Activists

This weeks WSJ had a special feature on the success of activists looking at 71 activist campaigns.  For those who missed it, I recommend taking a look.  The bottom line is that some activists are associated with gains in value and some not.  That's not a surprising conclusion.  Anecdotal analyses such as this one are interesting but are generally on a small scale and have a difficult time controlling for all of the various factors that can influence outcomes.

A more thorough analysis is contained in a recent article entitled: Myopic Investor Myth Debunked:The Long-term Efficacy of Shareholder Advocacyin the Boardroom.  They examine a sample of 1,039 activist campaigns.   In fairness, these authors reach a similar conclusion as the WSJ: activist representation on the board is the vehicle through which meaningful gains are produced.

In the same WSJ edition are the stories about Nelson Peltz investing $2.5 billion in GE (resulting in a 5.3% stock boost) and news that Ellen Kullman will retire after 'winning' an activist campaign at DuPont.

All the best,

Ralph

Banks and the Clustering of Mergers and Acquisitions Activity

Industry structural changes are a major M&A catalyst. The changes inhibit incumbent firms’ ability to create shareholder value. This is reflected in the current clustering of M&A activity in the healthcare, technology and oil and gas industries. Banking has also seen increased activity in the number of deals. The deals have been primarily in the smaller community and regional bank segments. Hence, dollar volume is still off pre crisis levels. Larger Too-Big-To-Fail banks are still reluctant to seek regulatory approval. Nonetheless, banking has structurally changed since the financial crisis as reflected in weaker operating performance. Many bank, however, have yet to adjust to the changes.

This is reflected in lower economic returns, ROE less cost of equity, and consequently lower pricing multiples like price to book.  Pricing multiples reflect underlying operating performance. Pressure is building, primarily from activists, to improve returns. Banks who “get it” will enjoy improved returns and values e.g. Warren Buffet’s favorite bank Wells Fargo. They will likely force changes upon weaker banks that “don’t get it” like Bank of America which trades below book value. This will spur increased banking M&A-initially smaller transactions until a larger deal is pushed thru the regulatory log jam. My thoughts on this matter are outlined in my attached American Banker BankThink comment.

J

Unincorporating Corporations: The Problem with Large Public Corporate Governance

Large public corporations and their managers have come under increased scrutiny since the great recession. They have taken the easy steps of reducing costs and returning cash to shareholders. Unfortunately, they still face revenue growth problems, excess capacity, changing technology and regulation, and lagging performance. These problems have depressed relative share prices and attracted the interest of third parties. Hostile takeovers bids from strategic acquirers have increased to pre crisis 2007 levels of 20%+ of M&A. Activists like Daniel Loeb’s Third Point have raised record amounts to fund new campaigns to instigate strategic change. Understandably, managers are concerned about this increasingly active market for corporate control. They are reluctant to change formerly successful business models even though conditions have changed due to organizational inertia.

These managers are seeking political support to protect their positions. They allege hostiles and activists with their alleged short term focus harm the long-term value of their firms and ultimately the country. Thus, they evoke stakeholder and long-term holding requirements arguments to slow the process; they just need more time to prove that everything will alright. As Ralph highlighted, allowing alternative stakeholders control over capital supplied by shareholders allows one group to risk the capital supplied by someone else-never a good idea.

Equally unwise is to discriminate against investors based on their holding period. Examples include granting long-term shareholder enhanced voting rights as in France or taxing short term investors at higher rates as proposed by Hillary. When it comes to bearing risk the length of ownership is not a factor. There is no grace period during which new shareholders are shielded from management miscues. The real problem with so-called “short-termism” is poor governance and weak board oversight regarding short term orientated incentive compensation plans. Many public boards have been “captured” by management.

The agency cost problem with large slow growth public firms was pointed out over 25 years ago by Michael Jensen in his seminal article. The eclipse is a work in process. Attempts to inhibit the market for corporate control will retard reform efforts. It is puzzling that we do not see more going private transactions for large public low growth firms (like Buffett-3G Heinz and Kraft acquisitions) if markets are so short term. This is especially compelling since they no longer need public capital market access to fund their limited growth opportunities

An interesting legal development is taking place which may offer some new solutions to the agency cost-governance breakdown. The development is outlined in a recent book. Business form matters because it impacts governance and agency costs. The statutory based corporate form may be inefficient for mature public firms. Contract based limited life alternatives like limited liability companies (LLC), REITS and limited partnership do away with permanent capital and encourage the disgorgement of cash. They require investors to “re-up” in new vehicles if they believe in management.

The problem of failed attempts to adjust to a volatile business environment (Schumpeter's Ghosts) is highlighted in a provocative new BCG report. The life expectancy of domestic public firms has declined by almost 50% over the past 30 years due to bankruptcy, liquidation, M&A, LBO, or other causes.  The 5 year morality rate or exit risk for for U.S. public firms is now over 30% compared to just 5% on the 1960s.

There is no escaping change. Not everyone can or will adjust. The agency problem in public firms complicates the problem. The market for corporate control and evolving legal structures are some market solutions addressing the problem. They are preferred over political “solutions”, which merely try to hold back change.

J

The Empire Strikes Back: DuPont's Response to Trian

As readers of this blog know, contested offers, proxy fights, and activist campaigns produce heated exchanges between the parties involved.  The latest round in the DuPont/Trian exchange is from DuPont, filed with the SEC yesterday.   This is management's defense of its record and counter claims against Trian and occurs in a letter to shareholders.  See DuPont's response.

As the letter indicates, DuPont has outperformed the market in the last one, three and five year periods.  What remains unclear, however, is what additional value can be obtained through the actions Trian proposes, namely splitting up the company.  It is difficult to defend against projected 'what ifs' and admittedly, the track record of activists in general, is positive in terms of creating value. In many cases where activists attack, however, the target has been underperforming.  That certainly isn't the case with DuPont.  In Star Wars, the Empire represented the villains.  That's not clear here.  Stay tuned.

All the best,

Ralph

One Sided Activism? A Note on the Symmetry of Market Problems and the Asymmetries of Activists

There are a couple of really interesting articles about activists in the last two Wall Street Journals.  The first is yesterday's "Activists Are On A  Roll With More to Come", which documents the power and success of activists, noting the growth in the number of campaigns and in the number of assets under control.  The article also notes the increased success rate of proxy campaigns.  

The second article, entitled A Radical Idea for Activist Investors presents a provocative question.  If Actists are so smart, why are they one sided in their attacks? As the article notes:

"The vast majority are making similar demands of their targets, delivered with what now feels like a dull percussion: Raise the dividend, buy back shares, cut these costs, spin off that division, sell the company."

Wouldn't we expect a similar pressure by activists encouraging at least some firms to invest more?  Shouldn't we expect at least some activists campaigns to push firms to be less conservative, to invest more, to pursue heretofore missed opportunities?  

The article suggests three reasons for the one-sided attacks.  First, CEOs can be driven by ego and are motivated to expand not contract.  Second, such an attack requires a longer term investment to reap rewards.  Activists tend to be more short term.  Third, it could cause destabilizing investor turnover as one type of investor replaced another.  (I confess to not fully understanding the latter idea.  How does this ever stop value creation?  Don't takeover attempts do the same thing?)

But I'd like to offer a fourth reason that activists are not prone to pushing firms to invest differently and it is simply this:  Activists are not by nature, build it, type individuals.  Also, the expertise it takes to recognize over investment is likely to be more plentiful than the type of expertise it takes to build something.  I'm not saying one of these skills is more valuable than the other, just that it is not surprising that activists don't possess these skills.  Also as the article notes:

"These are the very opportunities that private-equity firms exploit, capitalizing on the market’s impatience for such undertakings."

So from my perspective, there is nothing unusual about specific types of investors being adept at different approaches.  Both articles offer a lot of food for thought and are well worth reading.  

All the best,

Ralph

Offense and Defense - The Evolution of Takeover Strategy and Defense

One of the hot topics of today's acquisition climate is the role of activists.  While activism has been a hot topic before the situation today is a  bit different, with many boards actively listening to activists.  It is another step in the give and take of corporate acquisitions between bidders and targets.  In fact, the recent history of acquisitions reveals the continually evolving offensive and defensive strategies.   Consider just a bit of the historical give and take (not in exact order but close):

• Hostile takeovers were big in the 80's.  
• Poison Pills are invented by Marty Lipton (Enstar 1982)
• Acquiring firms started using junk bonds to finance deals.  Even large companies were vulnerable
• States enacted anti-takeover statutes to slow down hostile deals.  
• Courts strike down many of these statutes.
• States revise anti-takeover statutes to be in conformity with the law 
• Poison pills become a bit more popular
• Poison pills are challenged in the courts (Household International)
• Courts uphold poison pills (November 1985)
• Poison Pills become widespread. 
• Hostile deals decline
• Shareholder activism picks up but doesn't capture great momentum (Mid - 90's)
• Governance Scandals rock the corporate world (Enron, Worldcom)
• Sarbanes Oxley is passed
• Boards become independent in response to the law
• Shareholder advisory services gain influence (Institutional Shareholder Services)
• The financial crisis occurs
• Dodd Frank is passed
• Shareholder activism picks up speed - boards start to work with activists

Stay tuned.  It's a rapidly changing world.

All the best,

Ralph

Shareholder Activists: The Empire Strikes Back

Activists have become victims of their own success. The number of activist campaigns is near 300 this year-the highest level in years. Furthermore, their success rate is increasing as is the funds under management by such investors. These facts have an out-sized fear factor impact on corporate America. Consequently, they and their shills, Harvard Business Review, New York Times and corporate law firms inter alia, have attacked activists as being responsible for income inequality, slow growth, under investment, and reduced competitiveness. I think they will also be blamed for global warming. Let’s look at some of the charges.

The first attack is activists are not long term shareholders and thus do not seek to advance the firm’s long term interests. Consider the following:

1)     There is no evidence activists are short term investors.

2)     Even if they are-so what? Firms are valued based on the market investment horizon-T- and not on the investor holding period. Does the value of your home depend on whether you own it for 1 year or 5 years?

3)     Long term is used as an excuse for lagging short term performance. Remember, the longer you must wait for value, the more value you must receive.  It is as if the steepness on your treadmill increases. Look at what happened in Japan with their massive over investment in the 1980s, and what may be happening in China now. The size of the investment should be proportional to the expected long-term risk adjusted cash flows. Companies not following this rule like Nokia and Blackberries end up destroying wealth unless stopped in time by activists or the board.

4)     The short termism frequently seen at under- performing firms concerns the perversion of incentive compensation schemes by management and a compliant board toward short terms measures like EPS and earnings growth.

The next attack states that returning funds to shareholders via dividends or stock repurchases instead of reinvesting the funds in the firm is harmful to the firm and the economy. This is related to #3 above. The argument is more investment, regardless of its risk adjusted return, is better. This mistaken approach neglects, or should I say mistrusts, the role of capital markets. If a firm cannot earn enough to cover its cost of capital, then the excess funds it has should be returned to shareholders. Over investing in under-performing projects helps no one-the economy, the employees or the firm. The funds returns do not sit idle. They are reinvested and recycled into new more productive endeavors as part of the creative destructive process.

The last attack is that firms should not be managed solely for the benefit of its shareholder owners, but more broadly for all stakeholders. The problems with the stakeholder theory are as follows:

1)     Faulty premise: long term wealth creation is not based upon the exploitation of stakeholders. Communism is dead. Stakeholders, whether they are employees or suppliers have alternatives.

2)     Which stakeholders and who chooses what they get?  This is a political issue best left to the political process and not CEOs.

3)     Capital goes where it is welcome and stays where it is treated well. Taking from shareholders will always be supported by the “takees”. The result will be a higher cost of capital and less wealth for all.

4)     A simple clear objective is needed to hold management accountable. It is no wonder managers like stakeholder theory. If you are accountable to everyone, then you are accountable to no one.

Bottom line, activists may be rough around the edges, and you may not want them going out with your daughters. Nonetheless, they provide a valuable check on managerial excesses. The problem is not with the activists, but with the breakdown of the internal control system i.e. the board, which typical gets captured by management.

Sorry for rant, but these attacks are totally baseless. The empire should just be honest and say ”let them eat cake”.

J