An Introduction to Activist Stewardship

Robert G. Eccles is Visiting Professor of Management Practice at Oxford University Said Business School; Aeisha Mastagni is Portfolio Manager within the Sustainable Investment & Stewardship Strategies Unit at the California State Retirement System (CalSTRS); and Kirsty Jenkinson is Head of Sustainable Investment & Stewardship Strategies at CalSTRS. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance by Lucian A. Bebchuk and Roberto Tallarita (discussed on the Forum here); Companies Should Maximize Shareholder Welfare Not Market Value by Oliver Hart and Luigi Zingales (discussed on the Forum here); and Reconciling Fiduciary Duty and Social Conscience: The Law and Economics of ESG Investing by a Trustee by Max M. Schanzenbach and Robert H. Sitkoff (discussed on the Forum here).

The time has come for “activist stewardship.” Simply put, this means putting the skills and techniques of activist hedge funds to work where a company’s financial performance is deteriorating and traditional engagement tools have failed to produce meaningful results to protect value and mitigate long-term risks, including recognizing the importance of environmental, social, and governance (ESG) risks. Historically, ESG issues have been the province of the engagement and stewardship group in the asset manager due to their importance in creating value over the long-term. These groups have sought to change corporate behavior through private, constructive conversations. Large asset managers, including asset owners who manage their own assets, have been rapidly increasing their commitment to engagement and, more broadly, to stewardship activities including proxy voting and advocacy work with regulators and policy makers.

Despite this growing commitment to engagement, there are some companies who remain absolutely implacable after years or even decades of efforts by their shareholders. We call them “Corporate Castles.” They are uninterested in engaging with their shareholders, let alone stakeholders. They have drawn a moat around their corporate walls and are exercising every means at their disposal to persist in their practices, even as their financial performance declines and the negative externalities they are creating in the world persist. For such companies, the traditional tools of engagement, typically used in selective and discrete fashion, are simply not effective.

Investors have two choices for dealing with such companies. One is selling the stock. For many investors this is a sensible option. Why waste resources on trying to get a company to change, even when it’s for its own good, as its financial performance deteriorates even as executive compensation remains high? A deterioration for which the board bears ultimate responsibility, either because it doesn’t understand why and how the company needs to change, or does but can’t sum up the courage to confront the CEO (who, in the U.S., is often also the Chair). By selling the stock, the investor transfers the problem to another investor. There is no shortage of buyers in the marketplace and often the new buyer cares less about these long-term issues. They can either try to engage or just hope for the best.

Selling the stock is not an attractive proposition for a “universal owner.” In “Universal Ownership in the Anthropocene” Ellen Quigley at the Centre for the Study of Existential Risk at the University of Cambridge explains that “the Universal Owner owns a more or less representative slice of the economy and cannot reasonably sell out of individual companies whose activities add costs to the balance sheets of other companies in its portfolio.” In other words, a universal owner must be concerned about system-level effects like climate change and income inequality since it cannot diversify away from them. If the State of the World is destabilized, the universal owner cannot earn the beta it requires to meet the needs of its beneficiaries.

Universal owners have to deal with a company at two levels. The first is the company itself and the second is the negative contribution the company is making to the investor’s ability to earn returns across its own portfolio. Activist stewardship addresses both levels. It is a way of getting the changes necessary to improve the company’s financial performance. It also makes the company an example to others, in its industry and beyond, where declining financial performance and negative externalities are mutually reinforcing.

Exercising activist stewardship on a Corporate Castle starts with getting the castle guard’s attention, whether through the media or proposing an alternative slate of a critical mass of board directors. Because the company has resisted all reasonable entreaties for a prolonged period of time, the only way to effect the changes necessary requires substantial changes on the board. After all, the current board has been complicit for many years in not requiring management to engage with investors, and typically board members haven’t done so either. A reinvigorated board can then press the CEO, potentially a new one, for a substantially new strategy which results in changes in capital allocation, new metrics for measurement and reporting (through integrated reporting) and a compensation system tied to these metrics, and perhaps other changes in the executive team. For sure the Chairman and CEO needs to be split if it isn’t already. The new board should also publish and individually endorse a “Statement of Purpose.”

An example of activist stewardship is the “Reenergize Exxon” campaign being spearheaded by Engine No. 1, “an investment firm purpose-built to create long-term value by harnessing the power of capitalism” which believes that “a company’s performance is greatly enhanced by the investments it makes in workers, communities, and the environment.” It has put an alternative slate of four board directors with substantial experience in the energy industry. Although its investment in ExxonMobil is a modest one of $40 million it has the support of the California State Teachers’ Retirement System (CalSTRS) which owns $300 million of the company’s stock.

CalSTRS is a prime example of a universal owner. It is the second largest pension fund in the U.S. with approximately $275 billion in assets as of November 30, 2020. It provides retirement benefits to California’s public-school educators from prekindergarten through community college. It has 975,000 members and beneficiaries. CalSTRS has a fiduciary duty to meet the retirement needs of its members, a liability that extends 30, 50, or even 100 years into the future. Today CalSTRS has 300 members collecting pensions who are over 100 years old.

Although ExxonMobil is famous for decades of denial that climate change is real and largely a result of human activity, the campaign is not fundamentally a climate argument. It is an economic one and summarized in “Can a Tiny Hedge Fund Push ExxonMobil Towards Sustainability.” Today the company’s market cap is around $190 billion, down from its peak of $528 billion on December 24, 2007, but up from its trough of $139 billion on October 26, 2020. One of the reasons for this destruction of shareholder value, as noted in an open letter on of December 7, 2020 from Engine No. 1 to Exxon’s board of directors is the decline in Return on Capital Employed (ROCE) on the company’s Upstream projects. Historically these have accounted for over 75% of total capital expenditure. ROCE) has fallen from an average of around 35% from 2001-2010 to around 6% from 2015-2019.

While other oil & gas companies, such as BP and Shell, have recognized that climate change requires them to change their business models to lower carbon sources of energy, ExxonMobil has continued to drill for oil. It has done so as the world is increasingly passing it by in recognition of the needed energy transition to keep global warming less than 2° C. Feeling secure behind its corporate castle walls that have eschewed any meaningful engagement with its shareholders, ExxonMobil has destroyed over $250 billion in shareholder value, a decrease of about 2.5, during the time that the S&P index has increased by a factor of 2.5.

For CalSTRS, ExxonMobil is problematic at both the company (loss of shareholder value) and the system (puling high carbon assets out of the ground) level. This is why it is supporting Engine No. 1’s campaign. It sees this campaign as its first foray into the practice of activist stewardship. The result of this campaign will be known on May 27, 2020 at the annual shareholder meeting. In the meantime, CalSTRS is working on developing its model so that it can be substantially scaled in order to address the many environmental (e.g., global warming, loss of biodiversity, and plastics in the oceans) and social (e.g., racial, gender, and income inequality) that will make it difficult for its entire portfolio to deliver the necessary returns to fund the retirements of its beneficiaries. Here the work of The Shareholder Commons is proving very useful.

While still in the early stage of development, the model for activist stewardship contains the following elements:

  • The lead investor who identifies the target Corporate Castle. This will require identifying a small set of companies in any given industry that are likely candidates and then determining which one is best for the campaign. This will require extensive analysis and funding for this may be required
  • The army of investors (could be few but mighty) who will support attacking the castle walls. Ideally this will include some of the largest asset managers and perhaps a hedge fund or two
  • NGOs and other stakeholder representatives who can be marshalled to apply pressure
  • A funder source to provide the resources to develop the holistic approach. Initially this could be foundations, and this will be very bespoke by their interests. Eventually it would be good to have a permanent source of capital where there is broad discretion in how it is applied. Perhaps find a hedge fund manager looking for redemption.
  • The organization to do the financial analysis and partner on developing the holistic approach.
  • The law firm(s) for the necessary legal work
  • The executive search firm(s) for identifying the slate of new executives and directors
  • The appropriate media outlets who can amplify the message

The “Reenergize Exxon” campaign is the pilot for further developing the idea of Activist Stewardship. We will learn from this experience and others to come. For sure there will be others. History is littered with companies whose executives and management failed to recognize the need for a fundamental change in their business model. Eastman Kodak and Blockbuster are storied case studies. While these are industry specific examples, almost every industry is facing fundamental challenges due to the need to transition to a net-zero world and adapt to other system-level risks such as income inequality.

Companies with visionary leaders and competent boards will recognize the need to change, however difficult and painful it might be. Many, due to a combination of ignorance, obstinance, arrogance, and unwillingness to constructively engage with their shareholders, will not. These companies will need the tough love of Activist Stewardship. Our goal is to create Activist Stewardship capabilities at scale in order to ensure that companies deliver the returns required by those who depend upon them.

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One Comment

  1. Adalberto Vianna
    Posted Thursday, March 4, 2021 at 10:48 am | Permalink

    These words are like a bug fixing in my stewardship purpose:
    “… a universal owner must be concerned about system-level effects like climate change and income inequality since it cannot diversify away from them. If the State of the World is destabilized, the universal owner cannot earn the beta it requires to meet the needs of its beneficiaries.”

    and, “The first is the company itself and the second is the negative contribution the company is making to the investor’s ability to earn returns across its own portfolio.”

    Thank you so much.
    Adalberto Vianna