This article is Moody's first published outline of its general approach to analysing shareholder activism, and our finding that its effects on the creditworthiness of Moody's-rated issuers is almost universally negative, even if only moderately.
As short-term shareholder activists have become more influential, we have observed numerous examples in concessions to activists that have eroded credit quality contributing to downgrades. A common theme in negative rating actions revolves around a company's adoption of a more aggressive financial policy, including increases in an issuer's dividend or share buyback program achieved through higher leverage.
There has been a small minority of situations where activism led to positive change over the long term (rarely are the changes positive in the short-term). Even in those situations, however, it was hard to predict the likely outcome of the activist's activities, in part because there was considerable execution risk in the activist's plan.
This special comment describes our views on the characteristics of the companies that activists typically target and the general response to activism by those companies. The appendix lists some prominent activist initiatives and their subsequent effects on Moody's ratings. The report outlines the way Moody's evaluates shareholder activism, on a caseby-case basis, and, where appropriate, how we communicate to the market the likely effect on the ratings if activist demands are met.
More rated issuers are in the sights of shareholder activists
Moody's has noted a higher incidence of rated issuers facing demands from short-term investors agitating for strategic or financial changes, alongside governance improvements. Such shareholder activism is becoming commonplace in Europe, as well as in the United States. We view this trend as important, because these investors are often successful in getting management to accept some of their proposed changes. Indeed, according to a Thompson Financial 2006 study, such investors achieved at least one of their stated goals in 45 percent of cases observed.
Unlike the corporate raiders of the 1980s, today's so-called shareholder activists do not generally seek to own the target firm, but rather push for changes the activists believe will boost the stock's value in the short-term. These shareholder activists stand apart from other long-term investors who call for improved governance practices in a number of ways. Short-term shareholder activists:
- Have a short-term investment horizon-typically 18-24 months-after which they divest their holdings (or a large portion of them)
- Use governance as a platform for agitating for strategic or financial changes
- Commonly use high-pressure tactics, such as media coverage and the threat of proxy fights. They are quite willing to place director representatives on the boards of the companies they target
Moody's believes these activists have become emboldened in recent years for a number of reasons, including:
- Structural: Regulatory changes in 2002, such as the Sarbanes-Oxley Act and revised stock exchange listing rules, have enhanced director accountability to shareholders, necessitated the appointment of more independent board members, and encouraged boards to act more independently of the CEO. Also, many larger-cap companies began eliminating certain takeover defenses such as poison pills and classified boards after a string of successful shareholder campaigns by institutional and individual investors. The reduction of takeover defenses makes the threat of a proxy fight more effective.
- Cyclical: Companies adopted more conservative fiscal policies following the stock market bubble in 2000 and the corporate scandals in 200102, such that today they have stronger balance sheets and higher cash positions. Such companies can be ripe targets for activist investors seeking to push management to return excess cash to shareholders.
- More impatient shareholders: After suffering through the technology bubble and governance-related problems, shareholders have much less patience with companies failing to exceed median performance levels. Shareholder activists have appeared in a wide range of sectors. Traditionally, they focused on small-to-mediumcap companies, but they have increasingly focused on large-cap companies in recent years. In assessing those companies that have faced such pressures in recent years, Moody's has noticed some common traits:
- Issuers with strong balance sheets, especially large cash balances or other assets that can be quickly monetized
- Management teams that appear entrenched or prone to complacency
- Relatively low leverage that allows for larger purchases of stock or increased dividends, sometimes through debt financing
- Issuers with multiple lines of business, especially if unrelated, which could be sold to "unlock" shareholder value
- Issuers with lower valuation multiples compared to peers
- Issuers in sectors that have light or no sector regulator (we have observed more activism aimed at corporate, non-financial issuers)
An activist's well-trodden path
Each activist investor has his own approach to selecting stocks and pushing for changes that release value. However, at its simplest, every shareholder activist follows a similar path:
- Build up an equity position. The activist first builds up a small equity position in the company. In most advanced countries, shareholders over a certain equity threshold-typically three or five percent-have to disclose their holdings.2 More often, though, activist shareholders build relatively small positions, typically below 2%. As such, outsiders may not know these investors' holdings until they announce their intentions voluntarily, through the media or in regulatory filings.
- Seek allies to bolster position. In building their equity stakes, such activists may seek other investors to support their agenda. Increasingly, we see activists reaching out to hedge funds rather than more traditional allies in the investment community.
- Promote change behind the scenes. Even the most confrontational activist investor may take the strategy of meeting confidentially with management to discuss his concerns and outline his demands. Usually the activist prefers to hold such meetings outside of the public spotlight.
- Take a public position. Where the private negotiations fail or where the activist wishes to use media pressure as a means to support his private discussions with management, the investor would likely make his intentions known, or, at a minimum,speculation would begin in the media as to those intentions. It is at this point (or later in public discussions) that the activist may propose the threat of a proxy contest.
- Either change occurs or a proxy fight begins. Often, the threat of a proxy fight either spurs change within the company, in which case the investor may back away from the threat of a proxy fight, or the contest process begins in earnest. Although often threatened, activists use proxy contests sparingly because they can be an expensive strategy to execute, and the results are hard to predict. More often, investors use the threat of the proxy fight, coupled with private and sometimes public pressure, to create a catalyst for change.
Of course, to the extent the activist has exhausted all avenues, and success is uncertain, the activist may divest his shares.
The activist's demands
The most common demands by short-term shareholders activists include:
- Strategic changes
- Acquisitions, asset sales, sale of the company.
- Share buybacks, increased dividends
- Cost reductions, implementation of operational changes
- Board representation, governance changes, or removal of the CEO
Clearly, these are potentially significant demands, and any one has the potential to change the company's credit profile over the short to medium term. Moreover, management can become distracted from running the business while dealing with such demands, which is also a negative, in our view. In our experience, the effect of activist agitation for strategic or financial change at rated issuers has typically produced negative rating pressure of varying degrees.
There has been a small number of situations where activism led to positive change, from a bondholders' perspective, over the long term (rarely are the changes positive in the short-term). Even in those situations, however, it was hard to predict the likely outcome of the activist's activities ahead of time, in part because there was considerable execution risk in the activist's plan.
However, we believe an activist's demands can be separated into two broad categories (see the appendix for some examples of activism at rated issuers):
- The break-up of the company or the sale of significant assets with the proceeds passing to shareholders, especially if it was a high cash-generating asset
- Significant increases in dividends or share purchase programs, especially if paid for with increased leverage or sharp reductions in maintenance capital expenditures
- A more aggressive growth strategy or more leveraged financial strategy, including leveraged buyout or going-private transactions
Credit neutral to long-term positive
- A more focused strategy, with a move away from expansion into non-core businesses-the manner in which any dispositions take place and the way in which the company uses the proceeds would be an important consideration in determining whether a more focused strategy is, in fact, a positive for bondholders
- Significant improvements to a company's governance practices, including new board members, more balanced executive compensation, more rigorous risk management, and greater attention to internal controls
- More disciplined decision-making, e.g. in capital allocation
We now set out how Moody's differentiates between these two categories and, for the potentially credit negative situations, how we define when subsequent changes could change the company's credit profile materially.
Communicating the effect on the rating
Moody's has found it difficult to predict the outcome of shareholder activism. There have been planned outcomes that would have been viewed as positive, based on prior facts, but, in practice, the execution of subsequent changes was so dismal that the effects were negative. In other cases, despite calling for significant changes, activists have gained a seat on the board and subsequently promoted actions that only change the company at the margin
Given that the potential for substantive change to an issuer's credit profile can be significant, Moody's believes that it is important to monitor these situations actively and communicate clearly to the market how the rating could move if management cedes too much to activist shareholders.When an issuer is faced with pressure from short-term shareholder activists, Moody's analytical team focuses on the following issues:
- Determine the activist's intent. Sometimes, activists make their intent known publicly, either through the media or in regulatory filings. If the intent is not immediately apparent, Moody's evaluates the activist's past demands at other companies to gain some insight into his likely intent.
- Evaluate the activist's success at other companies. Moody's has been building up case histories of shareholder activism to distinguish those activists that have been successful in stimulating significant strategic or financial changes at targeted companies.
- Engage the issuer. With some understanding of the activist's agenda, Moody's engages the issuer's existing management team to discuss their response to the activist initiatives and review likely future scenarios.
- Communicate to the market. Moody's does not expect to change ratings ahead of management's response, but, where possible, we will outline our view on the activist's demands and the potential effect on the rating if management meets the demands. In some situations, we may change the company's outlook, particularly when we feel the company's public comments suggest a material negative outcome is becoming more likely. In doing so, we evaluate relevant covenants and cross-guarantees to determine what effect, if any, these would have on the effect of meeting the activist's demands.
In those situations in which the only apparent change is the election to the board of a shareholder activist or the representative(s) of activists, Moody's continues to monitor the situation. An activist gains a seat either by waging a successful proxy fight or, more often, because the board agrees to appoint the activist director to avoid a proxy fight. In either case, Moody's believes this can be disruptive to the board and management team dynamics, and brings some level of additional event risk to the credit.