randy lampert and andrew shiftan
Despite media coverage o the contrary, activism is not necessarily drawn out adversarial process. The activist fund, like all investors, is interested in seeing its holding appreciate and believes that it has a plan that (in the portfolio manager's mind) is superior to management's for achieving that goal. Clearly, as an outside shareholder, the fund may not be privy to the realities that motivate management's decisions and, as a result, the whole situation may deteriorate rapidly. When this occurs, it is not uncommon to see the activist fund put forward a proposal to the target's shareholders demanding a vote on a specific action or on granting board seats to its nominees. On the whole, activist funds have had surprising success with their proposals-more than 35 percent of the campaigns we analyzed resulted in an activist winning board representation.
At its core, shareholder activism is a communications battle to win the support of the shareholder base to back a particular direction for a company. As activism has become an increasingly recognized investment strategy, other investors have begun to follow activist funds into particular situations, thereby increasing the likelihood that the fund will succeed. Accordingly, traditional takeover defenses are becoming less and less effective and are actually a boon to the activist's argument that management is entrenched and is not sufficiently focused on providing shareholders with an increasing stock price.
On average, the activist hedge funds we tracked have $1.9 billion in equity capital under management and range in size from less than $100 million to nearly $10 billion in assets under management. Most are based in the
The Rise of Activism
Two factors have driven shareholder activism as a discrete investment strategy: an abundance of capital and the heightened scrutiny of corporate leaders and their boards of directors in the wake of recent corporate scandals. The historically impressive returns of hedge funds make them an ideal place for cash-rich institutions, like pension funds, endowments and wealthy individuals, to invest. This demand has encouraged new entrants to join the hedge fund industry from other money management operations. As a result, the number of hedge funds and the amount of capital they manage has grown tremendously since 1990. It is estimated that there are currently 8,000 hedge funds with total assets under management exceeding $1 trillion.
The activist fund's goal is to create a triggering event that will unlock shareholder value and yield stock price appreciation. This can include changing the capital structure, altering a company's M&A decisions, forcing a ale or breakup of the company, cutting costs, firing management or modifying the composition of the board. In most cases, the fund accumulates ownership in a company to obtain a foothold. After some accumulation, the fund's conversation with management will shift from investigatory questioning to proactive suggestion. If the fund finds management unreceptive to its ideas, the activist attempts to draw public attention to the company's underperformance or management's shortcomings. In an attempt to pressure management, they rally shareholders or attract other activists to the cause.
The fund sees itself as a catalyst for change, with goals as specific and diverse as the companies it targets. These can include increasing dividends, paying a special dividend, initiating a share repurchase program, optimizing the capital structure by issuing more debt or selling and breaking up the company. In other cases, the activists' goals are less well-defined and may include functional changes in management or the board, or changing board composition to include its nominees, splitting the roles of chairman and CEO or changing compensation practices.
Type of Company Targeted
Activists target companies whose share price they perceive to be significantly less than its potential value. Target companies may have other characteristics that attract attention. These include companies that are overcapitalized, have made bad strategic decisions, or have noncore, underutilized or extraneous assets. Specifically, characteristics include high cash balances, M&A activity with questionable rationale, underexploited asset values, depressed valuation multiples, earnings underperformance or the presence of disparate businesses with limited strategic underpinning wrapped within a single entity.
Companies with large cash balances and no definitive plans to use that cash are particularly vulnerable because activists see an opportunity for redistribution of cash to shareholders through a share repurchase. This is not surprising-cash as a percentage of market value at S&P 500 com- panies is higher than it has been in more than two decades. Cash as a percentage of long-term debt is just below 40 percent, close to a record.
Companies with minimal debt and stable cash flow are also attractive targets because the company can raise additional debt without materially affecting credit ratings and use the cash to heighten share value through a special dividend or share repurchase. The presence of noncash flow generating assets that have greater value to other entities and create divergences between the market value of the stock and the underlying asset value is also attractive to activists. These can include firms with noncore real estate, energy firms with oil reserves and closed-end mutual funds. While many companies initially targeted were smaller than their peers, since the coffers of activist funds have increased, blue chip companies such as Time Warner, Wendy's and Heinz are in the activist's crosshairs.
The ultimate defense is a healthy stock price. Failing that, two elements mark an effective defense: a proactive stance and responding to activist approaches swiftly. A "just say no" defense, particularly if the company is vulnerable, often leads to ruin. Strategic initiatives and in-depth reviews of financial policies can be a powerful defense. It demonstrates that the company is looking at all the options available to it to create value, but just taking such initiatives is not enough. Shareholders need to be informed of decisions. A well-thought-out plan for communicating the rationale behind management decisions is crucial and is difficult for activists to surmount.
When all else fails, traditional tactics such as poison pills, litigation, staggered terms for directors and standstill agreements could be considered. However, these tactics are largely ineffective and can backfire as management's time is diverted, resources are expended and in the court of public opinion, management might be viewed as entrenched and inflexible. Whatever else, management must be seen as proactive if it is to seize the moral high ground. Stalling only creates the impression that the company is vulnerable to a hedge fund, which may redouble its efforts, make additional demands, and ultimately seek to oust management. Shareholders view the time and money spent on such measures as wasteful, and proxy solicitation firms have proven clever at blunting such defenses. Moreover, such tactics serve only to attract more activists than they repel.
A quick response is key to taking control of the public dialogue that inevitably takes place. If management believes that what the activist fund proposes is shortsighted or incorrect, this needs to be communicated to shareholders swiftly or else the company risks losing a one-sided argument. This is particularly true for businesses that are in cyclical industries where cash positions are being built to finance future opportunities.
What's a company to do? We have developed a framework for management to work with professionals in addressing activist concerns or to head off intervention by activists before they arise. The first step is an objective, analytical review of the company, its plans, projections, anticipated investments in research, development, capital equipment and marketing. At this stage, identify the basic risks and returns from the existing capital invested in the business. Figure out how much additional capital is required to support the business and determine whether the returns on the existing and to-be-invested capital are worthwhile.
Comparing the operating and financial character of a company to its peers is critical. The goals are to identify differences and deficiencies; determine the basis for differences and whether management can repair below-average performance; and determine the impact of operating differences on value.
As part of this analysis, companies need to examine transaction trends and what they portend for values in the industry in order to identify the value of the business as a whole, the value of its component parts and whether or not the capital to be invested is justified. With this information in hand, management is prepared to review the range of financial strategies and initiatives available to the company and develop a proactive path to improving value for the benefit of shareholders. As always, communications are critical. Part of being proactive is building a consensus for the actions being taken. A strong communications message and a refined and supportable program, built on solid analysis, will keep the company moving forward and in control of the process.
It is very important to remember that only paying lip service to the program without carrying through will likely result in more demands and less shareholder support. Even if you, as management, decide to maintain status quo, so long as it is the conclusion from a well-considered, well-advised process, you are more likely to succeed in getting shareholder support for your management.
Randy Lampert (rlampert@morganjoseph. com) and Andrew Shiftan (ashiftan@ morganjoseph.com) are managing directors and co-head the Shareholder Activist Group at Morgan Joseph & Co., a New York investment banking firm serving middle market companies.