Last week, the CEO of Automatic Data Processing taunted activist investor Bill Ackman from the stage of the company’s shareholder meeting, describing a proxy vote the investor had lost as an “ass-whooping.”
As October began, two of the world’s largest companies, General Electric and Procter & Gamble, faced looming battles with a hedge fund. G.E. opted to award a board seat to Trian Fund Management, while Procter & Gamble faced off against the same investor, who narrowly lost a proxy vote.
Corporate shareholders’ using their ownership to steer companies is nothing new. But shareholder activists are more plentiful and ambitious now than ever before. And, as passive index fund investing becomes increasingly common as well, activists may find more opportunities to place a check on poor management.
What Is Shareholder Activism?
Individuals or institutions who own stock in a public or private corporation—shareholders—elect a board of directors to oversee the corporation according to a process decided by internal bylaws. When they wield their influence as owners by leaning on the board to make changes, they’re activists.
Activists’ goals typically determine their change-making methods.
“Traditionally, it’s been associated with hedge funds who take public positions and push for strategic changes in direction,” Rakhi Kumar, managing director at State Street Global Advisors, told InsideSources.
But the practice, which began in the Roaring Twenties, has grown increasingly common in recent years. Activist Insight recently released a report which found 758 companies worldwide faced shareholder activist campaigns in 2016—compared to 520 campaigns in 2013.
“They are operating in all segments of the market,” David Beatty, a senior adviser at the management consulting company McKinsey & Company, told InsideSources. “This is global. Any publicly traded company that isn’t number one in its peer group is going to have someone at least looking at them.”
Three Types of Shareholder Activism
Shareholder activism breaks down into three broad categories: The economic activist advocates for changes to create gains within the company, while governance activists work to change boards and the policies governing them. But both are means to turn a profit. Social and environmental activism, meanwhile, seeks to make a company’s practices more ethically and ecologically sound; these are newer strains, and less capitalistically productive.
Governance and economic activism often work well in tandem: Governance activists seek changes to the bylaws governing the board of directors—in order to clear the way for economic activists. “They really worked together on breaking down the barriers at companies to enable them to be approached and sold. When you take away a poison pill and a classified board, you take away defenses a company has against a hostile bid,” FTI Consulting managing director Steve Balet explained.
A classified board has directors serving staggered terms of different lengths, robbing activists of the opportunity to unseat more than a small segment of the directors at once. Aggressive governance activism, however, would change the bylaws in such a scenario to make elections more frequent.
McKinsey’s Beatty notes that shareholder activism, the vast majority of the time, makes money and usually intends to make money for the company. And shareholders generally want to get more back on their investment. In recent years, however, a new type of shareholder activism has also been a means of pushing for environmental and social causes.
Over the past decade, social and environmental activism has picked up steam. These practices, designed to get corporations advocating for outside political and social causes, take advantage of large corporations’ considerable influence. A Harvard Business School study found shareholder activism proposals that include environmental sustainability issues have doubled between 1999 and 2013.
It’s disputed whether the social form of shareholder activism even belongs in the same category of activist investing. The intended outcome is typically external, as opposed to internal, and less concerned with strict asset stewardship. Activists might try to get a corporation to take a stance on an issue like wage equality, for instance, which would naturally affect operations.
The Effect of Passive Investing
The recent rise of what’s termed “passive investing” may help fuel opportunities for activist campaigns. After the recession, index funds and exchange-traded funds rose in popularity. These investments track a large portfolio of stocks over time, changing little in overall composition. Index funds owned 11.6 percent of the S&P 500 in 2016—double their stake, according to a Wall Street Journal analysis, from a decade prior.
In the recent proxy battles at Automatic Data Processing or Proctor & Gamble, the results tie closely to how the largest shareholders voted, and in both cases, the largest shareholders were the major index fund and exchange-traded fund management companies—Vanguard, BlackRock, and State Street. The passive fund managers are often less likely to push for change in a company and have a history of siding with company management against activists. But the rise of passive investing could have two impacts on the market.
First, it could lead company management to be more complacent and open opportunities for activist campaigns. Without the pressure that active portfolio management has historically put on company management via the board and movement of capital, activist investors stand likely to find even more openings for their campaigns in the years ahead.
It could also present an opportunity for passive investors to increase their returns by loaning shares to activists. Active and passive investor interests are often aligned in increasing the value for shareholders, so the benefits could be twofold.
“There is much comment that shares in the hands of passive funds makes it harder for activists,” John Cochrane, a professor at the University of Chicago Booth School of Business, said in an email to InsideSources. “I’m not totally convinced. For one, passive funds ought to loan out their shares around proxy time, and charge some money to do that! I also think we should see more issuance of non-voting shares.”
Cochrane sees opportunities for how the market can adapt to the rise of passive investing while also allowing activists the opportunity to improve company performance.
“If I were running a passive fund, say S&P 500 index, I would love to buy non-voting shares, especially at a discount,” Cochrane said. “So long as there were ironclad protections that my shares are treated the same way as all other shares in distributions. Finally, most passive funds are not slavishly indexed. They can sell shares to activists one company at a time, and if they really want exposure, keep it in the non-voting options market. So if it were really a problem, money would be on the table, and money is a great way to encourage people to solve problems.”
How Shareholder Activism Is Changing the World
Shareholder activism, now a global practice, varies depending on the local laws and customs: Some developed countries have formed sophisticated approaches to shareholder activism while some regions of the world are just starting to explore the practice. “The biggest difference is what your jurisdiction allows in terms of being able to run for board seats and promote an agenda, or to challenge boards of directors,” Balet, who has advised public companies and hedge funds for roughly two decades, said.
FTI Consulting compared shareholder activism across a range of developed countries, finding that shareholder activism is most likely to occur in North America, Australia, and the United Kingdom. Shareholder activism has also taken root in Asian and other European countries.
“In the U.K. they are fairly sophisticated in their corporate governance approach,” Balet said. “The chairman of the board is usually the main contact for shareholders, but in other jurisdictions, it’s completely new, and engagement has not been as strong. U.S. shareholders are used to a certain degree of engagement from management and sometimes boards.”
American investors have inspired international shareholder activism. They have come to expect the domestic practices to which they’re accustomed when they invest in foreign companies. Those expectations influence foreign companies to adopt practices that encourage activism.
“What’s really interesting is that because U.S. shareholders vote regularly, and as U.S. shareholders are owning more and more of foreign companies, certain elements that U.S. shareholder have used, like shareholder activism, proposals, or engagement with management and the board, are becoming more prevalent in jurisdictions where it never happened before,” Balet said.
Japan has a unique form of shareholder activism, different from other countries’ in that it’s being primarily pushed by the government to help promote its economic development agenda. “In Japan,” Kumar said, “investors have a role to play. But I think the changes are really coming from the government.”
Japan’s business culture has not fostered activist investing in the past: The Japanese corporate sector tends to favor employees at the expense of shareholders’ profit and the growth of the national economy—and Prime Minister Shinzo Abe hopes shareholder activism will encourage reform.
Is Shareholder Activism Good for the Economy?
Company management and some politicians on the left are often critical of activists. Activist campaigns frequently will push out the CEO of a company, and they may force internal changes to cut costs or improve operations that could lead to some job loss. Many economists, however, acknowledge that the role of activist investors is essential for the long term health of the company and economy as a whole.
“Activist investing is very important,” said Cochrane, who is also a senior fellow at the Hoover Institution. “Activist investment may produce some better information, which aids market efficiency in the sense that the market can better price things, price accurately reflects better information,” he said. “But the big point of activist investing is to force corporate efficiency, to take the unpleasant actions that make companies more efficient.”
Shareholders are generally supportive of activist campaigns because a successful campaign often leaves the company in better shape than it was before.
Company management, however, will mount public campaigns critical of an activist investor. They’ll make claims that the activist has only short-term interests and that the company and other shareholders will be harmed in the long term. This plays into a common trope on Wall Street about worries over short-termism and forcing company management to hit quarterly targets.
A study published in the Columbia Law Review addressed this criticism. The study tracked 2,000 activist hedge fund interventions from 1994 to 2007, examining a five-year window after the intervention to measure performance.
“We find no evidence that interventions are followed by declines in operating performance in the long term; to the contrary, activist interventions are followed by improved operating performance during the five-year period following the intervention,” write the study’s authors. “These improvements in long-term performance are also present when focusing on the two subsets of activist interventions that are most resisted and criticized – first, interventions that lower or constrain long-term investments by enhancing leverage, beefing up shareholder payouts, or reducing investments and, second, adversarial interventions employing hostile tactics.”
Shareholder activism does have its potential downsides. First of all, it can backfire. A campaign can be very distracting for corporate leadership which still has to run the business. And a public campaign can also sow uncertainty and discord, and even hurt the reputation of a company – as was seen in the battle between activist investor Bill Ackman and Automatic Data Processing, where the war of words seemed juvenile.
Aggressive activism can be rewarding, but it has risks. “When a shareholder activism campaign happens, and the activists are talking about selling the company or splitting the company, or cost reductions, that has an effect on the employees of the company, it has an effect on the company’s ability to negotiate and talk with suppliers,” Balet, who has advised on contested proxy campaigns, corporate-governance issues, and mergers, said.
Shareholder activists and corporate boards often try to handle everything behind the scenes to avoid awkward publicity, as negotiations can heat up and progress quickly. But private negotiations aren’t always successful either—and newer activists may go public straightaway. The most important pitfall for campaigns to avoid, Kumar notes, is controversy brought on by confusion. When the message and intent are clear to outsiders and the board of directors, particularly as activist campaigns become more and more common, they’re better poised to be fruitful and reward everyone’s efforts.
The authors of the Columbia Law Review study push back against any assertions that activism is harmful to the company and that boards should fight back against activists. “Our findings should inform how corporate directors view and engage with activists. Corporate boards facing an activist should not ‘circle the wagons,’” they write. “To the contrary, boards should keep in mind that activist interventions are on average associated with beneficial outcomes in the long term. Rather than taking an adversarial position, boards should be open to the activist’s ideas and to discussing them with the activist.”
Some populist politicians have also tried to curtail the ability of activists to acquire large enough stakes in a company to influence a board. U.S. Senators Elizabeth Warren and Bernie Sanders introduced legislation last year to shorten 13D disclosure deadlines with the Securities and Exchange Commission when activists acquire more than 5 percent of a company. Because these filings cause stock prices to spike, a shorter window prevents activists from acquiring large stakes. The legislation also blocks “wolf packs,” when several activists work together but hold fewer shares than would trigger SEC disclosure.
But the economics of such public policy efforts don’t seem particularly logical.
“Policies intended to restrict activists build on the premise that they are bad for shareholders. However, over two decades’ data show that the stock prices rise, on average, 5 to 6 percent (in excess of the market) upon announcement of activism via 13Ds,” explains Columbia Business School Professor Wei Jiang. “The phenomenon continues into the most recent years. The short-term ‘pop’ is not followed by reversal later on. It would be hard to argue that the stock market ‘got it wrong’ for this long.”
She adds: “Part of the argument for shortening the 10 days or to restrict the ‘wolf pack’ is to reduce the part of the gain that accrues to a small group of investors, notably the activists and their allies. Such an argument seems to accept the premise that activism is expected to raise share price. If so, why should policy restrict activities that are welcomed by shareholders?”