What’s behind this new muscle-flexing?

Activist hedge funds have been very, well… active lately, and their actions have had a major effect on the value of companies. The current run of successes has not been due to any one thing but to a nexus of circumstances and events. First, success breeds success, confidence is infectious. Second, there is the apparent lack of readiness among very large companies to deal with hedge funds. Finally, there is a general lack of confidence among the boards and management teams that hedge funds have challenged. All these are leading to activist triumphs.

Not only was Icahn Enterprises’ campaign to force eBay to sell PayPal successful, causing the stock price to climb to a six-month high, Icahn’s criticisms of eBay director Marc Andreessen’s lack of independence resulted in him stepping down from the board.

Daniel Loeb’s Third Point has been running a campaign to shake up auction house Sotheby’s. This led to the announcement of CEO Bill Ruprecht’s resignation and a significant uptick in the company’s stock price. In addition, Loeb has now installed four independent directors on Dow Chemical’s board, cementing the idea that hedge fund influence in U.S. boardrooms is on the rise. To be sure, the immediate increase in Dow’s stock price was short-lived.

Pershing Square has also been busy. Bill Ackman’s challenges to Herbalife (he accused it of being a pyramid scheme, which led to a government investigation) has led to a significant income slowdown at the company, much of it due to changes the company has made to its sales strategy to mitigate the pyramid-scheme allegations. Ackman also successfully sued to gain permission to vote his 10% stake in Botox-maker Allergan in support of a takeover of the company by rival drug company Valeant. Allergan had a poison pill in place, an instrument designed to prevent hostile takeovers, but the judge still ruled in Ackman’s favor. In fact, the only way Allergan was able to avoid Ackman’s power was by being taken over by yet another rival pharmaceutical firm, Actavis.

Outdoing Pershing Square, hedge fund Starboard Value not only ousted the CEO of Darden Restaurants (the owner of Olive Garden, among other chains), but, last month it replaced the entire 12-person board with its own nominees.

This is beginning to look like a trend.

A recent survey of directors by consultancy PwC concludes that big companies need to watch out because the activists are about. Directors at over a third of these large companies (over $10 billion in revenues) indicated they had had interactions with activists. By contrast, less than a fifth of smaller companies reported dealings with hedge funds.

Yes, some hedge funds have been instrumental in instituting change at large companies in the past—Relational Investors successfully changed management and compensation policy at both Occidental and Home Depot. However, the increased focus on the biggest companies is atypical and marks a new development. Hedge funds previously focused on smaller companies, where it was easier to acquire a significant stake with enough voting power to make changes. Now, these funds are using their success with small firms, which in many cases resulted in enormous gains, and devoting resources to taking large stakes in big companies.

At the largest companies, boards often do not expect the attention of hedge fund activists and are therefore not prepared and don’t know how to react. This lack of confidence has allowed hedge funds to have their way with these companies.

But that’s not all. Boards are crumbling in front of the likes of Loeb and Icahn because the value released by changes they are forcing through is making it more likely that other shareholders will support them. Replace directors? New CEO? Divestments? If it came to a vote, management and existing boards would likely lose the fight, so they capitulate before combat actually begins.

In most cases, these campaigns benefit all shareholders, so don’t expect the hedge funds to go quiet any time soon.