The activist generation

Shareholders on both sides of the Atlantic are getting more aggressive, writes Selwyn Parker

 
 

When Elliott Management appeared on the share register of Hess Corporation late last year, the family-dominated American oil company, it was not good news for John Hess, chief executive, chairman and son of the founder.

It did not take long for his worst fears to be realised. In May, pressure from Elliott, an arm of one of America’s oldest hedge funds, forced Hess to relinquish the chairmanship and accept the appointment of eight new directors – three nominated by Elliott and five recruited from outside by Hess. In the boardroom turntable, five Hess-appointed directors had to make way for the newcomers. At the end of the exercise, the power of the founder’s son was substantially reduced.

And Elliott Management, ultimately controlled by hedge fund legend Paul Singer, achieved all this with just 4.5 percent of the company’s shares. Yet it was a big enough stake to launch a proxy battle with the goal of splitting Hess into two companies – one based on property and the other on its extensive shale-rock real estate, a valuable asset for an oil explorer. Although the founder’s son was able to head off the split, he had to bow to the boardroom revolution. As a family source told the Wall Street Journal, the entire episode was “a near-death experience for John and the whole company.”

Welcome to increasingly aggressive minority shareholders, and not just in the US. The same phenomenon is showing up in Europe in the wake of the financial crisis, but as Hess Corporation learned, the US is leading the way. As Stephen Arcano, an M&A expert at US law firm of Skadden, Arps, Slate, Meager & Flom, pointed out in late June, shareholders are becoming more unsentimental: “Shareholder activism in the US has increased significantly over the past several years, with activist campaigns targeting well-known, large, market capitalisation companies.”

And although many of the disputes involve legal wrangling over the technicalities of mergers and acquisitions, the new breed of minority shareholders are deploying forensic analysis to force change in numerous other ways. Earlier this year, Apple agreed under pressure to return some of its $137bn hoard of cash to shareholders in the form of preferred stock after hedge fund Greenlight Capital mounted a campaign. Although chief executive Tim Cook called the issue a “silly sideshow”, he has issued debt as a first step recognising that the investor has a case.

No immunity
No company, however big, is immune. In June, Bob McDonald, the long-serving chief executive and chairman of Procter and Gamble, stepped down after a campaign led by Paul Ackman, a particularly aggressive shareholder with a $1.8bn stake, who argued among other things that McDonald served on too many boards to devote his full attention to the consumer durables giant.

In these campaigns, the activist is often looking for headlines. Ackman claimed the chief executive was on 21 boards and only spending 75 percent of his time on the company’s affairs. As a Procter and Gamble spokesman pointed out, McDonald served on only one board but had other trade association commitments.

But the trend is clear. “At the moment shareholder activism is exerting considerable influence in the M&A and corporate governance areas”, adds Arcano. “In this evolving landscape, public company boards and managements need to be aware that virtually any company is a potential target.”

Several factors have conspired to bring about this situation. Some of the bigger shareholders, and especially hedge funds, are tapping sophisticated lines of credit known as “dry powder” to acquire larger blocks of stock. With these in hand, they are in a position to march into battle.

Institutional shareholders are also gingering up their portfolios by buying into activist funds. By doing so, they get two bites of the cherry – above-average returns (Elliott Management has posted average gains of over 14 percent in the last 35 years) and a good chance of better performance from their bread-and-butter investments (such as Hess Corporation) if the activists prove to be right. For the institutions, these fearless funds provide another tool in the investment armoury.

Breeding
And finally, activist shareholders are breeding. Known as “sons of activists”, a whole new generation of hard-nosed funds have been launched by investors who cut their teeth in the pioneering firms. There’s even a sub-branch known as “operational activists” who don’t just sit on the sidelines. Having mounted an argument, they are prepared to roll up their sleeves and do some of the donkey work in, say, repairing a poor-performing subsidiary while of course earning extra fees.

The current generation come to battle well-armed. As Greenlight Capital’s David Einhorn showed, they routinely do such highly detailed research that some know more about the company than do the boards. Often enough the argument is that a company should sell an asset – or even the entire company – and thereby enrich shareholders. It’s this kind of tactic that has earned some activists a reputation as short-term opportunists.

Class actions
But generally they rush into the fray over mergers and acquisitions. In a vast study of M&A transactions over the last four years by Cornerstone Research’s Olga Koumrian and Stanford law school’s professor Robert Daines, they show that many of these deals are challenged through class actions. The objection follows a familiar route: “Plaintiff attorneys typically allege that the target’s board of directors violated its fiduciary duties by conducting a flawed sales process that failed to maximise shareholder value”.

American commercial law being what it is, there’s quite an array of possible objections. Among others the plaintiffs can claim the sale process was not sufficiently competitive, conflicts of interest such as bonuses for the executive team, restrictive conditions, and insufficient disclosure (very common). In 2012, shareholders challenged the vast majority of M&A deals over $100m by value. In fact, 93 percent of deals ran into objections with each one attracting nearly five lawsuits apiece.

And the bigger the deal, the bigger the rate of objection. “For deals over $500m, 96 percent of target firms reported deal-related litigation in their SEC filings, with an average of 5.4 lawsuits per deal,” the researchers found. The trend has been rising for years. In 2009, 85 percent of M&A deals over $100m encountered the legal ire of shareholders compared with 93 percent in 2012.

And the winners? Generally, it’s lawyers. Most of the suits were settled when the firm in question provided more information about the deal and the plaintiff attorneys walked away with more fees. The average agreed attorney fee last year was $725,000.

El Paso
But where the courts agree with the plaintiff’s case, settlements have been growing in size. Take conflict of interest, a common trigger for a suit. When Kinder Morgan bought El Paso, the natural gas group, for $21.1bn in late 2011, the target’s adviser was Goldman Sachs’ investment banking arm. However the same firm’s private equity division not only owned 19 percent of Kinder Morgan but had two appointees on its board. Result? Criticising the failure to fully disclose conflict of interest, the court ordered Goldman Sachs to forgo $20m advisory fee.

Activism has crossed the Atlantic. In March, a shareholder revolt forced Daniel Vasella, the retiring chairman of Switzerland’s pharmaceutical giant Novartis, to give up his CHF 72m [€59m] golden handcuffs. Never mind that Vasella was been a considerable success during his long tenure.

The writing’s on the wall. As international law firm Slaughter and May points out, “shareholder activism by institutional investors [in Europe] with a longer-term horizon and other investors with a more strategic agenda has seen an increase.” Favourite target companies are in industrial, technology, consumer, food and retail sectors.

Dialogue
So how should companies deal with aggressive shareholders? As consultants point out, boards have a legal obligation to pay due attention to the interests of shareholders, which involves inviting them inside the door and listening to their arguments. It’s called shareholder diplomacy – and both parties learn from it.

Highly leveraged hedge funds with a self-serving proposal are a different matter. They can in fact be shown the door, but if a company elects to hear what they say, consultants strongly advise them to do so in a strictly formal setting – and to take notes immediately afterwards.

But if the shareholder genuinely has the interests of the company – and the shareholding – at heart, dialogue is the key. As Arcano explains, “companies need to maintain an effective, ongoing shareholder outreach program. The strength of the relationship with shareholders and whether shareholders trust management can make all the difference in the world if an activist situation emerges.”

In short, it’s too late to reach out to shareholders only after Elliott Management or some other activist fund has started an argument.

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