The activists are coming

And that just about sums it up. For Mr Icahn - and arguably for all the other so-called activist investors - it's only about the money; how much they can make from a deal. None of the rest - the nature of the company they are targeting, its dynamics, its customers or its employees - matters a jot. When you are as focused, as obsessive, as mean and as greedy as Carl Icahn, all that matters is the profit made from dealing - and the figure on Mr Icahn's score sheet is $24bn (£14.29bn) and counting.

Except that maybe we do the great Icahn - and all of the little (or not so little) activist investors - an injustice. These are the guys - to date, they are invariably men - who do what it says on the can. They are not just investors, but 'activists' too. Roughly speaking, that means they shake up the companies with which they are involved with a view to making fat - and often quick - profits.

A bit like Monty Python's Spanish inquisition - though not so funny - their chief weapons are surprise, fear and ruthless efficiency. They creep onto a vulnerable company's share register as surreptitiously as they can. When they have sufficient clout and/or when regulations oblige them to declare their ownership, they make their presence known. That sparks fear into incumbent bosses who, implicitly, have been making a pig's ear of running the company. Then comes the ruthless efficiency. They lobby and harry, cajole and bully until they get what they want - a special dividend here or a division hived off there; maybe a change in management or even the sale of the whole company. But it’s all done with one aim in mind: an almost fanatical devotion to making money.

Once activists were labelled 'greenmailers', an occupation even more repugnant than blackmail. Then they became 'activists', which was still pretty bad but at least it meant they sometimes stuck around to make constructive suggestions at their target companies. Now perhaps it's an exaggeration to think of them as corporate philanthropists, but at least they are accepted into the mainstream as agents of a socially-useful purpose - improving the long-term performance of the companies they target.

One quirk is why activist investors have been so - well - inactive in the UK; after all, the UK's branch of Anglo-Saxon capitalism has a takeover culture at least as well developed as that of the US. The chief explanation is that the pre-emption rights of UK shareholders effectively makes a non-starter out of greenmail - a favourite activists' ploy where a few shareholders set out to be treated more favourably than the rest. Nor does it help that UK companies were - and, to an extent, still are - more restricted in their ability to buy in their own shares than US companies.

However, the latest thinking is that this is set to change; that activist investors will soon be targeting UK companies - perhaps even more cosseted European ones, too - wildly and freely. We will deal with why that might be so and what sort of companies they could target in a moment. But first let's sort out this notion that activist investors perform a socially-useful function because of an improvement in not just the short-term, but also the long-term performance of the companies they target.

Therein lies what was always the chief criticism of activists - that their arm-twisting brought only a short-term spike in the share price of target companies. They made their threats, got their response, took their profit and moved on, leaving the target company to slip back into slothful ways and the hapless outside investors who stayed aboard to pick up future investment returns made all the more lousy because they would have to compensate for the outperformance while the activists were on the rampage and on the share register.

Obviously, we caricature. However, more seriously, a trio of US academics has produced a paper* that refutes the conventional wisdom that activists have a bad influence on the long-term interests of both target companies and their shareholders. The academics trawled through 2,000 incursions by activist funds in the US from 1994 to 2007, paying particular attention to performance for up to five years after raiders first appeared.

Naturally enough, they found that activists tended to target companies that were performing worse than competitor companies. More interesting, they found that company performance tended to improve immediately after intervention. Most interesting, they found that the improved performance persisted - "there is no evidence that the improved performance comes at the expense of (worse) performance later on. During the third, fourth and fifth year following the start of activist intervention operating performance tends to be better not worse than during the pre-intervention period."

Much the same applies to share-price performance. The academics expected to find - and did, indeed, find - that performance spiked upwards when activists were on the register. But they were keen to test the idea that longer-term investment performance was especially poor to compensate for the short-term jump. Systematically they checked to see if long-term returns from targeted companies were lower than they should have been according to standard financial theories, such as the capital-asset pricing model. Then they checked returns against those of shares in companies of similar size and share rating. Last, they assembled portfolios of targeted companies and calculated whether their five-year performance delivered low returns. Their conclusion was emphatic - "we find no evidence of the asserted reversal of fortune during the five-year period following the intervention".

Nor did it matter if the activists had sold out. When the academics calculated the three-year share-price performance after an activist's holding had fallen below the 5 per cent threshold for disclosure they found no evidence of poor stock returns.

If it all seems to good to be true, it may well be. The critics of activists investors tend to assume the validity of their own claims, say the academics, or else they rely on anecdote. Either way, it means they have not collated a wide scale project to test their supposition. If and when they do, their findings may be predictable.

By that time, however - or so the notion goes - activist investors will be pillaging UK companies. The new factor making that more likely is that from the start of 2014 yet more - and tougher - rules controlling bosses pay come into force via the Enterprise and Regulatory Reform Act. In particular, at least every three years each of the UK's 900 or so listed companies - although not those quoted on the Alternative Investment Market (Aim) - must ask shareholders to approve their pay policy for directors in a binding resolution. That gives activists more scope to shake up underperforming companies and maintain the pressure, especially as the annual advisory shareholder votes on pay have become more important. If an advisory vote rejects the policy, it must be followed by a binding resolution the year after.

Meanwhile, social media make it easier for activists to start and to maintain a campaign. As we mentioned earlier, they don't have to worry that UK target companies can rustle up a poison pill and last - but particularly important - they are increasingly likely to have the backing of a target's institutional shareholders, especially the pension funds. Pressure on pension funds - in particular, defined-benefit funds - means that fund managers have to squeeze every last fraction of performance from a portfolio. If that means forming unholy alliances with activists, so be it - better than carrying weaklings in a portfolio.

True, the pre-emption rights of shareholders in the UK mean that activists can't use greenmail and they have to show their hand sooner than in the US - a stake must be disclosed when it is at least 3 per cent of a company's equity (compared with 5 per cent in the US). Nevertheless, one leading US activist, Bill Ackman of Pershing Square, told a conference last autumn that "Europe is 10 years behind the US in the degree of shareholder activism and in how directors respond". So the assumption is that these over-aggressive and over-greedy investors will soon be over here.

Except that some already are. Nelson Peltz, who has been at the game almost as long and as successfully as Mr Icahn, shook up Cadbury Schweppes in 2007 so much so that the group split itself into two and barely more than two years and, after that, the confectionery side was bought by Kraft. This year Elliott Associates, headed by Paul Singer, took a disclosable stake in supermarkets operator Wm Morrison (MRW) and Sandell Asset Management, led by Tom Sandell, is pushing for change at bus and rail operator FirstGroup (FGP).

Sadly, however, Mr Icahn probably won't be joining them. He has never targeted a UK company, though once he did a deal in the US in conjunction with British American Tobacco (BATS) when it was still a conglomerate; at 77 he runs a small operation, no longer needs outside capital and refuses to go into partnership for any deal. So it's unlikely he'll feel the need for geographical diversification. Pity. It would have been fun to watch UK bosses squirm under the lash of Mr Icahn's tongue.

*The Long-term Effect of Hedge Fund Activism; Lucian Bebchuk, Alon Brav and Wei Jiang. Available at SSRN: http://ssrn.com/abstract=2291577.

What activists want

Activists and private-equity managers forage among the same sort of companies. They want underperformers among well-established companies that - most likely - are already profitable though, with the right sort of treatment, could do much better. That said, both are fully aware that the accounting profits that a company declares are irrelevant. What really matters is the free cash - ie, what's left over for shareholders - that a company can generate over many years; though, obviously, the sooner that those cash flows can materialise and the greater their certainty, the better. So activists focus on:

■ Cash flow. This includes both the cash that a company throws off currently and its potential to generate cash if, say, capital spending was cut back or working capital was managed more efficiently. Thus it has to be of interest that capital spending at Wm Morrison last year easily exceeded net cash flow before cap-ex and equalled 20 per cent of the company's stock-market value. Similar comments could be made be made about the other giant retailers in the table Tesco (TSCO) and Marks & Spencer (MKS).

Sure, these companies operate in highly competitive arenas that demand that they keep their assets in top-notch shape. Obviously, all capital spending can't simply be axed, but the scale at which those under-pressure companies are pouring resources into expansionary projects is open to question. So an activist investor is going to ask how much of it is being poured down the metaphorical drain and might be better used either by a new set of bosses or in the hands of shareholders?

Maybe the target company is already generating cash but this is not recognised in its share price, as could be the case at transport group Wincanton (WIN). Another possibility is that cash generation is crimped by poor performance in limited parts of the group, as at FirstGroup or bookmaker Ladbrokes (LAD). Whichever applies does not really matter; the key questions for the activist are whether or not cash generation looks feasible, whether it can be enhanced or diverted elsewhere.

■ Tangible assets. Companies that are rich in land and properties are favoured. Those assets are much more likely to be easily-realisable than the intangible assets that a company logs on its balance sheet. True, some properties - such as a purpose-built distribution centre - can be so specialist as to have few potential buyers but, in general, activists are enticed by bricks and mortar. That is particularly so if - as in the case of Wm Morrison - the properties have not been re-valued for some years. After all, there is only one thing that turns on an activist more than value and that’s hidden value.

■ Idle cash. Every company needs to keep some cash in order to run its day-to-day affairs. But some simply have too much and the surplus would be better off with shareholders rather than keeping the bosses cosseted. Thus activists like spare cash that can be distributed both to themselves and to the other shareholders, whom they want on their side. As a rule of thumb, a company needs cash equal to about 1 per cent of annual sales to keep the business running smoothly. Anything above that may be surplus, though there may be umpteen company-specific reasons why that would not be the case.

That said, FirstGroup had £419m cash (before netting that off against its £1.9bn of debt) in its September 2013 balance sheet, which was 22 per cent of its share price. True, the company was flush with cash because it had just raised £584m via a rights issue. Yet even before that issue, at the start of the year - and helped by seasonal cash inflows from its operation that buses US students into school - it had £682m of cash. Any activist would ask: why does the company need so much cash when it could pay down more debt or return most of it to shareholders?

And you could ask much the same question about Wincanton, another company for whom debt reduction is a priority. Sure, the transport group has got its net debt down to 60 per cent of the market value of its equity, but that comprises an unbalanced mix of £121m cash (ie, 91p per share surplus, by our definition) and £208m of debt.

Oil explorer Cairn Energy (CNE) is a special situation. It has become a complex mixture of cash-rich explorer plus a repository of deferred assets and - possibly - liabilities in the shape of its interests in Cairn India and tax on both the past and future profits from selling bits of that stake. Free from its kerfuffle with the Indian Income Tax Department, Cairn would sell its remaining holding in Cairn India and use its cash to pursue its exploration ambitions and to buy back its shares. As it is, the buy-back programme is in suspension and its exploration plans may yet be squeezed. Meanwhile, the more that its share price sinks and the more that the company crosses swords with India's tax authorities, the more that activists may be tempted to question its bosses' plans.

■ Break-up potential. There is nothing like carving up a big listed company to create value, or so the theory goes - which largely explains why US activist investor Sandell Asset Management is so interested in FirstGroup. The hedge fund has a 3 per cent stake in the company and wants its bosses to spin off its Greyhound US bus operation, its division that buses students to school in the US or both. True, these activities have little corporate fit with FirstGroup's UK operations - running a fifth of the UK's local buses and operating rail services in the west country and in Scotland - yet their performance could be improved, though whether that would be best achieved inside or outside the present corporate structure is unclear.

It is for similar reasons that activists like Wm Morrison. As well as being an underperforming supermarkets operator, it is a property company with over £7bn of freehold property on its books. This might be sold to a property investor or funnelled into a newly-created real estate vehicle to maximise shareholders' returns.

Not that break-ups necessarily work. The bosses of Cookson - a mixture of speciality chemicals and foundries’ supplier – thought it would be a great idea to split their group into two. So they created Alent (ALNT) and Vesuvius (VSVS) in the hope that - despite some duplication of corporate functions - one plus one would equal more than two. So far, it has not worked out like that. At recent prices of 305p for Alent and 439p for Vesuvius, the market value of the two combined is almost £2.1bn. Yet at its peak Cookson's value was clear of £3.2bn.

Carl Icahn in seven sound bites

"Some people get rich studying artificial intelligence. Me, I make money studying natural stupidity."

"Very few managers are irreplaceable, especially in this economy."

"It is up to shareholders to step up to the plate and demand changes at their companies. For too long shareholders have been complicit in allowing management excesses and incompetence by not taking a stand."

"If you want a friend on Wall Street, get a dog."

(After raiding a US paper company in 1979) "I’m only in this for the money. I don't know anything about the paper business. I don't care about the paper business. All I care about is the money and I want it quick"

(Asked by a member of a US congressional panel why he bid for Trans World Airlines) "Do you ask John McEnroe why he holds a tennis racket a certain way?"

"I don't like giving up equity. I've learned over the years, a dollar bill is a better partner than a partner."

Twelve companies that might excite the activists