By Ben White
Washington Post Staff Writer
Tuesday, May 17, 2005; E01
The weak support shown yesterday for MCI Inc.'s current board of directors reflects the unusually active role hedge funds have played in the bidding war over the Ashburn-based telecommunications company. More than a quarter of shares were withheld in voting to reelect the unopposed board members. For months, hedge fund managers with large blocks of MCI stock have pressed the company to accept buyout offers from Qwest Communications International Inc., going so far as to offer to help Qwest arrange financing for another bid, an uncommon occurrence in merger deals. MCI's board resisted the pressure, ultimately accepting an $8.5 billion offer, or about $26 per share, from Verizon Communications Inc. The board said Verizon, which is larger than Qwest and in stronger financial condition, is the better long-term partner. Qwest had offered $30 per share, or $9.74 billion, for MCI. The MCI fight comes against a backdrop of rising hedge fund activism on other fronts. On May 11, for instance, hedge funds helped financier Carl C. Icahn and two other dissident candidates win seats on video rental company Blockbuster Inc.'s board. Icahn, Blockbuster's largest shareholder, has argued that the company should cut spending on new ventures and instead distribute cash to shareholders through a dividend. Hedge fund managers say Icahn's strategy may in fact be the right one for Blockbuster. But critics argue that the fund managers don't care about Blockbuster's long-term prospects and simply want a big, immediate payout. In Germany, hedge funds recently helped force the ouster of top executives of the Deutsche Borse stock exchange in an effort to derail the Borse's bid for the London Stock Exchange. There, too, fund managers say the Borse would be better off sending cash to investors. Critics say pressure on hedge funds to take a more activist role is mounting as more money floods the industry and returns diminish. Hedge funds use complex and often risky investment strategies to generate returns for their clients, mostly wealthy or institutional investors. In 1990, according to Chicago-based Hedge Fund Research Inc., there were 610 hedge funds with about $39 billion in assets. Currently, there are nearly 8,000 funds with assets of about $1 trillion. (By comparison, mutual funds control about $8 trillion in assets). From 1987 through 2004, hedge funds returned an average of 14.94 percent per year, according to data from Hennessee Group LLC, a hedge fund advisory firm. The funds have been especially attractive in years when the overall market suffered. For instance, in 2000, the year the equity bubble burst, hedge funds gained 7.6 percent while the Standard & Poor's 500-stock index dropped 10.1 percent. But so far his year, according to Hennessee, hedge funds are down about 1.6 percent, and the market has been flooded with rumors in recent days that some funds took huge losses on Ford Motor Co. and General Motors Corp. bonds when Standard & Poor's dropped each automaker's debt to junk status. The rumors have not been substantiated. "There are so many funds out there now, and so much money, that they have to take on an activist role or they are not going to continue to produce," said Joseph Aaron of Wood, Hat & Silver LLC, a San Francisco firm that invests in hedge funds for individuals and institutions. Despite Qwest's official withdrawal from the battle for MCI, some hedge fund managers continue to urge the company to press its bid in advance of a shareholder vote on the deal this summer. Some would like to see Qwest take its offer directly to shareholders in a hostile takeover attempt. The stakes for the hedge funds are very high. Four out of MCI's top six shareholders are hedge funds that collectively own about 43 million shares, or about 13 percent of the company. Based on the current offers, these four hedge funds stand to take in about $172 million less collectively if MCI accepts Verizon's bid. And it is not just hedge funds with big money at stake. The bidding war has also placed Baltimore investment management firm Legg Mason Inc. in an unusually activist role. The firm's legendary mutual fund manager, William H. Miller III, has made big bets on both MCI and Qwest stock and has loudly argued that Qwest's bid is superior. Legg Mason owns about 5.6 million MCI shares, which would be worth about $168 million under Qwest's offer and $146 million under Verizon's. The firm owns about 250 million Qwest shares, a stake currently worth about $900 million. If Qwest fails to acquire MCI, the value of that stake could decline. Through a spokesman, Miller declined to comment on his role in the MCI bidding. Hedge funds have occasionally stepped into the spotlight on big merger deals. In February, for instance, Highfields Capital Management LP went public with a $3.25 billion cash bid for Richmond-based Circuit City Stores Inc. Circuit City's board rejected the offer. But the funds more commonly stay on the sidelines, quietly making bets on potential winners and losers in big transactions. Critics, including Verizon chief executive Ivan G. Seidenberg, have blasted the funds' role in the MCI deal, saying they are interested only in an immediate payout and don't care about the future of MCI or its long-term stock and bond holders. In response, some hedge fund managers say they expect that Verizon will triumph and that, in the end, their influence will have gotten MCI investors more value for their shares as well the better long-term corporate partner. "The real criticism I would put forward is to MCI's board for having accepted such a low price to begin with," said veteran hedge fund manager Peter Schoenfeld, whose firm owns about 324,000 MCI shares. In the end, Schoenfeld said, MCI appears likely to wind up with "the more prudent acquirer." But things might have worked out differently. A person close to the situation, who spoke on condition of anonymity because the deal is not yet done, said Verizon considered walking away from the table at several points as hedge funds pushed MCI's price tag higher. "It's a dangerous game the hedge funds are playing," the source said. "Things did not have to work out they way they have."