Ivory Investment Management, which owns 1.5 percent of the shares of Yahoo, urged the Internet company to forge a search deal with Microsoft, saying it could more than double Yahoo's value.
The news comes as Yahoo prepares to tell 1,500 employees that they are losing their jobs, according to a person familiar with the situation.
The Los Angeles hedge fund has not typically acted as an activist in the past, preferring to more quietly act behind the scenes, and its actions may ratchet up the pressure on Yahoo to act. (Watch the accompanying video for more...)
In a letter outlining its proposal Wednesday, Ivory said Yahoo's board should salvage a deal with Microsoft, and estimates such a transaction could result in as much as $15 billion upfront payment from Microsoft .
Microsoft withdrew its $47.5 billion buyout offer for Yahoo in May after Yahoo Chief Executive Jerry Yang and his board rejected the bid as too low.
Bid speculation was renewed recently when Yang announced he was stepping down. Microsoft CEO Steve Ballmer ruled out a bid at that time, but said he was "open" to talks on a deal for Yahoo's search business.
Yahoo shares have fallen sharply since the bid with Microsoft unraveled, but were trading up more than 7 percent Wednesday.
"We believe a search deal with Microsoft could deliver value to Yahoo shareholders of $24-29 per share, or more than double yesterday's closing price of $12.19," Ivory Managing Partner Curtis Macnguyen wrote in the letter.
"We envision a deal whereby Microsoft would acquire all of Yahoo's search assets and enter into a perpetual agreement for Microsoft to be the search provider for all Yahoo properties," the letter said.
A Yahoo spokeswoman declined to comment. Microsoft has repeatedly said it was no longer interested in buying all of Yahoo but has left open the possibility of a search deal.
Ivory, which has 21.4 million shares of Yahoo, said Yahoo could get an upfront payment of more than $15 billion from Microsoft for the search business, and retain 80 percent of the advertising revenue generated through searches on its sites.
The deal could increase Yahoo's earnings before interest, tax, depreciation and amortization (EBITDA) by more than $500 million a year, Ivory said.
Yahoo and Microsoft could also save $800 million by combining their search operations and getting rid of duplicate costs, Ivory said. The company urged immediate action in the face of Google's dominance in the Web search market.
"This deal would offer Microsoft the unique opportunity to immediately gain critical mass to better level the playing field with Google, while it would simultaneously allow Yahoo to both receive a sizable upfront cash payment and increase its prospective cash flow," Ivory said.
-Reuters contributed to this report.