Shareholder Activism

Strategies for profit

Randall Dillard, Ben Funk and Tom Hardy, Liongate Capital Management

Shareholder activists purchase under-valued shares with the intention of making the price jump higher. Acting as self-interested shareholders, they make proposals to other shareholders, management, and interested market participants that are calculated to unlock the value gap they have identified. Activism can vary in style, and, depending on its focus, will appeal to different investors and corporate management, ranging from providing low-key guidance to brutal challenges for shareholder control. Common ground is found when interested participants decide they can make money with the activist, and agree to support the implementation of their proposals to maximise the total value of a company.

The fundamental premise is that activists have a greater profit incentive to acquire superior information and develop original insight about a company, compared to passive shareholders. Activists contend that passive shareholders construct more diversified portfolios to lower their capital risk, and lack the same incentives to invest resources into similar value creation. Because activism is so labour intensive and requires such skill to execute consistently, activist’s portfolios tend to be more concentrated, with a greater focus on their best ideas.

Investor signalling

As compensation for providing third party investors with useful information regarding a company’s value gap, activists benefit from other investors buying into the idea, and perhaps the company, thereby increasing the value of the activist’s initial stake. The market will react to the announcement of an activist target for a variety of reasons: activists signal a value gap in share price to other investment professionals, they pressure management to be more mindful of shareholders, and they offer the potential of value-increasing changes in the target company. The magnitude and the persuasiveness of the market ‘noise’ made by activists will influence the likelihood that a broader group of investors will purchase shares at higher prices. The most successful activists are therefore the ones having the highest credibility in this investor pricing game.

Sometimes the declaration of an activist’s interest alone will be sufficient to increase share value, especially when the activist enjoys a history of success in realising value gains. Simply signalling to other investors that there is a value gap between the current share price and fair market value is a very cost efficient method to increase the value of an activist’s stake. Disseminating market information is generally faster and cheaper than engaging management in a prolonged and costly dialogue to increase share value.

Shareholder discipline

When corporate managers exercise agency authority over shareholders’ wealth, interests can diverge. The resulting pockets of inefficiency can lead to pricing anomalies. These are the inflection points that activists seek to target. The reality of corporate life is that managers take the majority of a company’s important business decisions. The shareholder base is often too scattered to monitor even the most important manager decisions in a cost effective manner. But whilst shareholders are the last claimants on a company’s assets and feed on the bottom rung of the capital food chain, they nevertheless have the important right to vote on many extraordinary company decisions. The pervasive threat to corporate management is that activists may influence other shareholders to vote and change management. This is the powerful stick available to force deleterious management to implement activists’ value-increasing propositions.

Persuading and then monitoring managers to implement value-increasing proposals is certainly more costly than investor signalling. Yet it is often a necessary process in order to increase the share price, as well as to maintain street credibility with participants in future transactions.

Activist styles

The style of activist managers varies across market capitalisations, favoured sectors, the complexity of a solution to raise share value and, most noticeably, in the friendliness or outright hostility of their approach. Yet the importance of tailoring an approach to the character of a target company or region can not be overstated. Whilst ‘poison pen’ activists in the United States have often enjoyed success, activists in Japan have usually preferred a more cooperative approach. Most activists in Japan, and increasingly in the United States, now highlight the importance of taking a kinder, friendlier approach, rarely criticising managers publicly and presenting themselves as more akin to consultancy firms.

Sometimes managers may tactically agree with the activist publicly, whatever their own business views, hoping that the activist will reap enough profit quickly from the ensuing share price pick-up by selling their shares and exiting. Share buybacks and dividend increases are ‘quick fixes’ and popular tactics compared to the pain of major corporate restructuring. Spin-offs and hard asset sales are usually easier to achieve than proposed cost reduction strategies. This is the spot where many managers like to dig in their heels. Of course, if management subsequently fails to move the share price closer to true value, the activist can return. In the long run, an underperforming management will show its true colours.

Company targets

Shareholder activists look for a variety of qualities in their targets. Activists in particular target inefficient companies with significant hard assets, plenty of cash, minimal debt, and disparate business components. The profiles of these companies make them a more likely target for value increasing transactions. Activists must pay particular attention to the ownership structure and the dispersion of shareholders, as well as to the strength of management. All of these factors will affect the activist’s negotiating position with interested participants.

The activist often looks for thesame catalysts as a value investor, but in addition wants to expedite events. Standard tactics include improving corporate governance, cost cutting, refinancing debt, changing management, returning cash to shareholders, and selling non-core assets. Expanding on the techniques of merger arbitrage provides another opportunity set. Activists cajole one other, as well as passive shareholders, to vote alongside them either for or against the adoption of a merger or a major restructuring.

Proposed corporate restructurings occasionally thrust activists into the public consciousness when management resists their proposals. If management resists, the consequences could be a public proxy fight or an acrimonious struggle between shareholders for control, as they become divided over their self-interest. Limited proxy fights to gain management influence are more frequent battlegrounds for activists than outright moves for gaining corporate control.

Capital scale, whilst useful, is not essential for success. Even the smallest of activists can make a difference with good ideas, as exemplified by the activist with less than one tenth of one percent ownership of Shell, who gained enough support from other shareholders to compel the company to reform its dual board structure. It is certainly more difficult for an activist to force change with a smaller stake in a company, yet there are also significant benefits to the way in which activists can operate. Most notably, activists do not have to pay the control premium that private equity does in order to persuade management to change a company. There is also the significant benefit of share liquidity, offering activists a ready exit when desired.

Regulatory limitations

Legal and regulatory rules such as disclosure, shareholder treatment, insider trading, and market manipulation frame the activities of the activist seeking greater pricing efficiency. Activism also has its own legal and regulatory challenges when attempting to influence managers through voting. For example, regulators are paying increasing attention to the practice of empty voting. Activists are able to borrow a stock immediately before a key vote, significantly increasing their voting presence and decoupling the alignment of voting and economic ownership. Activists can also sometimes build up significant voting positions whilst maintaining a negative delta exposure, giving them an incentive to vote in ways that would hurt the company. As a result, stock borrowing is becoming harder to source for short positions, as large institutions prohibit stock lending of their block equity positions. Further regulation of vote gathering is tempered only by the general concern that the limitations might go too far and be worse than the cure.

Results

Ultimately, as with any hedge fund strategy, results talk loudest. Studies on the efficacy of activism show a range of alpha generation compared to the broader market. Reports vary based on their sample set and their time horizon. A Citigroup report on activism (Figure 1) shows the hike in the target’s share price in the days surrounding the announcement of a position. Here the signalling effect is clear, as most market participants will, in such a short time period, not have been able to do the depth of research necessary to see the full value of a company. This chart also reveals the effect of information being leaked to the market and rumours circulating, as a significant move comes in the days prior to the announcement. Meanwhile, Morgan Joseph’s report on activism shows significant alpha generation over a one year time horizon (Figure 2), with activists more often than not successful in achieving a range of requests (Figure 3); considered together, these findings would suggest activists are successful in identifying ripe targets as well as in implementing the strategies that help these targets fulfil their potential.

Activist managers will not be for everyone: concentrated long positions within portfolios can be volatile and can create inconsistent returns. Activist skills, however, cannot be easily arbitraged out from the increasing efficiency of markets and, executed correctly, can provide a unique source of alpha, with less correlated returns.