Activist investors are often presented as the bad guys of financial markets. They burst onto the scene, shout loudly their plans and can offer brutal verdicts on the performance of company bosses. Naturally, CEOs would prefer to prevent this public struggle, and the best way for a company to defend itself from these insurgents might be borrow some of their tricks.
In theory, activist investors get interested when there are easy pickings to be had; when boardrooms have become complacent or are missing opportunities. This can make activists an important part of the corporate governance of firms. They seek out possible levers to increase company value beyond what the incumbent management is able to achieve. Their often confrontational style is simply a way of getting these ideas noticed.
Most recently, news broke that Third Point LLC, the investment vehicle of billionaire activist investor Daniel Loeb, has acquired a US$3.5 billion stake in Nestlé. Loeb is now one of the Swiss food group’s largest shareholders. His investment firm has a range of strategic thoughts for Nestlé, including the sale of some of its non-core holdings.
Piling on the pressure
At the heart of all activist investor strategy is the pursuit of a profit on their investment. This can come through major changes in corporate strategy which boost the share price or a simple increase in the amount of money given out to shareholders. One neat trick for activists is that they can spark a rise in a share price – and therefore book an early paper profit – simply by announcing they hold a stake.
Activist investors most often take a minority stake in a market-listed firm and that means they have to exploit all means possible to put public pressure on the target CEO. Now, other large investors may also talk strategy with the CEO, but tend to prefer a softly-softly approach, behind closed doors. Activists will frequently seek to convince those other big shareholders to support them in order to ramp up the pressure.
Common top priorities for activist investors are to increase payouts to shareholders through dividends or share buybacks, to cut costs, and to increase debt levels to fund investment. Academic research finds that firms which hoard too much cash and maintain relatively low levels of debt tend to make value-destroying investment decisions. That drives activists to target cash-rich, mature, stable-cash flow firms. In short, if a company is treading water and playing it safe, then it risks becoming a target.
Typically, activist investments follow a three-step process. First, as in the case with Nestlé, activist investors will start with a public announcement of their stake and the measures they think the target firm should put in place. Mostly, the target firm dismisses the initial request by the activist.
Next, the activist will become more confrontational and will launch a bigger media campaign highlighting the weaknesses of the current corporate policy. What follows is verbal back-and-forth between firm and activist carried out through the media. As a final measure, to change the course of action in the target firm, the activist might initiate a so-called “proxy fight” at the annual general meeting – where those other investors can lend their support and vote against management. In rare circumstances, an activist might even file a lawsuit if it feels the target firm has violated securities laws.
One successful lawsuit came in 2013 when Greenlight Capital sued Apple for violating financial market rules. Greenlight argued Apple was limiting shareholder democracy by forcing a vote on a combined package of items instead of allowing them to vote on each matter separately. While there was no actual court ruling, the court did issue a preliminary injunction which made Apple remove the bundled items. Proxy fights often involve proposals to sack some board members and bring in others who are supported by the activists. If that succeeds, then often the CEO starts to look less secure in their job.
Of course, whether these fights are successful relies on gaining support, and a key part of activist strategy is to assess how likely those alliances might be with other key investors like pension funds and major investment houses. They sometimes get it wrong. One recent attempt by Greenlight to have General Motors split its shares failed to win enough support.
Making the most of it
Dealing with activist shareholders can be a lengthy and distracting endeavour for target CEOs; the natural reaction is try and fend them off. However, in essence, activist investors provide a “free” but confrontational market assessment of the firm, and they do highlight possible areas of improvement.
This assessment can, of course, be wrong. However, research suggests that in the majority of cases, the stock price goes up at the announcement of an activist investor taking a large stake in a firm, suggesting that shareholders expect future value increases. And it is not only the target company’s shareholders who benefit. Research also shows that rivals often begin to implement measures that might prevent them falling under the gaze of activist investors themselves.
The lesson here should be clear. Why wait for the so-called bad guys to batter down the door and start calling out lazy strategy and missed opportunities? For executives, the best defence against activist investors is attack, but aimed squarely at their own failings. CEOs need to mimic activist scrutiny over their own firms and by doing so, become less attractive as a potential target. It is important for bosses to continually benchmark themselves against leading peers and to keep close ties to existing large shareholders. They are the crucial factor that can tip the balance one way or another, and giving an ear to their more gentle concerns could dissuade them from a dangerous alliance with the activists.