Posted in Finance Articles, Total Reads: 792
, Published on 19 April 2015
"We believe the best way to ensure improved performance at PepsiCo is to separate global snacks and beverages, putting the future of each business in the hands of empowered and focused management". This was written in the letter posted to the management of Pepsico by Trian Partners headed by the Activist Investor Nelson Peltz. Investor activism, which started in 1980s - then called ‘Corporate Crusaders' - has grown in importance with more and more companies targeted every year, be it Bill Ackman’s public failure at JC Penney, or Carl Icahn’s argument for a buyback at Apple, one of America’s most loved and successful companies.
An activist shareholder uses equity stake in a company to put pressure on its management. The trick is simple. Buy upto 5% stake in the company and get a seat at the Board. Once comfortable, make demands that would in all belief increase shareholder value. In case the Board refuses, fight a proxy battle. If the demands seem legitimate to other shareholders, chances of winning are high post which a new 'friendly' Board would be appointed. In case the proxy fight is lost, nevermind. Liquidate and look for another target. This is the standard way an investor activism exercise works.
While much of investor activism is practiced outside the public eye, there has been a consistent increase in public actions, whereby activists' play a key role in changing either the strategy or the governance of companies they have invested in. This has resulted in growing acceptance of the many policy changes that the activists are seeking to effect. Post the financial crisis of 2008, activist activity has increased, and new money is beginning to flow into activist funds mostly in search of returns which are uncorrelated with other asset classes. The Assets Under Management (AUM) of this asset class are quickly growing and returns are consistently outperforming the average hedge fund. In 2013, according to Schulte Roth & Zabel, public actions of activism were launched at a total 237 companies worldwide including giants like Apple, Hess and Proctor & Gamble.
What Attracts Activist Shareholders?
Not unexpectedly, fundamental underperformance is the most likely weakness that triggers an activist investor campaign. Activists most often focus on underperformance relative to competitors, rather than absolute declines in performance. Other factors include poor revenue growth, lagging shareholder returns vis-a-vis the industry peers in the previous two years, and an increasing gap in margins relative to competitors. Recurring restructuring charges and large cash balances are also strong indicators of looming activism. According to McKinsey & Company however, company’s gap in consensus earnings and executive compensation are not significant indicators of activist interest. In certain sectors, it has also been observed that those companies where the breadth of the corporate portfolio has a market value which is lower than the sum of independent businesses are attractive targets.
Major Activist Trends in FY 2013
According to Schulte Roth & Zabel, the year 2013 saw an increase in activism activity with 237 companies being targeted worldwide as compared to 218 in 2012. Out of these, more than 70% of the total cases were observed in the United States, followed by 18% in Europe and only 6% in Canada. Sectors like Technology, Services and Basic Materials were the most preferred and comprised of around 75% of the total investor focus. Also, 2013 saw twice the number of companies targeted with a market capitalisation of more than $10 billion than the previous year. A total of 42 such big size investments including UBS and Celesio were made in 2013 compared to only 23 a year ago. This is leading to an increased perception that size no longer matters for activism.
According to consultancy firm McKinsey & Company, three out of every four activism campaigns start collaboratively, but half of those eventually turn hostile. This suggests that management teams should focus not just on whether to accept activist proposals but also on how they engage with an activist.
On the performance side, activist hedge funds enjoyed a strong year in 2013. They beat the MSCI World Index by over five percentage points in the period of bullish growth. According to Activist Insight’s Activist Index, which is made up of 30 activist funds, a return average of 21.7% was achieved over the first three quarters of 2013, which compared favourably to S&P 500 Index’s 17.9% and MSCI’s 16.3%. Therefore, there is plenty of evidence to suggest that with investors closely watching the performance of activists, money will continue to increasingly flow into activist funds in FY 2014. Gregg Feinstein of Houlihan Lokey believes that activism has been grossly undervalued by the market in general. According to him it has been proven to increase value for shareholders.
Defence Techniques to Counter Activism
Accompanying the rise in activism has been a burgeoning defence industry in the US which is experimentation with new bylaws designed to frustrate activists. Although bylaws vary widely from organization to organization, they generally cover topics such as how the Board is elected, how the meetings of Directors are conducted, officers the organization will have and description of their roles and responsibilities. However, it remains to be seen how long lasting their impact will be. Some of these defence mechanisms include the following:
1. 13D Pills: In US, an investor is required to file either form 13D or 13G when an ownership threshold of 5% shares in a publicly traded corporation is reached. An activist investor files a 13D whereas a passive investor who does not intend to influence the management or wage a proxy contest is required to file 13G. However, many companies now include a special clause with filing a 13D which prevents activist investors from increasing their holdings beyond 10%. The same threshold is 20% for passive investors who file 13G. This clause prevented Bill Ackman from taking a significant ownership position at Air Product & Chemicals.
2. Tax Pills: This is a slightly more obscure use of poison pills. It takes advantage of tax regulations and helps companies keep activist ownership below the 5% threshold. These tax pills trigger increased burdens for investors at this level, rather than the traditional 10%. This is because a change of ownership would mean tax-beneficial operating losses are abandoned.
In order to avoid an activist campaign, company executives should run a pre-emptive audit to evaluate their company’s performance and review their strategic and operating plans in that light. An unbiased and rigorous pre-emptive audit that helps in identifying weak spots and evaluates all alternatives can help in keeping activists at bay and bring forth many opportunities for value creation.
The Road Ahead
In 2013, many big name activist funds including Pershing Square, Third Point, Clinton Group and ValueAct saw their stock picks work well for them. All saw their stock choices increase by an average annualized value of 75% or more. Analyst forecasts suggest strong growth in activism activity in the US, but a continuing weakness in Japanese and eurozone equity markets. Activists are testing these markets with certain optimism and also because of the growing acceptance of increase in shareholder value via this asset class. In case these regions enjoy an upswing in growth, the activists will be the first to enjoy the benefits. In India also, anecdotal evidence suggests that activism by both foreign and domestic investors is on the rise. However, so long as the Government has large interests in companies and the legal system is slow and onerous, activism would continue to remain hindered in India.
The fundamental question however still remains – do activist investors save companies by influencing incompetent management and increasing shareholder value or do they play corporate crusaders who intend to make short term gains by shaking things and finally exiting at attractive multiples. As a follow up to the discussion however, it certainly seems the trend is moving from the latter to the former. It also seems highly likely that this year will prove to be ‘the end of the beginning’ phase of an invigorated age of investor activism.
This article has been authored by Mukul Gupta from IMT-Ghaziabad