By Leah McGrath Goodman
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| Illustration by Greg Mably |
Barry Rosenstein, co-founder of JANA Partners, did not own any stock in the McGraw-Hill Companies at the end of last year. By the end of the first quarter, he’d quietly scooped up more than three million shares. By late June, he was buying at a rate of more than 40,000 shares a day, amassing nearly eight million in total. He persisted throughout July, even as McGraw-Hill’s stock leaped above $43, snapping up another 1.2 million shares. Heading into the last quarter of the year, he secured more than 10 million shares of McGraw-Hill, bearing a price tag of well above $400 million. Then the news came. McGraw-Hill, in the second week of September, announced it would split in two, creating a market data company and an education and textbook publishing business. It also committed to buying back $1 billion of stock by the end of the year. At first glance, this would appear to be a victory for Rosenstein, as his mission was to gain the voting power to build enough pressure on the $12 billion conglomerate to spur a breakup that would boost its value by as much as 50%. But McGraw-Hill may not be going far enough to achieve Rosenstein’s goals.
“He definitely thinks the stock is too cheap below $40,” says Ian Dogan, pointing to data showing that Rosenstein bought as much as 300,000 shares a day in August when McGraw-Hill’s stock dropped into the mid-30s. “But I don’t think he expects a lot of easy upside.” Dogan is the founder of website Insider Monkey, which evaluates and publishes hedge fund portfolio data based on public filings.
For all Rosenstein’s conviction, the renowned activist investor has hardly thrown caution to the wind in embarking on his McGraw-Hill buying spree. Unlike JANA’s full-bore investment in El Paso Corp., which this year represented as much as 25% of JANA’s portfolio before the company announced a breakup, the fund did not seek to do the same with McGraw-Hill. Early on, Rosenstein shrewdly roped in Ontario Teachers’ Pension Plan—a pension fund holding a sizable stake in McGraw-Hill—to offset inherent risk.
Initially, Ontario’s investment in McGraw-Hill was a passive play, an individual close to the situation says. It was JANA’s idea to turn their combined firepower into a greater-than-the-sum-of-its-parts activist play. As of late August, JANA’s share of McGraw-Hill came to 3.3% of outstanding shares and counting—close to 20% of JANA’s $1.98 billion portfolio—while the pension fund’s take came to 2.3%.
A hedge fund teaming up with a pension fund on an activist crusade is an unconventional move. But Ontario has been mixing with the hedge fund crowd for some time—mostly through its relationship investing portfolio, led by former Lehman Brothers executive Bill Royan, who joined in 2008.
While Ontario does not have much to contribute by way of an activist campaign, its $107.5 billion under management gives it outstanding financial clout. And as an existing client of JANA’s, it offers the kind of loyalty perhaps only billions of dollars can buy. (In fact, many of the McGraw-Hill shares owned by Ontario are handled by JANA itself in a managed account, in addition to JANA’s own, making clear which of the two funds is in the driver’s seat.) This is the first time JANA and Ontario have partnered on an activist investment.
McGraw-Hill has long been regarded as a dinosaur—bulky, slow-moving and more than 123 years old. While its stock climbed as much as 20% this year before McGraw’s breakup announcement, it remains well below its 2007 peak of nearly $71. Even after the announcement, the stock gained only 4%, indicating the company may need to consider more radical steps. In a joint statement, JANA and Ontario said they planned to review the “scope and impact” of McGraw-Hill’s plan, which they characterized as “vital.” They also hinted that they won’t be backing off their activist assault.
Run by a fourth-generation member of the family, Harold “Terry” McGraw, McGraw-Hill has a board that includes his brother, Robert McGraw. “All of the board members are in a similar age group,” observes one trader at a multibillion-dollar hedge fund with a substantial investment in McGraw-Hill. “It makes me wonder, how many of them are too cozy with senior management? Are they more loyal to Terry than doing what’s right for the business? Terry owns about 4.7% of the company, and he has family on the board.”
In its present form, McGraw-Hill consists of a hodgepodge of divisions: McGraw-Hill Financial, McGraw-Hill Education, Information & Media, and the Standard & Poor’s ratings service, which, in Rosenstein’s view, “is an overly complex equity story for analysts and investors” in an age of specialization. While McGraw-Hill plans to divide in two, Rosenstein prefers a four-way breakup, separating the company’s education unit from its information and media businesses, and establishing a stand-alone S&P index business apart from McGraw-Hill Financial.
Rosenstein and Ontario’s Royan aired their views in a private meeting with Terry McGraw at McGraw-Hill’s headquarters August 22 in New York. “McGraw-Hill’s conglomerate structure acts as a significant constraint on each of its businesses, hampering operational performance, strategic flexibility in allocating capital and share price valuation,” JANA said in an August filing with the Securities and Exchange Commission. Only a few weeks earlier, many did not realize the full extent of JANA’s and Ontario’s position in McGraw-Hill, revealed only in a 13D filing August 1. That day, the stock leaped 5% in after-hours trading. Rosenstein declined to comment on the talks.
In rejecting some of Rosenstein’s suggestions, an individual familiar with the situation at McGraw-Hill says, “JANA’s proposal is a combination of things we’re already looking at and things that frankly don’t make any sense.” The company aims to complete its split by late 2012.
McGraw-Hill began a self-review in late 2010, and in late August it released a statement promising “significant actions in the next few months to accelerate global growth, align appropriate cost structures and build shareholder value.” The company put its broadcasting group on the auction block this spring after selling BusinessWeek in 2009. It also launched a stock buyback targeting 50 million shares.
Since the financial crisis, McGraw-Hill’s shares remained low enough to prevent Terry McGraw from exercising many of the millions of options he’d received as part of his annual compensation package. Hundreds of thousands of his calls will expire unused before 2015 if he cannot get the stock price past the $47 to $56 range—a level McGraw-Hill hasn’t been at since the stock’s 2007 peak. Additionally, all of the analysts retained by the company to advise it on its portfolio strategy believed McGraw-Hill’s disparate businesses had few synergies and might require decoupling.
Rosenstein has carefully turned the screws. When Standard & Poor’s downgraded the nation’s triple-A credit rating August 5, McGraw-Hill’s stock lost $6 in as many days, dragging down the value of all its businesses. In the political backlash that followed—which included S&P president Deven Sharma’s resignation—JANA and Ontario ratcheted up the pressure by voicing concern that the brouhaha served “as an overhang on McGraw-Hill’s valuation.” Behind the scenes, Rosenstein was ravenously purchasing more stock.
Ever since the housing crash has been blamed in part on spectacularly flawed ratings issued by S&P, among other agencies (an investigation by the Department of Justice continues), traders have whispered among themselves that McGraw-Hill could be ripe for an activist onslaught. It wasn’t until this year, however, that the hedge funds with the deep pockets felt the legal and regulatory risks had subsided enough to place their bets.
Some of the hedge fund world’s biggest luminaries, including D.E. Shaw, Citadel, Renaissance Technologies, Millennium Management and SAC Capital Advisors, have sizable stakes, according to regulatory filings. Of those, Renaissance for a time led the pack, accumulating nearly $32 million of McGraw-Hill shares by the end of the first quarter before unwinding its position by June. Millennium backpedaled as well, paring its $5.5 million stake to $1.7 million.
Second to JANA’s stake is Tetrem Capital Management’s; Tetrem sank $50 million into the stock. Newcomers piggybacking JANA in the second quarter included AQR Capital Management, Alyeska Investment Group and Carlson Capital.
However, D.E. Shaw and SAC resisted following Rosenstein’s lead in purchasing McGraw-Hill shares throughout its rally to nearly $44 in July. Meanwhile, Citadel increased options to buy and sell McGraw-Hill stock, with a heavy bias on calls as of late June, quadrupling them to $4 million from the end of March.
Whatever the outcome, Rosenstein appears poised to benefit. At least until the split announcement, McGraw-Hill’s stock traded for less per dollar of revenue than any of its closest pure-play rivals. Douglas Arthur, an analyst at Evercore, says a reasonable post-breakup target price for the company could fall anywhere from the low 50s to the low 60s. Rosenstein’s average purchase price this year for McGraw-Hill stock has been about $40.
