of boards and senior managements,” says Clifton Robbins, chief executive of Blue Harbour. “They are listening to shareholders like never before, particularly shareholders who bring value-enhancing ideas to the table.

“And this isn’t temporary: we won’t go back to a world of poor corporate governance, insular boards and limited transparency.”

Activist investors such as Nelson Peltz, Ralph Whitworth and Carl Icahn have also benefited from this trend. But there is a fundamental difference between their tactics and those of Blue Harbour and Sageview, who exert a level of pressure on managements, but without engaging in proxy fights.

Instead, they look at companies through what they describe as a “private equity lens”, identifying targets that are undervalued and could do with some transformation, whether in the form of balance sheet restructuring, the disposal of certain assets or the sale of the entire company.

“They are applying the same discipline that private equity groups do and are shaking up companies,” says Paul Schaye, managing director of Chestnut Hill Partners, a New York boutique investment bank.

Sageview’s first deal, for example, involved a stake in Guitar Center, and working with management to slow its store expansion, which many felt unnecessary as the company already dominated its music retail niche.

One way in which executives can benefit from bringing in an investor such as Sageview or Blue Harbour is that it can deter the appearance of an activist.

“As an executive, you might want to defuse the criticism that you are underutilising your balance sheet and not making tough decisions,” says Peter Schoenfeld of P Schoenfeld Asset Management, a New York-based hedge fund.

“A change in strategy may raise the stock price and require a significantly higher buy-out price.”

The strategy has potential pitfalls. In spite of the fact that their investment horizon spans several years, a sharp drop in stock market valuations could dramatically hit these funds’ portfolios, while private equity groups are somewhat protected by swings in public company valuations.

In addition, it remains untested across many fund managers: it is unclear what might happen if a company’s management is unable to execute a plan and the sides disagree on future strategy.

But so far the returns look good. Although Blue Harbour declined to comment on its returns, one investor said the firm had posted a 25 per cent gross internal rate of return last year.