Boardroom blitz – the rise of activist investing

29 May 2014

After Sotheby’s and Microsoft, activist investing is transforming corporate culture and fundamentally restructuring the boardroom. Christopher Silvester reports on how those buying shares are demanding a greater influence on how businesses are run.

The growing culture of "activist investing" has shaken many a boardroom recently, as those buying shares in businesses seek more influence over how they are being run.

Hedge-fund manager Mick McGuire has been spending a lot of time analysing Sotheby's balance sheets and has told the management that he does not like what he sees. Why should Sotheby's listen? For the simple reason that he has accumulated a 7% stake in the auction house, and has a track record of persuading others to listen. McGuire has run no fewer than five activist campaigns during the three years he has been in charge of San Francisco-based Marcato Capital Management. Prior to that, he was a partner in veteran activist investor William Ackman's Pershing Square Capital Management.

McGuire is not the only activist to have taken a stake in Sotheby's. As soon as McGuire made a 13-D filing to regulators, declaring his intentions to lobby Sotheby's management, Daniel Loeb's Third Point announced that it had acquired 5.7% of Sotheby's stock and Nelson Peltz's Trian announced that it had bought 3%.

Instead of mounting an aggressive public campaign, these activist shareholders are lobbying the Sotheby's boardroom quietly but vigorously to change its policy towards the deployment of shareholder capital. For example, it might make sense for Sotheby's to sell its headquarters on Manhattan's Upper East Side or take on debt, rather than relying on cash in its lending business, which helps clients who are waiting for their artworks to sell. Sotheby's has said it is "committed to a healthy two-way communication with shareholders" and "to pursuing return of capital alternatives".

Unwelcome attention

There are money motives for activism: to curb excessive executive pay, to engender better governance, to reduce inefficient hoarding of cash or to liberate assets. For years, Lord Weinstock was renowned for his GEC cash mountain, a mark of his wisdom and his machismo. Today, such a hoard would make him vulnerable to intervention by outsiders.

Some companies resist the attentions of an activist investor as much as they are able to do so. Computing billionaire Michael Dell has opposed billionaire Carl Icahn's efforts to stop him taking the company he created private again, while Sony has declined the invitation of Loeb to spin off its entertainment arm, gaining the high-profile support of George Clooney, who dismissed Loeb as a "carpet bagger" and "market manipulator".

Elsewhere, there is a spirit of compromise. Microsoft has signed a pact to cooperate with ValueAct Holdings LP, which saw an activist shareholder join the Microsoft board as it sought a replacement for retiring CEO Steve Ballmer. In return, ValueAct agreed not to propose an exchange offer or pursue a proxy contest - gathering enough shareholders' votes to overrule management - over this year's dividend. And Apple's CEO Tim Cook has publicly welcomed the views of Icahn about the possibility of Apple increasing its share buy-back plan.

However, even activist strategies can invite activist objectors of their own. William Ackman sold his 18% share in retailer JC Penney, and left the board after a three-year activist role resulted in falling store sales and a drop in the share price. Having lost hundreds of millions, Ackman came under pressure from institutional investors in his hedge fund who sought meetings to discuss his strategy.

As many as 66% of proxy contests in 2013 were successful in effecting changes in management policy - if not in fulfilling their every aim. In the US, they are supported by established proxy advisers to shareholders.

"Activist investors are often able to force companies to make decisions, such as returning cash to shareholders through a special dividend, which they are reluctant to make because of their corporate culture."

While there is little enthusiasm - or cash available - to drive eye-popping takeover bids, there is plenty of money chasing activist causes. The reason for this is simple; activism is profitable. According to Hedge Fund Research, in the past year or so, event-driven hedge funds have outperformed all other strategies, producing returns of 7.8% compared to the 5.8% returns produced by equity hedge funds.

Continental selection

Continental Europe, despite having more publicly quoted companies, lags behind the US in terms of activist interventions. European institutional investors tend to be more deferential towards company boardrooms and are suspicious that interlopers are mere arbitrageurs. They prefer dialogue to confrontation. Dan Mannix, chief executive of activist investment manager RWC, prefers quiet, constructive engagement to public grandstanding as a better way "to create alpha and good governance".

The UK lags behind Europe when it comes to shareholder associations, but it has several activist entrepreneurs and hedge funds that are leading the way. For example, Christopher Mills, a former private-equity executive who founded Harwood Capital in 2011, teamed up as a passive investor with two former managers at Guinness Peat - Blake Nixon and Max Lesser - to form Worsley Investors, a new fund that will target lower mid-cap and small-cap companies, an area where there is little in the way of competition from activist hedgies. Once it has raised sufficient capital, Worsley hopes to target companies in the €200-300 million range, but it favours a collaborative posture towards management.

Cashing in

A July 2013 paper co-authored by Alon Brav of Duke University, Lucian Bebchuk of Harvard Business School and Columbia Business School's Wei Jiang examined 2,000 interventions by activist hedge funds over a 13-year period. It found that the average share-price jump following the announcement of activist-shareholder interest in a company was 6%, that this initial positive stock reaction is generally not reversed in the long term and that return on assets (ROA) increases in each of the five years following an activist intervention.

"We find that the activist intervention is followed by systematic improvement in operating performance relative to industry peers," wrote the authors. "These improvements are both statistically significant and economically meaningful."

Activist investors are often able to force companies to make decisions, such as returning cash to shareholders through a special dividend, which they are reluctant to make because of their corporate culture.

"When a company has excessive cash holdings or investment levels, management might refrain from taking actions that would reduce the size of the empire under its control," wrote the authors of the report.

Commenting on the report's findings, Charles Elson, a corporate governance expert at the University of Delaware, said: "The notion that they are only pushing short-term results suggests the long-term investors are idiots. I'm not surprised by the study. It confirms what I thought; activist investors create a culture of accountability."

However, there is still a tendency to paint activist hedge funds as sinister villains. For this reason, some campaigners prefer the term "suggestivist" to activist, especially when they are seeking support from institutional investors.

Whether or not we have entered what Forbes has called "the golden age of activist investing", the demonisation of activist hedge funds as short-termist is on the wane, since their average engagement in a stock is 20 months, compared with institutional investors who often dip in and out of a stock each month, while activist investors are adopting less abrasive and more nuanced approaches to their game.