July 15, 2014

It has been argued by more than one commentator that the world is “awash in capital” after years of loose monetary policy and quantitative easing. The portion of this capital that has found its way into stock markets has helped buoy valuations; and part of the money in the stock market is seeking outperformance in new strategies, amongst which can be numbered “activist investing”. Probably $120-150 billion of capital is focused on activist strategies – $75-80 billion in activist funds and perhaps up to as much again in funds that will collaborate with activist investors. (For example certain of the very large Canadian pension funds have open lines of dialogue with activist investors.)

Over the past decade the US and Canada has seen an average of 150 activist campaigns per annum; this pace has been accelerating and the success stories have become increasingly impressive (see our blog post “Communications Technology & Investor Demands For Strategic Clarity” 13 January 2014). Indeed data from S&P Capital IQ, Thomson Reuters Datastream suggest that, at least for mid0-cap and large-cap companies in North America, activist initiatives act a prelude to outperformance relative to peer groups for as much as three years after such a campaign is launched.

This seems to apply in cases where activists “win” as well as in cases where the companies ultimately co-operate. A noteworthy Canadian example of the former is historic railroad firm Canadian Pacific (CP-TSX) where, in May of 2012, an establishment-heavy board was effectively routed by Pershing Square Capital Management, a new CEO appointed and a new strategic direction (high efficienty railroad operations) implemented. An example of the former is Hess Corporation (HES – NYSE), which opened a constructive dialogue with Elliot Management after some initial hesitancy. Elliot pushed for rationalisation of the corporate portfolio and a focus on E&P activities. Hess management ultimately embraced the opportunity, and surprised the market with a $2.6 billion dollar sale of its portfolio of service stations to Marathon (MRO-NYSE) at a highly impressive 14x EBITDA.

15 July 2014 Blog Post

Cheverny would therefore submit that activist funds are now an inescapable part of the capital markets landscape and, unless securely armoured behind multiple voting share structures controlled by a dominant and sympathetic owner, companies must be increasingly proactive in how they adapt to this reality.

Historically many companies facing an approach from activist investors have crafted responses that are swiftly and almost instinctively hostile. This should hardly be viewed as surprising. Firstly the executive suites and boardrooms of public companies are not populated by shrinking violets easily habituated to being challenged. Secondly, a standard tool in the activist playbook has been the public letter calling companies to account. These letters are a boon to journalists. They can be in turn hortatory, accusatory and long on invective. Consider Third Point Capital’s campaign against venerable auction house Sotheby’s (BID_NYSE). Third Point’s founder Mr Daniel Loeb began the campaign by terming Sotheby’s “an Old Master painting in desperate need of restoration”. By April he was writing  to the shareholders in harsher terms yet. Sticking strictly to the first three paragraphs one finds that this follow-up letter (dated April 2014)  refers to “failed leadership”, a “dysfunctional corporate culture”, and “poor corporate governance and malfunctioning board processes”. Third Point further noted that management lacked “skin in the game” and Sotheby’s board was termed “asleep at the switch”.

Sotheby’s effectively went to war with Third Point, even to the point of moving to implement an aggressive shareholder rights plan (aka a poison pill).  Yet, seemingly lacking shareholder support, in early May of this year Sotheby’s allowed Third Point’s three nominees to join the board and Third Point was allowed to raise its stake to 15% (despite the proposed shareholder rights plan). During the court cases that preceded this denouement it emerged (via internal emails read into the record at Delaware Chancery Court) that some board members agreed with Third Point: “the board is too comfortable, too chummy and not doing its job” wrote one director to another. Sotheby’s was embarrassed and Third Point was handed – as one expert in activism told Reuters – a “significant victory”.


Lessons For Boards & Management In This New “Activist” Era

Cheverny would draw four broad lessons from this emerging new era of activism.


Lesson 1: Ego And Corporate Strategy Do Not Mix

The partners of Cheverny have found many activist investors to be thoughtful, methodical and highly analytical. Many activist campaigns begin after thorough analysis of the company, its industry and sources of corporate under-performance. Whilst the typical activist tone – whether in a public or private communications – may be offputting, this does not necessarily mean the strategic dialogue the investors are seeking – and the strategic direction they would like to explore – is devoid of value. Recent research from consultants McKinsey & Co suggests that the activist campaigns where a negotiated settlement is reached produce the greatest outperformance whilst, conversely, situations where management sees off an activist tend to produce the greatest relative underperformance.


Lesson 2:  Boards need to focus less on governance and more on strategy and capital allocation

In the era of Sarbanes-Oxley and strict corporate governance, many boards find that meeting days are overloaded with “box ticking” activities that stretch to overwhelm the agenda, consuming time and squashing discussions of strategy into the last hours of the day, when flight schedules risk foreshortening necessary discussions and travel plans begin to intrude on the focus and attention of directors.

Given that a tussle with an activist investor can cost many millions of dollars (easily run up by proxy consultants, lawyers, public relations consultants) and consume weeks or months of management time (potentially a far greater cost, both financially and in terms of focus), it should be incumbent on boards and senior management to devote sufficient time to issues such as:

  • Operations & Strategy : Is the strategy correct? Is the company underperforming industry peers in terms of margins and cash flow generation? Are we able to change strategy to adapt to evolving market conditions?
  • Capital Strategy: is the capital structure well-matched to the firm’s strategy? Are capital allocation policies tuned to making the corporation “bigger” or are they tuned to enhancing shareholder value?
  • Are we aware of decision biases at the board and management level when making significant operational and capital allocation decisions?

A review of board surveys – such as Spencer Stuart’s Canadian Board Index – would suggest that this is not widespread and that governance remains a preponderant issue.


Lesson 3: Boards and managements should consider “activist audits”

Given the costs alluded to above, and the negative publicity attendant on an activist campaign, senior managements and boards should consider engaging independent advisers (such as Cheverny) to conduct “activist audits”. At times companies can benefit from a dispassionate outside analysis. Independent advisers can help companies look for warning signs – and further help with some of the capital structure and M&A strategies that may flow from this analysis. Warning signs include:

  • Frequent restatements of earnings and writedowns of goodwill
  • Underperformance to the peer group (revenue growth, key operating metrics)
  • Underperforming the peer group in terms of EBITDA margins
  • Low levels of management share ownership
  • Poor correlation between results and management compensation (absolute compensation is not an issue so long as the results are strong)
  • Excessively complex corporate structures/portfolios that may invite a splitting up of the company in order t liberate value
  • Undervalued divisions where value is lost in a blended corporate valuation
  • Lack of responsiveness to new industry trends (M&A, technology etc)

An analytical and benchmarking exercise of this type can allow companies to hone their strategies and pre-empt activist campaigns.

Major global banks and Canadian bank owned dealers are poorly suited to this exercise because of myriad conflicts of interest (they may be trading in your shares on behalf of an activist, may have an investment management arm collaborating with an activist, may provide financial services to an activist, may lend to or advise your industry rivals and so forth)


Lesson 4: The Chairman and the CEO will not see an activist off unaided

Once an activist campaign begins the CEO and board will invariably need strong financial and strategic advice. They also need to form a team composed of both internal resources and independent financial advisers; this team will analyse activist proposals and clearly and dispassionately come to a view of whether this represents good strategic thinking – regardless of any tone or invective that may accompany it. This clearheaded analysis should guide how a company responds. Any potential loss of face in accepting some activist proposals may be more than outweighed by shareholder happiness at additional, positive returns.