Review and Analysis of 2017 U.S. Shareholder Activism

Melissa Sawyer is a partner at Sullivan & Cromwell LLP. This post is based on a Sullivan & Cromwell publication by Ms. Sawyer, Marc Treviño, Lauren S. Boehmke, and Korey R. Inglin. 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); Dancing with Activists by Lucian Bebchuk, Alon Brav, Wei Jiang, and Thomas Keusch (discussed on the Forum here); and The Agency Problems of Institutional Investors by Lucian Bebchuk, Alma Cohen, and Scott Hirst.

Shareholder activist hedge funds grew modestly in 2017, not yet restoring global activist fund assets under management (“AUM”) to 2015 highs. Moreover, the rate of formation of new activist funds continued to decline, and the “winners” in this environment—those activists attracting the most new capital—seemed to be the well-established activists with strong brand names and track records of outperforming the market. Mirroring this development in fundraising, 2017 also saw a resurgence of campaign activity by frequent activists. Notably, these frequent activists appeared to focus on the largest companies, with activists targeting large-cap companies in over 21% of all campaigns (up from 19% in 2016). Large-caps like P&G, GE, General Motors, Nestle and ADP became notable targets. Despite this increased activity by frequent activists, the overall number of proxy contests and the number of board seats sought by activists both declined during 2017, continuing similar declines observed during 2016.

Meanwhile, the concentration of ownership among the largest passive institutional investors continues to grow. The three largest index fund providers (BlackRock, State Street and Vanguard) now own about 18.5% of the S&P 500 (compared to 14.7% in 2013), and the top ten institutional holders own over 30% of the S&P 500. In contrast, retail holders now hold less than 30% of the S&P 500. Although retail share ownership at smaller market cap companies remains slightly higher than at the largest companies (e.g., 38% at companies with market capitalizations between $300 million to $2 billion), it also continues to decline, consistent with the overall trend.

With the growing size of the index fund providers’ stakes, an activist now only needs to convince a handful of holders (as opposed to hundreds) of its attack thesis. For example, if an activist can accumulate a significant stake of an issuer in which Vanguard, State Street and BlackRock each own a large percentage, then the top four holders would control such a large portion of the outstanding shares that the top 10-12 investors alone could determine the outcome of a shareholder vote. This is particularly the case if the matter to be voted on, such as the election of directors, requires approval of only a majority or plurality of the shares voted rather than a majority of the shares outstanding, because the average percentage of shares voted (even in a contested election) is below 85%. Retail holders, who suffer from a collective action problem, historically have been less likely to vote and may become even less inclined if they perceive their votes as irrelevant to the outcome.

Well-known activists often develop relationships with significant institutional holders because they have communicated with these investors in prior activist campaigns and maintain a regular dialogue. In comparison, issuer management teams and directors may have fewer or more limited relationships with institutional investors, especially passive asset managers and voting teams at active managers. While many issuers have engaged in significantly more outreach to the largest institutions as part of an increasingly proactive and routinized shareholder engagement calendar, they are not always successful in reaching their audience. This is especially the case at smaller-cap issuers who, despite at times hiring sophisticated advisors to assist with investor relations, may struggle to secure meetings with the portfolio managers and governance teams at the largest funds who have limited resources to engage in routine update meetings with the thousands of issuers in their portfolios.

This potential asymmetry of access by issuers and activists to institutional investors is supported by observations from the 2017 activism landscape. First, index funds showed an increased willingness to support dissidents in complex and consequential proxy contests, perhaps because with better access to the index funds, the activists were able to convince the funds of the merits of the dissident slate (e.g., BlackRock supported Pershing Square at ADP). Second, the resurgence of the most prolific activist investors in 2017 may not be solely related to their brand names and fund raising efforts. It also may be partly attributable to the fact that they may have deeper relationships with certain institutional investors, thereby increasing the likelihood of success in any particular campaign.

There is a further hidden cost in the growth of passive investing in that index funds by definition do not make judgments about the businesses or operations of the issuers whose shares they hold. Moreover, expense management in the index fund industry, where margins are already very thin, requires that they focus on voting principles that are scalable and more likely to be “one-size-fits-all” or at least easily and objectively comparable across peers. The result has been index funds and other large asset managers using relative share price performance (such as total shareholder return statistics) and relative executive compensation metrics issues as the key parameters for guiding their voting behavior. Additionally, index funds, public pension funds and large activists alike place a strong emphasis on environmental, social and governance (“ESG”) parameters.

Indeed, these institutions have given activists and issuers alike clear guidance about their ESG engagement priorities. In 2017, ESG issues played a prominent role in the passive investors’ public discourse, with the index funds’ CEOs making public statements on investment stewardship principles and the index funds publishing annual reports articulating more aggressive stances on issues like gender diversity on boards and climate risk. At times, the index funds have even openly targeted specific issuers on these issues. For example, BlackRock has urged oil giant ExxonMobil to be more open about the effects of climate change on its business and criticized its directors’ lack of engagement with shareholders. When combined with the parallel focus of pension funds and other large activists, the index funds’ focus on ESG has influenced the discourse in corporate governance circles to a large extent, even catalyzing explicit updated voting policies from the proxy advisory firms Institutional Shareholder Services (“ISS”) and Glass Lewis.

Unsurprisingly, the index funds’ focus on ESG has caused some activists to start to tack toward ESG topics. Activists now not only have additional avenues to launch ESG-based attacks on companies but also a potential path to distinguish their fundraising efforts and appeal to pension funds and other asset managers. Jana Partners, for example, announced that it is raising funds for a new sustainability fund—an announcement that gave emphasis to Jana’s and CalSTERs’ joint campaign at Apple to institute more parental controls on iPhones.

Not to be overlooked was the clear message that BlackRock’s Larry Fink delivered in his 2018 annual letter to CEOs (the “BlackRock CEO Letter”) in which he admonished issuers to be focused on and prepared to speak to investors about long-term strategy. [1] It still remains to be seen whether institutional investors will reward issuers who comply or hold activists to the same standard of having to articulate a viable long-term strategy for the targets of their campaigns. Recent index fund criticism of “short termism”—i.e. institutional investor criticism of issuers’ swift settlements with activists—did not have a significant impact on the outcome of activism contests in 2017. More than a third of activist campaigns in 2017 resulted in settlements, which is on par with the rate of settlements in 2016, and the speed with which issuers and activists reached settlements in 2017 was, on average, comparable with 2015 and 2016.

In this environment, ISS has continued to maintain its “what’s the harm” approach to voting recommendations in activists’ short-slate proxy contests, whether or not the activist presents shareholders with a viable long-term alternative to the issuer’s strategic plan. The results of ISS’s approach are predictable. Activists are now obtaining board seats at a record rate as a percentage of the overall number of proxy contests—activists won an additional 76 board seats in 2017 alone, raising their five-year total to 642. These directors are also staying on the boards for long periods of time. Since 2010, prominent activist fund insiders who became directors following a settlement agreement stayed on the relevant board for an average of approximately two years longer than the minimum provided for in the settlement agreement, and many insiders in this subset were still on the relevant board at the time of review.

Finally, an important and growing consequence of activism is its nexus with M&A. Activists both catalyze deals (in some cases, by creating a welcoming environment for unsolicited acquisitions) and hold up deals by engaging in so-called “bumpitrage.”

Activist agitation has been the genesis for numerous strategic and sale processes, with the activists promoting the M&A alternative, whether a divestiture or a whole company sale, as a “fix” for underperforming businesses. In this environment, 2017 saw a dramatic uptick in unsolicited M&A, with 80% of “friendly” M&A being initiated by bidders rather than targets conducting planned sale processes. Acquirers are able to leverage the disruption engendered by activists, a phenomenon observed at Buffalo Wild Wings, BroadSoft, Parexel, SeaWorld and Whole Foods. In some cases, activists also pressure companies to consider unsolicited takeover bids, as was the case with PPG’s ultimately unsuccessful bid for AkzoNobel, which was supported by Elliott Management, and Land & Buildings’ pressure on Hudson’s Bay to consider Signa’s bid for its German retail business.

For any announced M&A transaction, there is the threat of having shareholder approval of the transaction held up by an activist seeking a higher price. Activist pressure resulted in the scuttling or sweetening of multiple M&A deals that were poorly received by investors in 2017, including SandRidge/Bonanza, Huntsman/Clariant, Qualcomm/NXP, Bain-Cinven/STADA, Safran/Zodiac, KKR/Hitachi Kokusai and GE/Arcam. For example, in EQT/Rice Energy, Jana Partners sought to terminate the deal outright, arguing that the dealmaking was motivated by a desire to maximize production growth, the key metric that formed the basis of EQT’s executive compensation plans, rather than a desire to secure earnings growth.

Trends and developments in shareholder activism in 2017 portend another busy year for activists and issuers alike in 2018.

Endnotes

1See Larry Fink’s Annual Letter to CEOs—A Sense of Purpose (available at: https://www.blackrock.com/corporate/investor-relations/larry-fink-ceo-letter, discussed on the Forum here.)(go back)

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