Activism in 2018

Ethan A. Klingsberg is a partner and Elizabeth Bieber is an associate at Cleary Gottlieb Steen & Hamilton LLP. This post is based on a Cleary Gottlieb publication by Mr. Klingsberg and Ms. Bieber. Related research from the Program on Corporate Governance includes The Long-Term Effects of Hedge Fund Activism by Lucian Bebchuk, Alon Brav, and Wei Jiang (discussed on the Forum here); and Dancing with Activists by Lucian Bebchuk, Alon Brav, Wei Jiang, and Thomas Keusch (discussed on the Forum here).

Two years ago, we explained to clients that the shareholder activism landscape was undergoing significant change. Returns at many of the “brand name” activist funds were down, companies had become savvier at messaging to their investors about why their positions on areas of activist focus were well-founded and, in numerous cases, companies had preemptively taken steps to adjust their strategic plans to be consistent with the approaches that activists would take.

Many clients remained on high alert, but they were regularly encountering “false alarms” when famous activists would show up in their profiles after the quarterly Form 13F filings and generate media buzz, but the investment would turn out to be for purposes of liquidity rather than influencing management. In addition, a number of clients received requests for meetings or telephone calls with activist investors, only to realize later that the investor was primarily interested in gathering information for purposes of macro-economic analysis, rather than as a first step in launching a campaign.

Meanwhile, the letters and inquiries to clients from actively managed (but not “activist”) funds—such as T. Rowe Price and Neuberger Berman—became increasingly pointed and urgent, focusing on the areas that were traditionally the turf of the high-profile activists—allocation of capital, strategic alternatives and separation of parts from the whole. We regularly heard from investor relations personnel about how the actively managed funds were loyal long-term investors who “love us,” and then these letters would arrive. We anticipated, at the time, a new era of “activism by traditional long-term holders” and the fading of the celebrity activists.

While activism, including threats of proxy contests, by the traditional, actively managed institutional funds is now becoming increasingly commonplace, the brand name activists are back. Their tools (white papers and threatened and actual proxy contests) remain the same. But they have shifted their time horizons and initial focus. The activists are now regularly holding investments for four to five years and focusing more consistently during the initial years of their investments on advocating for operational turnarounds. A push for a sale of the company remains a favorite solution, but many activists are prepared to maintain their investments for a few years before this alternative becomes an urgent, best next step. In addition, while campaigns to force out management still exist, the focus initially is now more typically on the need to refresh the composition of the board.

The activists had no choice but to adapt to this new, longer-term approach because companies susceptible to quick fixes—such as a spin-off or sale of a division, a leveraged recapitalization or a sale of the company to a cash-rich competitor—had largely disappeared due to preemptive actions by boards that had learned to “think like an activist.” Moreover, the market has made it worthwhile for the activist funds to adapt. Not only are assets under management for activist funds at an all-time high, but we are now seeing activist groups able to raise large, special-purpose funds for a specific, multi-year investment on short notice.

Another change in hedge fund activism is traceable to the shift of approximately $5 trillion over the last 10 years in the United States from actively managed funds to index and other passive strategy funds. This shift is causing not only companies, but also the activists themselves, to appeal to the longer-term and often structural and governance-oriented concerns of the passive strategy fund shareholders. Activists are now fluent in issues of “diversity of tenure,” “gender, race and age diversity,” “board skillset matrices” and provisions in charters, bylaw and governance guidelines that “good governance” advocates find compelling.

The activist hedge funds will shamelessly lace their communications to companies with references to these issues as a way to signal that they intend to round up the passive strategy funds and others in the “good governance” community to support their campaigns. At the same time, we are spending more time working with clients to refine their messaging and strategy in these areas, including through regular by-law and governance guideline upgrades, off-cycle governance roadshows that include meetings with the leading passive strategy funds and improvements to their disclosures in the annual meeting proxy statement, sustainability reports and other shareholder communications.

The battle for the votes and loyalty of the passive strategy fund shareholders will continue to be hard fought for the next several years. We often see tensions between what actually drives the voting decisions of the ETFs and index funds in contested situations versus the statements made on behalf of these passive strategy funds in well-publicized annual letters, in published guidelines and by their governance-oriented spokespersons at conferences. Moreover, the recommendations of ISS and Glass Lewis are no longer sufficient to lock up the votes of the passive strategy fund shareholders.

We cannot emphasize enough how precarious these relationships with the passive strategy funds may become during an activist campaign and, despite signs that all is well during “clear days,” how important it is to nurture these relationships whether or not a company’s shareholder profile has signs of activist hedge fund interest.

The settlement vs. fight calculus has become tougher as well against this backdrop. The significant growth of index funds means that the 10 top institutional holders of the stock of U.S. publicly traded companies will increasingly hold over 40 percent or even 50 percent of the voting power—making it relatively easy for shareholders to be led in an efficient revolt against incumbents if the company’s relationship with these holders is not solid. In addition, when settling with an activist, companies ought to have an action plan in place to explain to this group of 10 top institutional holders why the terms of the settlement with the activist and its implications for the company’s strategic direction are in their best interest.

The fickleness of top institutional holders colored the recent “victories” by ADP and Procter & Gamble (and earlier by DuPont) against the short-slate proxy contests run by Pershing and Trian. These proxy contest “wins” not only cost these companies millions of dollars, but also left the boards having to digest voting data that indicated that very significant percentages of their institutional investors, including several top holders at each company, did not support the management slate (and, by implication, the strategic direction and leadership of the company) and, in the case of Procter & Gamble, resulted in the voluntary appointment of Nelson Peltz to the board. Moreover, and perhaps most importantly, the activists do not just go away after these votes; they continue their pressure and campaigns and often end up “winning the war while losing the first battle” as boards end up pushing back against plans that stick to the status quo.

Additionally, on the settlement front, the activist funds have been increasingly open to backing off in exchange for the appointment of directors with industry experience, as opposed to demanding that one of their funds’ own founders or other senior employees join the board. Companies are frequently open to having these well-regarded individuals join their boards (and, in fact, are sometimes grateful for the catalyst to board refreshment provided by the activists). In many instances, these new outside directors energize, contribute to and build new bridges within the boardroom.

In the same vein, we have found that senior executives have largely come around to accepting that their boards will inevitably include strong personalities and leadership experience that will not translate into easy deference to management. Outside directors are more eager than ever to critically analyze strategic decisions and corporate governance and no longer view embracing activist ideas as a taboo.

Against this backdrop, management teams, including the legal department, have an opening—and indeed are under pressure—to assure their outside directors that they have all material information about and analyses of the strategic plan, that messaging to investors about the long-term plan and goals is well-articulated and not neglected due to over-focus on short-term guidance, and that the spectrum of governance “hot buttons” is being addressed by the company in a thoughtful manner. Taking up this challenge is the best preparation for and defense against activism.

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