Small capitalization public company investment fund activism in Canada, and Crescendo Partners

1. Small-Cap Investor
Activism in Canada and
Crescendo Partners
Dave Litwiller
November 2010

2. Activist Hedge Funds
 Seek to exploit structural inefficiency in target companies
 Their premise is that markets are not efficient, and that
informational advantage and a catalyst even can generate
superior returns
 Generally develop intensive knowledge of target companies
prior to investing
 Very smart people working in hedge funds, since many of
the best i-bankers and sell-side analysts end up in hedge
because of the participation in ~20% of fund gains rather
than just annual management fees
 Focus tirelessly on capital allocation
 Believe they can beat the overall market
 Typically willing to concentrate in ~six active holdings,
when conventionally a lack of diversification is a handicap

3. Standard Activist Goals for Targets
 Reduce costs
 Sell the entire company
• Usually seen as the easiest kind of activism
 Break-up of conglomerate
• Remove conglomerate discount, better focus management
 Sell or shut underperforming division, or underperforming
capital assets (such as land or buildings)
 Pay out cash, including trimming and levering the balance
sheet
 Better governance
• This is usually a supporting argument toward other goals, to
discredit and pressure the board of directors and fiduciary
management

4. Activist Lever
 Proxy fight, threatened or realized
• Proxy fight is very time consuming for
management
• It is a liability for the board of directors

5. Typical Escalation Arc (1)
 Build the case for how structural change can build
shareholder value, and use this to build interest
from institutional investors to collaborate
• Research often includes interviewing customers,
shareholders, managers
• May involve preparing a sell-side style report on the
company
 Take enough of a position that management has
to take notice
• 5% entitling proxy of shareholders directly in Canada
• Public disclosure of shareholding not required until 10%

6. Typical Escalation Arc (2)
 Tell management and board what
structural change is desired
 May attempt to influence sell- and buy-
side analysts
• Including questions on conference calls,
contacting media, and hiring PR firms
 Pressure for seats on board of directors
 Proxy contest to get board seats or
change strategy
 Court actions to compel a special meeting
of shareholders to vote on binding “full
value” proposals

7. Target Selection
 Common:
• Low Price/Book ratio, with sound
operating cash flow in parts of the
business
• Low Return on Equity
 Management not deploying cash flow into
profitable businesses
• Peer underperformance
• Industries that are consolidating or are
ripe for consolidation

8. Small-Cap Benefits for Activists
 Low absolute cost of accumulating a
≥5% to <20% position
 Greater market inefficiencies to
exploit in small-cap issuers than
larger caps due to information gaps
 Small-caps usually trade at illiquidity
discounts
• A catalyst event upon exit can eliminate
this discount, enhancing returns

9. Typical Activist Tactics (1)
 Lure board into making a strategic,
technical or fiduciary error, limiting
downstream flexibility
 Identify a split within the existing board
on a significant issue with strategy or
management performance, and then work
to deepen that rift
 Wage publicity battle about corporate
performance, governance or management

10. Typical Activist Tactics (2)
 Court system
• Can include seeking oppression remedy if a disadvantageous
restructuring or recapitalization is carried out
 Encourage bid from strategic buyer
 Short slate proxy
• Easier to win, since they do not provide control
• Proxy advisory firms are sympathetic to this, particularly with
a poorly performing company
 Gain not just board seats, but representation on the
powerful committees
 White papers advocating value
• Difficult for companies to counter, since they end up tripping
over a self-defeating argument of “We’re not worth that
much.”

11. Sample Target Company
Tactics

12. Company Tactics (1)
 Proactively address reasons for
performance shortfall
• Review beefs of existing investors,
particularly institutions
• Look anew at arguments for spin-offs,
share buybacks, special dividends, and
other structural changes

13. Company Tactics (2)
 More specifically:
• Operational improvements
 Stronger performance incentives and culture
 Outsourcing, to lower capital intensity
 Leaning of the enterprise, to lower capital intensity
• Portfolio re-jigging
 Get rid of things that are unlikely to perform
 Sell to those who can generate higher value
• Balance sheet tune-up
 Get rid of exceptionally high cash balances, through share repurchases or dividends
 Reduce working capital levels
 Put some leverage in the capital structure
 Improve cash flow management
 Sell and lease-back real estate
• Improve governance
 There’s a pretty standardized checklist these days of better practices to adopt
• Build investor confidence
 Better financial guidance
 Higher quality communications
 Manage expectations

14. Company Tactics (3)
 Engage activist during initial phases
to induce a more moderate response
• Rarely works
 Agree to a minor accommodation as
a show of good faith and to buy time
during negotiations
 See if neutral 3rd party director(s)
can be agreed upon

15. Company Tactics (4)
 Engage advisors
• i-bank, if financial enhancement or
strategic review possibilities need to be
detailed
• Communication firm, if PR or proxy
campaigns are likely
 Prepare persuasive analysis that
defends the business plan
• Try to pre-empt value enhancing claims
expected from or made by activist

16. Company Tactics (5)
 Scrub down governance practices
 Review statutory and by-law
defences
 Review how hedge fund influenced
other companies
 Perform due diligence on the
experience and effectiveness of the
hedge fund’s intended representation
on the board

17. Activist Concerns
 Illiquidity, pressuring share price during cut stake
• Favours sale of entire company
 Hot money coming into the stock in the
slipstream of the activist, increasing share price
volatility. This makes mark-to-market pricing for
hedge fund more difficult
 Reputation damage liability in future fights if
current fight unsuccessful
 Redemptions in activist’s fund disrupting
campaign
• Countered with lock-up provisions
 Fiduciary obligations if they obtain board
representation

18. Reasons Some U.S. Activist Hedge
Funds Favour Canadian Targets
 Don’t have to publicly disclose holdings
until 10% ownership threshold reached
(vs. 5% in US)
 Can requisition shareholder meeting at
5% holding (vs. 10% in US)
 Dismantling of poison pills easier in
Canada
 Proxy battles easier, since most Canadian
companies elect directorate annually
 Canadian market less picked over

19. Examples of Crescendo Partners
Activism in Canada
Source: www.sedar.com

20.  Spar Aerospace
• 1999-2002
• Achieved board representation
• Sale of company to L-3
 Call-Net
• 1999-2001
• Achieved board representation
• Exited in 2001

21.  Western International Communications
• 1999-2000
• Achieved board representation
• Company sold to CanWest Global
 Ad Opt
• 2003-2004
• Achieved board representation
• Company sold to Kronos

22.  Pivotal
• 2003-2004
• Achieved board representation
• Company sold to CDC Software
 Sierra Systems
• 2003-2007
• Achieved board representation
• Company sold to Golden Gate Capital

23.  Emergis
• 2004-2007
• Achieved board representation
• Company sold to Telus
 Hip Interactive
• 2005
• Company went bankrupt
• A rare failure for Crescendo in Canada

24.  Geac Computer
• 2005-2006
• Achieved board representation after a rough
start
• Company sold to Golden Gate Capital
 Matrikon
• 2007-2010
• Achieved board representation
• Company sold to Honeywell

25.  Dalsa Corp.
• 2007-present
• Achieved board representation
 Q9 Networks
• 2008
• Did not publicly ask for or receive board
seats
• Company sold to Abry Partners

26.  Bridgewater Systems
• 2008-present
• Achieved board representation
 Cott Corporation
• 2008-present
• Achieved board representation

27.  The Forzani Group
• 2009-present
• Tried but failed to achieve board
representation thus far
 20-20 Solutions
• 2010-present
• Agitating for board representation at
mid-Nov ’10

28. Crescendo Partners Success
Statistics in Canada
 Based on cited examples where final outcomes have been reached:
• Achieved board representation when it was demanded over 80% of the time
• Sale of company occurred over 80% of the time
• Low rate of outright failure
 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
accommodation (study dependent), Crescendo Partners has historically
achieved considerably higher success in its Canadian efforts
 The percentage of Crescendo outcomes that result in the outright sale of
the company is particularly high relative to benchmarks
 Crescendo also has realized better than average activist hedge fund
success rates in Canada for:
• Sale or shutting of underperforming divisions
• Dividend payouts and share buybacks
• Senior management changes
when these structural and management changes have been demanded

29. Dave Litwiller is the COO of Prinova Inc., a growth stage enterprise software developer in Waterloo
region.
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 - Mergers &
Acquisitions, Partnerships, Restructurings, Turnarounds and Divestitures in High Technology”
http://www.amazon.com/Rapid-Advance-Acquisitions-Partnerships-
Restructurings/dp/1439200874/ref=sr_1_1?ie=UTF8&s=books&qid=1287516364&sr=1-1