Shareholder activism is good
August 2015 | SPOTLIGHT | BOARDROOM INTELLIGENCE
Financier Worldwide Magazine
Gordon Gekko was right. Arguably the most enduring businessman-villain in film history, the character created by Oliver Stone and played by Michael Douglas in the movie Wall Street served as a parable of the quick-buck excesses and moral ambiguities rampant in the financial industry during the 1980s. He wasn’t right to engage in illegal conduct, of course, such as the market manipulation activities that ultimately landed him in prison. But the point made by Gekko in his most memorable scene, during which he justified his plan to takeover and eliminate bureaucratic waste at fictional Teldar Paper by noting that “greed... is good, greed is right, greed works, greed clarifies, cuts through, and captures the essence of the evolutionary spirit” – was spot on then, and has proven true in the nearly three decades since.
What Gekko was talking about in that famous speech was what we refer to today as shareholder activism, a phrase that applies to a wide range of activities conducted by certain shareholders to promote change and unlock shareholder value in public companies. At the beginning of his speech to Teldar shareholders, Gekko noted that the company had “33 different vice presidents, each earning over 200 thousand dollars a year”, doing jobs that Gekko couldn’t identify, and serving as an anchor to potential profits. Gekko proposed to take over the company, and eliminate the waste. He noted that in his prior seven corporate takeovers, his strategy had made a pre-tax profit of $12bn for 2.5 million individual shareholders. What Gekko was right about is that shareholder activism works; both in the movies, and in the real world where activism has benefitted millions of smaller shareholders who alone could not feasibly challenge the status quo of corporate management.
Shareholder activism is surging
Activist investors have long since outgrown the negative caricatures created by the entertainment industry, as the strategy of activist investing has grown dramatically and become widely accepted as a welcome means of creating shareholder value. Assets under activist management have grown exponentially in recent years, from $93bn in 2013 to roughly $220bn today. Once stigmatised as peripheral ventures pursued only by ‘corporate raiders’ who sought to strip companies of their assets, activism is now seen as a legitimate tool to force improvements in corporate governance. Institutional investors and proxy advisory firms regularly support activist campaigns, which often lead to increases in profits, capital investments, and research and development in the target companies.
In 2014, activist investors publicly targeted nearly 350 companies, though that figure is likely just a third of all activists’ campaigns, most of which never become known to the public. Of the public campaigns that reached the point of a proxy fight, over two-thirds resulted in settlements or successful director elections. Some notable results in the onslaught of 2014 activist campaigns include the replacement of Darden Restaurant’s entire board of directors, Allergan’s sale to Actavis and eBay’s decision to spin off Paypal.
Shareholder activism increases corporate efficiency
Companies ripe for activist campaigns are typically profitable but undervalued, or have excess cash reserves. These targets are mostly owned by institutional investors and have boards that have grown stagnant. Even well-performing, large-cap firms are targets for activists with plans to increase shareholder value.
The varied goals of activist campaigns fall into three categories, though each focuses on increasing corporate efficiency and maximising shareholder wealth. The first category consists of those activists whose strategy is to change leadership and corporate governance. In companies that lack creative energy, activists might propose changes in board membership and management, while simultaneously re-evaluating the proper compensation packages for new and incumbent members alike.
Some activists in this category also propose removal of takeover defences, such as classified boards or poison pills, which are unpopular with shareholders and proxy advisory firms. Under a classified or staggered board, directors serve for different term lengths and, therefore, only a portion of the board can be replaced in any given election. Poison pills also discourage hostile takeovers by installing a system in which, if acquired, existing shareholders may buy more shares at a discount rate and thereby dilute the shares purchased by a hostile acquirer. These defences entrench boards that may have lost sight of shareholders’ interests.
The second category for increasing shareholder wealth involves activist investors looking to make strategic changes in the target corporation. This may include proposals to sell certain assets of the company or perhaps the entire company itself. It can also include plans for restructuring the business or implementing simple cost-cutting measures. The third category involves improvements to the capital efficiency of the target through means such as capital returns to shareholders or increased leverage.
Usually, when an activist recognises and targets an underperforming company, the activist will discretely acquire shares to approach a 5 percent stake, beyond which the activist would have to make a public 13D filing with the SEC. Some activists bolster their positions by using derivatives and partnering with other activists. Before going public with their goals, activists will often approach a target’s board privately to discuss various proposals for change. This signals to the board that they must address shareholders’ interests or risk a public proxy fight. At the discussion stage, many boards make the decision to listen to the activist’s recommendations and implement various suggested changes. If refused, however, the activist will begin a public campaign to gather shareholder support for those suggested changes. This can take the form of shareholder proposals, public letters, social media, litigation, and, of course, proxy fights.
Shareholder activism provides long term results
Critics often claim that activists are only after short-term personal gain by creating momentary increases in share prices. While short-term gains resulting from activist campaigns are well documented, it also has been shown that activist campaigns result in substantial long-term gains in overall shareholder value.
Studies show that abnormally high returns continue over the second and third year following a campaign. Measurements of operational performance, such as sales growth, return on assets, return on equity, cash flow, earnings, and productivity, also improve during the second and third years. Finally, the impact on capital structure tends to continue as targeted companies increase their leverage and reduce their cash reserves through payouts to shareholders.
Perhaps even more important than the noted benefits that come with launched activist campaigns is the overall benefit that the mere presence of activists brings to the overall market. Because of the massive increases in activist investing over the years, corporate boards have begun to proactively implement policies to stave off potential proxy fights. This means that even the boards of non-target companies have become more self-reflective in the way that they manage their business affairs and respond to their shareholders. This forces boards of directors across markets to become more efficient and to ensure that they are actively taking the steps necessary to produce results for their shareholders.
For those companies that are not proactively taking such steps, activist investors – predominantly activist hedge funds – are available to force positive change. The dominance of hedge funds in this arena is largely due to their unique structure. Hedge funds face relatively few regulatory restrictions, such as rigorous asset-diversification requirements or single-investor limits, which apply to other investment vehicles. Unlike most mutual and pension funds, which measure performance against benchmarks and charge flat percentage fees, hedge funds seek absolute returns. Hedge fund managers receive performance-based fees and are not typically affiliated with other financial institutions.
Activism earns market-leading returns for shareholders
Activist hedge funds are highly incentivised to pursue outsized gains by mounting difficult campaigns to influence changes at target companies. And they have been successful. In the period from 2004 to 2014, including the financial crisis, the gross returns of activist funds were more than double that of the S&P 500. Since 2009, activist funds have been on the rise again in an environment where shareholders want companies to either return capital or take on more risk: many corporations have low leverage and hold large cash reserves, interest rates are low, and the M&A market is picking up. These funds approach activism differently. Some focus exclusively on activism, others use it as one tool among many, and still others only occasionally pursue activist opportunities.
The best activists use a best-in-class legal team
Of course, an activist campaign will only provide the many benefits identified above if it works. And to do that, an activist needs to perform good analysis, due diligence, develop an effective strategy and execute that strategy with precision. No matter where a hedge fund sits on the activist spectrum, its manager must navigate a number of legal issues. For instance, activist shareholders must understand the target’s often complex charter or bylaws, particularly the provisions that govern shareholder voting and board membership. It is crucial that an activist understand how the organic documents’ terms will interplay with the ever evolving corporate laws of the target’s state of incorporation.
Because Delaware is the primary hub for the incorporation of US companies, it is important that activist investors work with counsel that has expertise in Delaware corporate law. Under Delaware law, for example, shareholders can vote by written consent, without waiting for a shareholder meeting, unless it is forbidden by the target’s charter. Depending on the makeup of the target’s shareholders, the option to vote by written consent may facilitate an activist’s rapid removal of directors.
Another early concern for activists is fulfilling disclosure requirements. Within 10 days of acquiring over 5 percent of a target’s shares, an activist must make a 13D filing with the SEC. The 13D filing not only can alert the target to an activist fund’s plans, but it can also put limitations on the campaign. For example, disclaiming item 4 on schedule 13D waives the ability to solicit up to 10 other shareholders privately, which can be crucial if there is a high concentration of institutional investment in the target.
Oftentimes, a campaign will go public in a proxy fight to enlist shareholder support. To do so, an activist will send ‘fight letters’ to shareholders, but it must first obtain the shareholder list from the target. Under Rule 14a-7, the target must either provide the list or mail the solicitation materials for the activist. The latter option gives the target more control over timing and does not grant the activist information about the number of shares each stockholder owns. To avoid that disadvantage, an activist could request a shareholder list under state law. Most states require a ‘proper purpose’ to inspect a shareholder list. To resist the demand, the target often will attempt a number of defences, such as attacks on the activist’s standing to request the list or the necessity of the list for the activist’s goals.
Once the activist has obtained the list, it cannot immediately send its proxy materials to shareholders. Proxy statements must receive SEC review before they can be sent to shareholders. This is true for the target’s proxy materials if the activist has communicated a sufficient threat. SEC clearance takes around two weeks, but approval can be quicker if the materials are well prepared. Unlike proxy statements, fight letters do not need to be reviewed by the SEC before being sent to shareholders, though the SEC still comments on them after they are sent. An attorney can help prepare proxy statements and fight letters that meet favourable SEC review and are effective in winning over shareholders.
Most of the time, these activist campaigns do not make it to the point where the campaign goes public, they instead end in settlement. The target will agree to a number changes to avoid the risk of a more dramatic result but will only do so in exchange for its own demands. It is important to compare the target’s terms with customary demands in other settlements and negotiate for a favourable resolution.
Perrie M. Weiner and Robert D. Weber are partners at DLA Piper. Mr Weiner can be contacted on +1 (310) 595 3024 or by email: firstname.lastname@example.org. Mr Weber can be contacted on +1 (310) 595 3009 or by email: email@example.com. The authors would like to thank summer associates Kirby Hsu and Lexi Peacock for their assistance with this article.
© Financier Worldwide
Perrie M. Weiner and Robert D. Weber