Small-Cap Investor Activism Small-Cap Investor Activism in Canada and Crescendo in Canada and Crescendo

PartnersPartners

Dave LitwillerDave Litwiller

November 2010November 2010

Activist Hedge FundsActivist Hedge Funds Seek to exploit structural inefficiency in target companiesSeek to exploit structural inefficiency in target companies Their premise is that markets are not efficient, and that Their premise is that markets are not efficient, and that

informational advantage and a catalyst even can generate informational advantage and a catalyst even can generate superior returnssuperior returns

Generally develop intensive knowledge of target companies Generally develop intensive knowledge of target companies prior to investingprior to investing

Very smart people working in hedge funds, since many of Very smart people working in hedge funds, since many of the best i-bankers and sell-side analysts end up in hedge the best i-bankers and sell-side analysts end up in hedge because of the participation in ~20% of fund gains rather because of the participation in ~20% of fund gains rather than just annual management feesthan just annual management fees

Focus tirelessly on capital allocationFocus tirelessly on capital allocation Believe they can beat the overall marketBelieve they can beat the overall market Typically willing to concentrate in ~six active holdings, Typically willing to concentrate in ~six active holdings,

when conventionally a lack of diversification is a handicapwhen conventionally a lack of diversification is a handicap

Standard Activist Goals for TargetsStandard Activist Goals for Targets

Reduce costsReduce costs Sell the entire companySell the entire company

• Usually seen as the easiest kind of activismUsually seen as the easiest kind of activism Break-up of conglomerateBreak-up of conglomerate

• Remove conglomerate discount, better focus managementRemove conglomerate discount, better focus management Sell or shut underperforming division, or underperforming Sell or shut underperforming division, or underperforming

capital assets (such as land or buildings)capital assets (such as land or buildings) Pay out cash, including trimming and levering the balance Pay out cash, including trimming and levering the balance

sheetsheet Better governanceBetter governance

• This is usually a supporting argument toward other goals, to This is usually a supporting argument toward other goals, to discredit and pressure the board of directors and fiduciary discredit and pressure the board of directors and fiduciary managementmanagement

Activist LeverActivist Lever

Proxy fight, threatened or realizedProxy fight, threatened or realized• Proxy fight is very time consuming for Proxy fight is very time consuming for

managementmanagement• It is a liability for the board of directorsIt is a liability for the board of directors

Typical Escalation Arc (1)Typical Escalation Arc (1) Build the case for how structural change can build Build the case for how structural change can build

shareholder value, and use this to build interest shareholder value, and use this to build interest from institutional investors to collaboratefrom institutional investors to collaborate• Research often includes interviewing customers, Research often includes interviewing customers,

shareholders, managersshareholders, managers• May involve preparing a sell-side style report on the May involve preparing a sell-side style report on the

companycompany Take enough of a position that management has Take enough of a position that management has

to take noticeto take notice• 5% entitling proxy of shareholders directly in Canada5% entitling proxy of shareholders directly in Canada• Public disclosure of shareholding not required until 10%Public disclosure of shareholding not required until 10%

Typical Escalation Arc (2)Typical Escalation Arc (2) Tell management and board what Tell management and board what

structural change is desiredstructural change is desired May attempt to influence sell- and buy-May attempt to influence sell- and buy-

side analystsside analysts• Including questions on conference calls, Including questions on conference calls,

contacting media, and hiring PR firmscontacting media, and hiring PR firms Pressure for seats on board of directorsPressure for seats on board of directors Proxy contest to get board seats or change Proxy contest to get board seats or change

strategystrategy Court actions to compel a special meeting Court actions to compel a special meeting

of shareholders to vote on binding “full of shareholders to vote on binding “full value” proposalsvalue” proposals

Target SelectionTarget Selection

Common:Common:• Low Price/Book ratio, with sound Low Price/Book ratio, with sound

operating cash flow in parts of the operating cash flow in parts of the businessbusiness

• Low Return on EquityLow Return on Equity Management not deploying cash flow into Management not deploying cash flow into

profitable businessesprofitable businesses

• Peer underperformancePeer underperformance• Industries that are consolidating or are Industries that are consolidating or are

ripe for consolidationripe for consolidation

Small-Cap Benefits for ActivistsSmall-Cap Benefits for Activists

Low absolute cost of accumulating a Low absolute cost of accumulating a ≥5% to <20% position≥5% to <20% position

Greater market inefficiencies to Greater market inefficiencies to exploit in small-cap issuers than exploit in small-cap issuers than larger caps due to information gapslarger caps due to information gaps

Small-caps usually trade at illiquidity Small-caps usually trade at illiquidity discountsdiscounts• A catalyst event upon exit can eliminate A catalyst event upon exit can eliminate

this discount, enhancing returnsthis discount, enhancing returns

Typical Activist Tactics (1)Typical Activist Tactics (1)

Lure board into making a strategic, Lure board into making a strategic, technical or fiduciary error, limiting technical or fiduciary error, limiting downstream flexibilitydownstream flexibility

Identify a split within the existing board on Identify a split within the existing board on a significant issue with strategy or a significant issue with strategy or management performance, and then work management performance, and then work to deepen that riftto deepen that rift

Wage publicity battle about corporate Wage publicity battle about corporate performance, governance or managementperformance, governance or management

Typical Activist Tactics (2)Typical Activist Tactics (2) Court systemCourt system

• Can include seeking oppression remedy if a disadvantageous Can include seeking oppression remedy if a disadvantageous restructuring or recapitalization is carried outrestructuring or recapitalization is carried out

Encourage bid from strategic buyerEncourage bid from strategic buyer Short slate proxyShort slate proxy

• Easier to win, since they do not provide controlEasier to win, since they do not provide control• Proxy advisory firms are sympathetic to this, particularly with a Proxy advisory firms are sympathetic to this, particularly with a

poorly performing companypoorly performing company Gain not just board seats, but representation on the Gain not just board seats, but representation on the

powerful committeespowerful committees White papers advocating valueWhite papers advocating value

• Difficult for companies to counter, since they end up tripping Difficult for companies to counter, since they end up tripping over a self-defeating argument of “We’re not worth that over a self-defeating argument of “We’re not worth that much.”much.”

Sample Target Company Sample Target Company TacticsTactics

Company Tactics (1)Company Tactics (1)

Proactively address reasons for Proactively address reasons for performance shortfallperformance shortfall• Review beefs of existing investors, Review beefs of existing investors,

particularly institutionsparticularly institutions• Look anew at arguments for spin-offs, Look anew at arguments for spin-offs,

share buybacks, special dividends, and share buybacks, special dividends, and other structural changesother structural changes

Company Tactics (2)Company Tactics (2) More specifically:More specifically:

• Operational improvementsOperational improvements Stronger performance incentives and cultureStronger performance incentives and culture Outsourcing, to lower capital intensityOutsourcing, to lower capital intensity Leaning of the enterprise, to lower capital intensityLeaning of the enterprise, to lower capital intensity

• Portfolio re-jiggingPortfolio re-jigging Get rid of things that are unlikely to performGet rid of things that are unlikely to perform Sell to those who can generate higher valueSell to those who can generate higher value

• Balance sheet tune-upBalance sheet tune-up Get rid of exceptionally high cash balances, through share repurchases or dividendsGet rid of exceptionally high cash balances, through share repurchases or dividends Reduce working capital levelsReduce working capital levels Put some leverage in the capital structurePut some leverage in the capital structure Improve cash flow managementImprove cash flow management Sell and lease-back real estateSell and lease-back real estate

• Improve governanceImprove governance There’s a pretty standardized checklist these days of better practices to adoptThere’s a pretty standardized checklist these days of better practices to adopt

• Build investor confidenceBuild investor confidence Better financial guidanceBetter financial guidance Higher quality communicationsHigher quality communications Manage expectationsManage expectations

Company Tactics (3)Company Tactics (3)

Engage activist during initial phases Engage activist during initial phases to induce a more moderate responseto induce a more moderate response• Rarely worksRarely works

Agree to a minor accommodation as Agree to a minor accommodation as a show of good faith and to buy time a show of good faith and to buy time during negotiationsduring negotiations

See if neutral 3See if neutral 3rdrd party director(s) can party director(s) can be agreed uponbe agreed upon

Company Tactics (4)Company Tactics (4)

Engage advisorsEngage advisors• i-bank, if financial enhancement or i-bank, if financial enhancement or

strategic review possibilities need to be strategic review possibilities need to be detaileddetailed

• Communication firm, if PR or proxy Communication firm, if PR or proxy campaigns are likelycampaigns are likely

Prepare persuasive analysis that Prepare persuasive analysis that defends the business plandefends the business plan• Try to pre-empt value enhancing claims Try to pre-empt value enhancing claims

expected from or made by activistexpected from or made by activist

Company Tactics (5)Company Tactics (5)

Scrub down governance practicesScrub down governance practices Review statutory and by-law Review statutory and by-law

defencesdefences Review how hedge fund influenced Review how hedge fund influenced

other companiesother companies Perform due diligence on the Perform due diligence on the

experience and effectiveness of the experience and effectiveness of the hedge fund’s intended hedge fund’s intended representation on the boardrepresentation on the board

Activist ConcernsActivist Concerns Illiquidity, pressuring share price during cut stakeIlliquidity, pressuring share price during cut stake

• Favours sale of entire companyFavours sale of entire company Hot money coming into the stock in the Hot money coming into the stock in the

slipstream of the activist, increasing share price slipstream of the activist, increasing share price volatility. This makes mark-to-market pricing for volatility. This makes mark-to-market pricing for hedge fund more difficulthedge fund more difficult

Reputation damage liability in future fights if Reputation damage liability in future fights if current fight unsuccessfulcurrent fight unsuccessful

Redemptions in activist’s fund disrupting Redemptions in activist’s fund disrupting campaigncampaign• Countered with lock-up provisionsCountered with lock-up provisions

Fiduciary obligations if they obtain board Fiduciary obligations if they obtain board representationrepresentation

Reasons Some U.S. Activist Hedge Reasons Some U.S. Activist Hedge Funds Favour Canadian TargetsFunds Favour Canadian Targets

Don’t have to publicly disclose holdings Don’t have to publicly disclose holdings until 10% ownership threshold reached until 10% ownership threshold reached (vs. 5% in US)(vs. 5% in US)

Can requisition shareholder meeting at 5% Can requisition shareholder meeting at 5% holding (vs. 10% in US)holding (vs. 10% in US)

Dismantling of poison pills easier in Dismantling of poison pills easier in CanadaCanada

Proxy battles easier, since most Canadian Proxy battles easier, since most Canadian companies elect directorate annuallycompanies elect directorate annually

Canadian market less picked overCanadian market less picked over

Examples of Crescendo Partners Examples of Crescendo Partners Activism in CanadaActivism in Canada

Source: www.sedar.comSource: www.sedar.com

Spar AerospaceSpar Aerospace• 1999-20021999-2002• Achieved board representation Achieved board representation • Sale of company to L-3Sale of company to L-3

Call-NetCall-Net• 1999-20011999-2001• Achieved board representationAchieved board representation• Exited in 2001Exited in 2001

Western International CommunicationsWestern International Communications• 1999-20001999-2000• Achieved board representationAchieved board representation• Company sold to CanWest GlobalCompany sold to CanWest Global

Ad OptAd Opt• 2003-20042003-2004• Achieved board representationAchieved board representation• Company sold to KronosCompany sold to Kronos

PivotalPivotal• 2003-20042003-2004• Achieved board representationAchieved board representation• Company sold to CDC SoftwareCompany sold to CDC Software

Sierra SystemsSierra Systems• 2003-20072003-2007• Achieved board representationAchieved board representation• Company sold to Golden Gate CapitalCompany sold to Golden Gate Capital

EmergisEmergis• 2004-20072004-2007• Achieved board representation Achieved board representation • Company sold to TelusCompany sold to Telus

Hip InteractiveHip Interactive• 20052005• Company went bankruptCompany went bankrupt• A rare failure for Crescendo in CanadaA rare failure for Crescendo in Canada

Geac ComputerGeac Computer• 2005-20062005-2006• Achieved board representation after a rough Achieved board representation after a rough

startstart• Company sold to Golden Gate CapitalCompany sold to Golden Gate Capital

MatrikonMatrikon• 2007-20102007-2010• Achieved board representationAchieved board representation• Company sold to HoneywellCompany sold to Honeywell

Dalsa Corp.Dalsa Corp.• 2007-present2007-present• Achieved board representationAchieved board representation

Q9 NetworksQ9 Networks• 20082008• Did not publicly ask for or receive board Did not publicly ask for or receive board

seatsseats• Company sold to Abry PartnersCompany sold to Abry Partners

Bridgewater SystemsBridgewater Systems• 2008-present2008-present• Achieved board representationAchieved board representation

Cott CorporationCott Corporation• 2008-present2008-present• Achieved board representationAchieved board representation

The Forzani GroupThe Forzani Group• 2009-present2009-present• Tried but failed to achieve board Tried but failed to achieve board

representation thus farrepresentation thus far

20-20 Solutions20-20 Solutions• 2010-present2010-present• Agitating for board representation at Agitating for board representation at

mid-Nov ’10mid-Nov ’10

Crescendo Partners Success Crescendo Partners Success Statistics in CanadaStatistics in Canada

Based on cited examples where final outcomes have been reached:Based on cited examples where final outcomes have been reached:• Achieved board representation when it was demanded over 80% of the timeAchieved board representation when it was demanded over 80% of the time• Sale of company occurred over 80% of the timeSale of company occurred over 80% of the time• Low rate of outright failureLow rate of outright failure

Compared to the general finding in US academic studies that activists in US Compared to the general finding in US academic studies that activists in US targets are successful 45% to 67% of the time achieving full or partial targets are successful 45% to 67% of the time achieving full or partial accommodation (study dependent), Crescendo Partners has historically accommodation (study dependent), Crescendo Partners has historically achieved considerably higher success in its Canadian effortsachieved considerably higher success in its Canadian efforts

The percentage of Crescendo outcomes that result in the outright sale of The percentage of Crescendo outcomes that result in the outright sale of the company is particularly high relative to benchmarksthe company is particularly high relative to benchmarks

Crescendo also has realized better than average activist hedge fund Crescendo also has realized better than average activist hedge fund success rates in Canada for: success rates in Canada for: • Sale or shutting of underperforming divisions Sale or shutting of underperforming divisions • Dividend payouts and share buybacksDividend payouts and share buybacks• Senior management changesSenior management changeswhen these structural and management changes have been demanded when these structural and management changes have been demanded

Dave Litwiller is the COO of Prinova Inc., a growth stage enterprise software developer in Waterloo Dave Litwiller is the COO of Prinova Inc., a growth stage enterprise software developer in Waterloo region. region.

He most recently was in progressively more senior R&D, marketing and M&A executive roles with He most recently was in progressively more senior R&D, marketing and M&A executive roles with DALSA Corp. Published in 2008, Mr. Litwiller is the author of “Rapid Advance - DALSA Corp. Published in 2008, Mr. Litwiller is the author of “Rapid Advance - Mergers & Mergers & Acquisitions, Partnerships, Restructurings, Turnarounds and Divestitures in High Technology”Acquisitions, Partnerships, Restructurings, Turnarounds and Divestitures in High Technology”

http://www.amazon.com/Rapid-Advance-Acquisitions-Partnerships-Restructurings/dp/1439200874/refhttp://www.amazon.com/Rapid-Advance-Acquisitions-Partnerships-Restructurings/dp/1439200874/ref=sr_1_1?ie=UTF8&s=books&qid=1287516364&sr=1-1=sr_1_1?ie=UTF8&s=books&qid=1287516364&sr=1-1