Hedge Funds  |  Deal Professor

As Activist Shareholders Gain Strength, Boards Surrender to Demands

By Steven Davidoff Solomon   October 14, 2014 4:30 pm

Updated, 6:43 p.m. |
Corporate America may try to hide from its shareholders, but two recent shake-ups — involving the tech giant Hewlett-Packard and Darden Restaurants, the owner of Olive Garden and other chains — show that escape is no longer possible. Shareholder activism has rapidly changed how corporate America thinks.

Hewlett-Packard, which is in Year 3 of a five-year turnaround plan, finally did what some shareholders had been demanding for years. The company said last week that it would split in two: One company will be a printer and personal computer manufacturer named HP Inc. and the other will be an enterprise software company called Hewlett-Packard Enterprise. The Wall Street response was to send the company’s stock up as much as 6.6 percent on the day this was announced. Yet the New York Times business columnist James B. Stewart suggested it might be a desperate maneuver that catered to shareholder whims and the spinoff stampede rather than a well-reasoned strategic plan.

In the case of Darden, the activist investor Starboard Value, after months of pressing for changes, succeeded in unseating all of the company’s directors. Throwing out every single company director is a rare and drastic event, one I called an epic failure. This happened after the Darden board, in a fit of chutzpah, decided to spin off its Red Lobster business just before a shareholder vote on the issue, one that appeared to be heading toward a rejection of such a sale. The Darden board thus sealed its own fate by blatantly ignoring shareholder will.

So what do these two events — one where a company appears to be catering to its shareholders and another where it had been rejecting them — have to do with each other?

Looked at together, the events show that the activist shareholders have triumphed. The two cases symbolize an end to the war of aggression between corporate America and shareholders, with a surrender driven by crusty breadsticks and a huge decline in PC sales. Corporate America, previously ruled by chief executives and boards, is racing to do shareholders’ bidding.

The Darden case in particular highlights the seismic shift that can happen if a corporation ignores shareholder demands. Indeed, Darden’s board members voted to sell Red Lobster at a time when the activists were organizing to oppose this move in part because they thought the seafood chain would be too small to survive on its own.

That Darden’s old board would go against the wishes of shareholders so stridently was puzzling. This was particularly true in light of the fact that a similarly hostile battle at the auction house Sotheby’s had also ended in a loss for the company after the hedge fund manager Daniel S. Loeb gained the three board seats he sought.

Wall Street chatter has attributed Darden’s obstreperousness to its advisers (the chatter, of course, is mostly coming from competitors). At both Sotheby’s and Darden, the advisers were Goldman Sachs on the financial side, Wachtell Lipton for legal issues and the firm Joele Frank for public relations advice. These firms are the trinity of anti-activism, the experts that companies hire when they want to oppose the activists. It is hard to blame the advisers for things going against the Sotheby’s and Darden boards because those are the firms to hire in a shareholder fight.

Goldman Sachs, Wachtell Lipton and Joele Frank all declined to comment for this article.

In the wake of Darden’s upheaval, strident opposition by boards is likely to disappear. It simply doesn’t pay. Even the most ardent anti-activist firms know it.

This trend is already taking hold. So far this year, activists had a success rate of 72 percent in proxy fights, up from 60 percent in 2013, according to FactSet SharkRepellent, a research firm.

Activists are gaining ground because institutional investors are increasingly willing to side with them, and even joining the fight (or ganging up, as some companies might say). These shareholder forces are often given an assist by two prominent shareholder proxy firms, Institutional Shareholder Services and Glass Lewis. But this is not a surprise as activists tend to focus on struggling companies in need of change.

It all adds up to pressure-cooking corporate boards. And as hedge funds have proved to be successful in their activism, earning extraordinary returns as a result, billions more in money is following. It is a virtuous circle, or a vicious one, depending on your perspective. At least until the returns go away.

That is why the loss at Darden, coming after Sotheby’s capitulation, is such a milestone. After the Darden fight, companies are not going to want to go the distance. It is too much misspent money on advisers in a fight that results in a loss of face.

If you needed more proof, you need only see what happened at Hertz. Carl C. Icahn popped up with an 8.5 percent stake in Hertz, and within a week, Mr. Icahn was able to appoint three directors, two of whom are sitting on the new chief executive search committee. Hertz quickly realized that the easiest thing to do was give in.

This is where the Hewlett-Packard spinoff comes in. As shareholder activists, backed by institutional shareholders, grow stronger, no company is safe. Apple and Microsoft have already been targets. It was only a matter of time until HP would have again been the target of an activist.

In this respect, what happened at Darden led to what happened at HP. HP’s spinoff can be seen as a precautionary step to keep the shareholder activists happy.

From the perspective of activists, every business that is even the slightest bit different from a company’s core must be broken off. In Darden’s case, the activists argued for a spinoff of Red Lobster and Olive Garden together.

A spinoff can be beneficial, as it allows management to focus better on each separate business. But in other cases, it pushes management to dump its worst-performing assets into the newly formed company. The result though is that corporate America is slowly being broken up, only to rebuild as these smaller companies again get acquired or acquire others.

At HP, it is uncertain whether a spinoff makes sense, but shareholders wanted it. And so the move by its chief executive, Meg Whitman, can be seen as responding to the market trend and the fact that activist shareholders must be obeyed.

This is the way it goes these days in corporate America. Corporations are running to reorganize and trying to prevent the activists from coming. But the activists are on the prowl, and there is nowhere to hide.

This is true even beyond activism and in takeovers themselves. The Botox maker Allergan (represented by the trinity of Goldman, Wachtell Lipton and Joele Frank) is trying to fight off Valeant Pharmaceuticals and the activist hedge fund Pershing Square Capital Management. But barring a court ordering otherwise, shareholders will soon get to vote on whether to unseat Allergan’s directors. Can you guess where the trend is going?

The real winners here are the advisers, who have seemed to figure out which way the wind is blowing. Guess who advised Hertz on its quick deal with Mr. Icahn? The holy trinity of Goldman, Wachtell and Joele Frank. For HP’s spinoff, it was Goldman and Wachtell. No matter how contentious things get, the current shareholder atmosphere is driving companies to break up and seek acquisitions. Wall Street will continue to profit from both those trends.

Yet one has to wonder about the corporations themselves. Shareholder activism can be a positive force and certainly companies should listen to shareholders as in the Darden case. But as companies run in fear to reorganize themselves, one has to wonder if fear alone is a good way to run corporate America.