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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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:
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.