The recent Governance Watch webcast, Shareholder Activism in Uncertain Times, raised important questions for both management and boards to consider in the midst of an economic climate that is making many companies particularly attractive to activist shareholders, and potentially vulnerable to aggressive moves that could force a board to take actions that may not be in the best long-term interest of the company or the majority of its investors.
The roundtable discussion was moderated by Ethan Klingsberg, a partner at Cleary Gottlieb Steen & Hamilton LLP, and featured three guests:
- Kathy Bostjancic, director for Macroeconomic Analysis at The Conference Board;
- Timothy Ingrassia, co-chairman of Global Mergers & Acquisitions at Goldman Sachs; and
- Glenn Eisenberg, CFO at Timken Co. and a director at both Alpha Natural Resources and Family Dollar Stores.
Bostjancic started the discussion by summarizing the current economic situation and outlook, noting that although the U.S. economy may avoid falling into another official recession, growth is likely to remain very slow through early 2012.
Looking at the third-quarter results, Bostjancic said one surprise was that business investment was up more than 16 percent in real terms for the quarter. That contrasts sharply with the results of a recent CEO confidence survey conducted by The Conference Board, which show CEO confidence plummeting during the last quarter. Bostjancic said it is too early to tell which of these factors is the outlier—whether CEO confidence will improve or business investment will slow—but meanwhile the latest profit numbers look good. As a result, cash is accumulating on many corporate balance sheets.
According to Bostjancic, liquid cash now accounts for 7.1 percent of corporate assets, the highest percentage in nearly half a century, since the fourth quarter of 1963. Prior to the recession, liquid cash was 5.3 percent of corporate assets. From 1980 through 2007, the average was 4.5 percent.
In addition, that 16-percent uptick in business investment last quarter is somewhat deceptive. Typically, when profits rise, investment in equipment and software keep pace almost dollar for dollar, but those investments are currently far below what one would expect given the size of corporate profits. The current gap between profits and spending on equipment and software is $431 billion, the largest in post-war history. That 16-percent increase may be a positive sign, and a small move toward closing the gap, but we still have a long way to go.
New Opportunities for Activist Shareholders
With Bostjancic’s economic rundown as context, Klingsberg, Ingrassia and Eisenberg began a wide-ranging discussion of how economic uncertainty, and the way many corporations are responding to those conditions, is motivating activist shareholders.
With companies sitting on record cash balances, and investing at a record low rate relative to profits, activist shareholders are seeing new opportunities. Activists who want to join a company’s board, and either force a leveraged buyout (LBO) or return money to shareholders, are attracted to companies that have a lot of cash and are clearly doing well. Increasingly, activist investors are asking tough questions about why companies are stockpiling cash instead of rewarding shareholders.
Ingrassia gave the example of a company that is holding $100 million in cash and earning 1 percent on that money. If the company is valued on a PE-multiple basis, and the current PE multiple is 14, then that $100 million in cash is valued at only $14 million in the stock price. Some would see that $86 million gap as an opportunity to challenge the board and the management team to explain why they are holding so much cash, how they intend to use it, and how much cash is enough.
“Companies should be able to answer those questions, “ Ingrassia said.
Indeed, they should. There may be a good reason for a company to have a lot of cash on its balance sheet—but the answers to those questions will be different for every company. For example, for some companies, acquisitions are a big part of their business strategy and the company may need cash to make those investments. —The panel believes the likelihood that every company has good answers to those questions and has effectively communicated its strategy to shareholders is very low. In response to the current economic uncertainty, many companies have taken a defensive posture, assuming that prudence and retention of cash is the best course. Activist shareholders are challenging those assumptions.
The Good and Bad of Shareholder Activism
Companies often view activist shareholders in negative terms, but they often do get results. During the webcast, Klingsberg cites a study conducted by the Stern School of Business at New York University, which shows what happened before the recession at more than 100 companies where activists filed a 13D and called for major changes.
At every company studied, activists succeeded in inducing some kind of share buyback, cash on hand almost always dropped within a year of the 13D filing, dividends almost doubled in size, and debt-to-assets ratios always increased. None of those things would have happened except for activists. Whether those changes were always in the long-term interest of the company is another question.
But shareholder activism can also be disastrous. Writing in the April 2011 issue of the Harvard Business Review (subscription required), former Blockbuster CEO John Antioco recounts what happened when activist investor Carl Icahn launched a proxy fight at the company. In Antioco’s view, Icahn forced changes that prevented Blockbuster from competing effectively with Netflix in the DVD-rental market and undermined the company’s long-term business strategy. Eventually, Icahn persuaded the board to challenge Antioco’s compensation package, replace him as CEO, and scale back the company’s business goals.
Things didn’t work out so well for Icahn, either. In a sidebar to Antioco’s article, Icahn gives a different view of what happened during and after the proxy fight, but he admits that, “Blockbuster turned out to be the worst investment I ever made.”
Nevertheless, Icahn’s perspective on shareholder activism is instructive: “The fact that I can make so much money as an activist investor [Forbes estimates Icahn’s net worth at $11 billion] shows that something’s wrong with governance in most of corporate America. There’s no accountability for CEOs. There are good CEOs and good boards, but too many directors don’t care. Activist investors provide some accountability and can be important catalysts for change.”
The Rise of Operational Activism
Operational activism is another type of shareholder activism, one in which activist investors try to improve a company’s performance by changing the way it operates.
During the webcast, Eisenberg says that companies with strong track records should always welcome ideas from others because it may help them improve, but he points out that operational activists and company boards often have different goals. While activists tend to want short-term improvements that will lead to a better short-term return on their investment, boards and management teams are more often interested in building long-term value for the company and may be willing to sacrifice near-term gains to achieve it.
Citing the same Stern School study as before, Klingsberg notes that most companies saw a quick increase in their stock price after the 13D filing, but most of that gain disappeared within a year unless the company was sold. If the company wasn’t sold, profitability rarely increased and many companies saw a decrease, while capital expenditures and R&D spending showed little or no change relative to what the activists did.
Klingsberg’s point seems to be that operational activists don’t seem to be very good at coming up with ideas to improve company performance and, in many cases, the changes they demand may actually undermine performance long-term.
How Can Companies Defend Against Shareholder Activists
The speakers on the webcast had a few key suggestions for companies that want to avoid the distraction, and possible disruption, of a proxy fight with activist shareholders:
1) Board Composition – Having a diverse board of independent directors who are highly qualified, with the requisite skills and experience to challenge management on business strategy, capital spending and other priorities is a strong argument against sweeping changes that might be suggested by an activist shareholder.
2) Shareholder Rights Plan – A shareholder rights plan can serve as a “poison pill” to give a board greater influence over bids for the company. The board should understand how the plan works, why it works, and the implications of adopting it. It is not necessary to adopt the plan in advance, or to have it in place ahead of time—in fact, a significant majority of larger companies no longer have “standing” poison pills. Such plans are most effective after someone has made an offer for the company, but those situations can sometimes develop very quickly. Ingrassia says Goldman Sachs has seen a lot of cases in which activist shareholders have used stealth, speed or derivatives to take a very large stake in a company, and the first notice the company receives is when they own 20 percent rather than the 5 percent disclosure threshold one would think the 13D would require.
3) Clear Compensation Plan – The annual Say on Pay vote is also creating an opening for activists. If a company loses the Say on Pay vote, it may end up in court being sued over its compensation practices. Companies should make sure the proxy statement clearly spells out its compensation practices.
4) Good Communication – Companies that have a solid business strategy and communicate their plans effectively and consistently to shareholders are less likely to lose support to an activist shareholder during a proxy battle.
Consistent, proactive communication long before an activist challenge occurs is really the key for corporate boards and management. Proxy services may tend to follow the lead of an activist shareholder, so the board has to make its case to shareholders. If it’s the first time the board is communicating with them, it will be hard to win their support.
The company should be prepared to engage directly with the portfolio manager of its shareholders to avoid letting the vote play out along a default path. The company may need to ask portfolio managers to influence decisions made by others in their organization on a proxy vote for the long-term health of the company and their investments. Most portfolio managers have that authority and know how to use it, but they are not likely to take that action unless someone high up in the company asks.
Ultimately, it may be necessary for a company to accommodate at least some of an activist’s demands. They are, after all, shareholders, and boards must decide what is in the best interest of all shareholders, including the activists. The goal is to have a constructive dialogue between the activist shareholder and the board that strengthens the company and improves performance rather than a battle that may undermine long-term business goals or put the company at risk.
For more information about shareholder activism in uncertain times, view the complete webcast.