The Conference Board
Governance Center Blog
Mar
03
2013
By Chuck Nathan,
Partner and Senior Advisor, RLM Finsbury
Activist investing has become quite the rage in the equity marketplace.
Activist investors are proliferating, and there is a marked inflow of new
capital to this asset class. The discipline of activist investing is
popping up in more conversations about the nature and role of equity
investors. As a result, it is occupying the thoughts, and sometimes the
nightmares, of an increasing number of corporate executives and their
advisers. The phenomenon has even become a topic du jour of
academics, who are busily finding sufficient economic value in the
function of activist investing to justify urging the SEC not to shorten
the historic minimum time frames for reporting accumulations of more than
five percent of a company’s stock explicitly to permit activists to
accumulate larger blocks before disclosure of their activities results in
a rise in market trading values for the stock in question.
Activist investing has a long pedigree in the equity markets dating back
to the late 1970′s. Back then and throughout the 1980′s, activist
investors were known by less flattering sobriquets such as corporate
raiders, bust-up artists, and worse. Activist investing has changed since
those heady, junk bond fueled days. Then, the favorite game plan of
activist investing was to threaten or launch a cash tender offer for all,
or at least a majority, of the target company’s outstanding stock with
funding through an issuance of high yield bonds. Today, activist investors
rarely seek equity stakes in target companies above 10 percent, and their
financing comes not from the public debt or equity markets but rather
through private hedge funds that they sponsor and manage.
Even though activist investing and company responses to it have changed
dramatically during the 40+ years of the existence of activist investing
as a recognized, if not always lauded, investment style, one aspect
remains the same. Just as in the 1970′s, activist investing, its
practitioners, and company defenses against activist investors remain
surrounded by myths that often get in the way of reality.
MYTH NUMBER ONE:
Today’s activist investors have a single, basic game plan—to force
companies to make imprudent changes in their capital structure resulting
in a large dividend or share buyback program or, worse, to force a sale of
the company.
Activist investors are “one-trick ponies.” Most follow the same game plan,
without regard to the realities of a given target’s actual situation.
REALITY:
As underscored by some of the current prominent activist campaigns,
including the Icahn/Ackman battle over Herbalife and the JANA Partners –
Agrium situation, activist investors’ game plans come in many shapes and
sizes.
Among the more common strategies advocated by activist investors are:
-
Returning excess cash on the balance sheet
to shareholders.
-
Restructuring the balance sheet by
leveraging the company and distributing resulting cash to shareholders.
-
Restructuring company assets by selling one
or more “underperforming” business units and distributing proceeds to
shareholders.
-
Restructuring company assets by spinning off
one or several distinct business units to optimize the combined trading
value of the resulting companies’ stock.
-
Restructuring company operations to create
efficiencies and achieve higher margins.
-
Selling the company to realize superior
value in the M&A market compared to the trading market.
Moreover, activist investors are not always buyers of target company
stock. In many instances, their game plan is to sell short the company’s
stock and to wage a very public campaign explaining why they have done so.
(Pershing Square’s campaign regarding Herbalife is an example of such a
short sale strategy.) Instead of uncovering hidden value in a company,
this strategy is premised on a directly opposed investment thesis of
uncovering hidden over-valuation in a company.
MYTH NUMBER TWO:
Activist investing is the epitome of “short-termism” as an investment
style and is inherently bad for this reason.
A
common misperception is that activist investors’ sole modus operandi is to
take an equity position in a company, rattle their sabers to induce
immediate actions contrary to shareholders’ best interests, reap quick
profits, and then cut and run.
REALITY:
While it is true that activist investors like quick returns, this is true
of all investors. The quicker the return on an investment, the higher the
IRR and the faster the investment funds can be re-invested for further
gain. But the fact that activist investors understand IRR math does not
make them slaves to short-term results. Many activist investors have
advocated strategies that require significant time to implement. Moreover,
most activist investors understand that there is an unpredictable time
frame between an initial proposal for a change at the target company and
acceptance and implementation of the change. Whatever the reasons, many
activist investors have undertaken investments with durations measured in
years, not months.
Moreover, although there is substantial sentiment that US equity markets
fundamentally need more long-term focus from institutional investors,
thereby encouraging and enabling long-term strategic planning by public
companies, that belief should not result in automatic condemnation of
strategies that create shareholder value in the short-term. As long as
those strategies do not destroy more value in the long-term, they should
not be dismissed simply because they produce short-term gains.
There also is the reality that a strategy some may believe is
value-destroying turns out to be value-creating and vice-versa. For
example, take the strategy of adding leverage in a company’s capital
structure. If the forty year history of LBO’s has taught us anything, it
is that increasing leverage on a balance sheet can be value-creating if
done at the right time at the right company. Condemning all
recommendations by investors to increase leverage at a given company as an
example of inappropriate short-termism simply makes no sense. The same, of
course, can be said for each of the typical activist investor’s strategy
recommendations. They are neither inherently good nor bad, whether or not
they are short-term or long-term in nature.
MYTH NUMBER THREE:
Activist investors may be successful, but they should not be viewed as
beneficial to our equity capital markets or as economically useful.
Another common misperception is that activist investors are more akin to a
necessary evil standing in the way of responsible long-term corporate
strategies than a beneficial influence contributing to shareholder value.
REALITY:
Activist investors act as important intermediaries in the equity markets.
Activist investing is often a useful contributor to good corporate
governance and a force for company implementation of strategies that
enhance shareholder value.
Shareholder participation in corporate strategy and operations is
essentially passive. While in theory shareholders elect the board of
directors, which is in a position to shape corporate policy and
performance, in practice shareholders do not and cannot use their
franchise to improve board performance through election of more effective
directors, unless there is an active proxy contest. The simple reality is
that the institutional shareholder community, which dominates share
ownership of most public US companies, is ill-suited to influence company
performance through dialogue with management or proxy contests and very
rarely tries to do so. Institutional investors lack the resources and
skill set to study a company and its operations in sufficient depth to
develop better corporate strategies. Moreover, they are not hired by their
clients to do so. Instead, in the absence of a well-founded campaign by an
activist, institutions have no practical recourse against an
under-performing management other than the “Wall Street Walk”—that is to
say, if they are unhappy with a company’s performance or management, their
only redress is to sell the company’s stock.
Activist investors are cut from a different cloth. Rather than managing
large and diverse stock portfolios, activist investors concentrate on one
company or a relatively small number of companies at a time. Moreover,
they do so in depth so as to discover alternative strategies to increase
the company’s value and, having developed an alternative game plan, to
persuade the company to adopt it. Put another way, activist investors
function to create market-based discipline for underperforming companies.
Their function, like that of M&A acquirers, is to arbitrage the value gap
between poor company performance and good company performance. And like
other arbitragers, they play an economically justified role in discovering
value equilibrium in the equity markets.
MYTH NUMBER FOUR:
Conventional institutional investors will tend to support a target
company against a challenge by an activist investor.
Companies, particularly those with effective IR programs, usually have
credibility with and the trust of their institutional investors. This is
particularly true of their longer term investors and new investors. Unless
a large number of investors are unloading their holdings of a company’s
stock, management can assume these shareholders will side with them in a
fight with an activist investor, especially an activist with an aggressive
short-term agenda.
REALITY:
While an inherent bias in favor of management may once have existed among
conventional institutional investors, this is no longer the case in many
situations. In fact, perhaps the most important change in the activist
investor game plan over the past several years has been the increasingly
sympathetic hearing activists receive from conventional institutional
investors. Institutional investors are, for better or worse, chained to
the wheel of quarterly performance statistics. As activist investing has
become more common and as it has resulted in realizable value creation,
institutional investors have become far more sympathetic to activist
investors, and the economic utility of the activists is now well
understood by the institutional investor community.
MYTH NUMBER FIVE:
If a company is in touch with its institutional shareholders through
quarterly earnings calls and similar outreach to portfolio managers and
buy-side and sell-side analysts, it will know whether there is reason to
fear a successful raid by an activist investor.
Although most activists begin their campaign with a claim of widespread
institutional investor support, if a company’s financial officers and IR
people haven’t perceived widespread dissatisfaction by its key investors,
there is no reason for a company to believe an activist’s claims.
REALITY:
In most cases of activist investing, management has not been reading the
pulse of its institutional investors correctly. Activist investors rarely
concentrate on a target company without first engaging in dialogue with at
least some of the company’s key investors. After all, if the basic
strategy of the activist is to acquire a relatively small block of stock
and rely on broad support from the company’s larger shareholders, the
activist is unlikely to amass its block first and then test the waters
with the shareholder community.
Today’s institutional investors are not only typically ready to talk to
activist investors about their investment thesis for potential target
companies, but they also are usually candid in their response to
activists. It is not in the interests of the institutional investors to
encourage activists to engage in campaigns that the institutions will not
support. When an activist claims wide institutional investor support, it
may exaggerate the extent of the support, but a target company should not
naively discount its claims entirely.
The reality is that institutional investors may not be as candid with
management as they are with an activist. No one likes to be a messenger
carrying bad news, particularly when an activist is more than happy to
deliver the message in the first person. Also, institutional investors may
feel that they haven’t been given an opportunity to express their views to
management or that they haven’t been listened to when they tried to do so.
The very fact that an activist campaign takes a company by surprise
suggests that the company’s management has been somewhat tone-deaf in its
dealings with its investors.
The bottom line is that when an activist claims wide institutional
support, the company should take its assertions seriously and recognize
the likelihood that the activist investor has received significant
encouragement from the company’s larger shareholders.
MYTH NUMBER SIX:
A company has no way of knowing whether and when it will be a target
of an activist investor.
Activist investors rely on stealth in building their ownership stake and
in plotting an activist campaign against target companies. Current SEC
regulations are inadequate to give companies fair notice of their being
the target of an activist investor. As a result, companies are frequently
victimized by activists who have been able to amass large share positions
without fair warning.
REALITY:
Of course, activists don’t want to reveal their game plan until they are
ready to broach it to the company privately or publicly. And, of course,
activists will use the existing rules to maximize their freedom of action
and to retain the initiative.
But that doesn’t mean companies have no ability to anticipate the
possibility of an activist attack. The best early warning device a company
has is an honest and candid “look in the mirror.” Activists do not target
high-performers. They seek out the low-hanging fruit. The obvious best,
and in many ways only, defense is for management to recognize when its
company is under-performing and to address the reasons for
under-performance promptly and decisively. Proactive, management-initiated
strategies to improve performance (which, along with a clear plan for
achieving them, have been widely communicated) will have far more
credibility with investors than actions clearly taken in response to a
well-reasoned challenge by an activist.
MYTH NUMBER SEVEN:
There is no point in trying to engage with activist investors because
they will not listen.
Activists are predators. Any attempt at dialogue with an activist will be
perceived by it as a sign of weakness and will only heighten its blood
lust.
REALITY:
Activist investors, at least for the most part, are rational and
thoughtful. Most do not pick a fight for the sake of it, nor will they
insist on strategic or other changes at a company if they can be convinced
the changes will not lead to value creation or that the company has an
equally good or better answer. Accordingly, a target should try dialogue
first. It may not be successful, either because the activist investor has
the better of the merits or because it is stubborn and set on its
strategy. Even if dialogue with the activist is not successful, if
properly handled management should be able to gain useful insights into
the activist’s business case, its sophistication and expertise, and its
personality. Finally, it is almost always better to talk than to fight, at
least in the first instance (taking care, of course, to ensure that the
case management takes to the activist investor is the one it is prepared
to take to the broader investor community). Refusing to talk first serves
no purpose and precludes any opportunity for a quiet and constructive
solution before the onset of a battle which is inherently somewhat
destabilizing, even if management wins.
MYTH NUMBER EIGHT:
The best defense against an activist investor is an aggressive
structural defense.
Conventional wisdom is that a company in the cross-hairs of an activist
should revise its existing poison pill to better target activist investors
or, as is more likely in today’s world of fewer and fewer poison pills,
implement a pill with a relatively low trigger threshold to protect itself
against the activist. Conventional wisdom also holds that a target company
should tighten its advance notice bylaws to give it maximum protection
against an imminent proxy contest, as well as revise other bylaws, for
example, to guard against a call for a special meeting or other proxy
contest shenanigans.
REALITY:
While out of prudence a company should review its structural defenses, it
should be cautious in rushing to introduce new defenses or tighten
existing ones. Structural defenses are of marginal value, at best, in
deterring an activist investor and in hindering its tactics.
-
It is rare that an activist investor or
group of activist investors will exceed the most common poison pill
trigger of 15 percent of the outstanding stock. Lowering the trigger
below 15 percent will increase a company’s vulnerability to shareholder
litigation and quite possibly backfire in the contest for the hearts and
minds of uncommitted shareholders.
-
Most activist investors simply will not be
fazed by amendments to advance notice bylaws that extend deadlines for
proxy contest proposals or establish higher informational requirements
for insurgents. The amendments, however, will probably be read
negatively by other shareholders as being too defensive and a sign of
weakness, not strength, on the part of the target company.
-
Other defensive bells and whistles are most
often even more incidental and ineffective. They, too, are likely to
create an impression of vulnerability on the part of the target company
and could hinder efforts to convince other investors to take the
company’s side in a forthcoming proxy contest.
More fundamentally, looking to structural defenses for protection mistakes
the nature of the contest. Unlike a hostile bid where poison pills are
useful, and perhaps necessary, to uncover higher value in the target
company, an activist campaign is not about seizing control of a company
for less than a market clearing price. Rather, an activist campaign is
about ideas—strategies for creating additional values. The true battle is
about whose view of the company is more likely to produce better
shareholder returns—management’s or the activist investor’s. The winner of
the contest will be the side which at the end of the day captures the
adherence of a majority of the shares. Defenses which ignore this reality
are at best a distraction and at worst a negative factor in the war of
competing strategies for bettering the company’s performance.
MYTH NUMBER NINE:
The best defense against an activist investor is running an
aggressive, negative campaign that highlights the past failures of the
activist investor and/or its proposed candidates for director.
The prevailing wisdom is that dealing with an activist investor is like
running a political campaign. And like political campaigns, proxy contests
have a long history of demonstrating the value of negative campaigning. As
a result, the best defense should rely first and foremost on attacking the
bona fides and credentials of the activist investor and its candidates for
the board.
REALITY:
While proxy contests traditionally have featured negative campaigning over
assertion of positive programs and strategies, the tradition is simply
outmoded. There may be a place for negative messaging, but it should not
be the starting place. The key to any successful political campaign is
understanding what messages – positive or negative – will resonate most
with the particular audiences you need to influence to win. The bulk of
the shareholders of an underperforming target company will be
sophisticated institutional investors, receptive to a credible change
message that improves the prospects for value creation.
Accordingly, the most effective campaign strategy to ward off the threat
of a proxy contest, and to win the proxy contest if it cannot be warded
off, is presenting institutional investors a more compelling and
substantive narrative than the activist. Since the activist’s chief weapon
is its proposed changes in company strategy or operations, a target
company needs to fight this fire with fire of its own. Its overarching
goal must be a more credible, company-developed strategy and/or better
operating policies. Unlike modern political contests in the US where
substance is far too often eclipsed by superficial arguments and sound
bites, the institutional investor community, on the whole, will be focused
on substance, and so must the company.
MYTH NUMBER TEN:
If a company has better ideas than the activist, it will win the
battle.
Substance is what counts, not presentation frills. Accordingly, the key is
getting the company’s proposal in front of institutional shareholders.
REALITY:
Substance is the key, but only if it is communicated effectively and
persuasively to shareholders and, importantly, all of the target’s other
stakeholders. Communication of the company’s ideas is at least as
important as the ideas themselves, and many would argue more important.
Facing a challenge by an activist investor, a company should not hesitate
to pull out all of the communication stops in its campaign to regain the
trust and confidence of its investor base. This typically means a
well-crafted and fully-integrated communications program that recognizes
the need to reach all of the relevant decision makers for the company’s
investors (including both portfolio management and corporate governance
personnel at institutional investors and ISS and Glass Lewis) and takes
advantage of multiple communication channels to the extent feasible and
appropriate.
Also importantly, a target company needs to communicate effectively with
its other stakeholders: its employees, customers, suppliers, regulators,
and communities where the company has facilities, in the US and abroad. An
activist investor campaign, particularly one culminating in a proxy
contest, can be very destabilizing for every company constituency.
Focusing solely on the activist and other investors can be akin to winning
the battle but losing the war. If, as almost always, performance is the
name of the ultimate game, the target needs to muster the understanding
and active support of all of its other stakeholders, who, unlike
investors, are the ultimate drivers of performance.
The target’s communications arsenal should include not only SEC filings
and traditional investor “decks,” but also different (although carefully
coordinated) presentations to other key constituencies, in-person meetings
with senior managers and town hall meetings for larger employee groups,
telephonic and email outreach, the use of social media, and polling
techniques, and audience segmentation where targeted audiences are
particularly large or diverse.
Being a target of an activist investor requires a company to run the same
gauntlet as a hostile bid, particularly if the activist investor threatens
or launches a proxy contest. It is a crisis situation and requires a
crisis response team, including experienced legal counsel, investment
bankers, proxy solicitors, and communications specialists to assist
management in countering the activist. The challenge for management and
its crisis team, then, is to craft the most compelling substantive
rebuttal to the activist’s challenge and to communicate that rebuttal
effectively to all of the company’s constituencies.
About the Guest Blogger:
|
Charles Nathan, Partner & Senior Advisor, RLM Finsbury |
|
Chuck Nathan
advises global clients on M&A, financial transactions, governance, Board
issues and shareholder matters.
Prior to joining RLM Finsbury, Nathan
was partner at Latham & Watkins, where he represented companies and
financial advisors in many significant, high-profile mergers and
acquisitions.
Nathan has been named by the National
Association of Corporate Directors as one of the 100 most influential
corporate governance professionals for two consecutive years. He is the
renowned author of many articles on M&A and corporate governance topics,
is a frequent panelist at M&A and corporate governance seminars and
programs, teaches M&A at Yale Law School, and has chaired a number of bar
association committees. Nathan received his B.A. from The Johns Hopkins
University and his J.D. from Yale Law School, where he graduated summa cum
laude.
This post first appeared as the March
1, 2013 RLM Finsbury Commentaries on Corporate Governance Series client
memo. |
