What CEOs Get Wrong About Activist Investors

May 1, 2018 Frank Partnoy

may18-01-737369307-Benjamin Harte
Benjamin Harte/Getty Images

We were shareholder activists once. For two years, we conducted an activist campaign at Tejon Ranch, the largest private landowner in California and a publicly traded company. We earned a 13% return — not bad by industry standards — but we failed to change the company much. We wrote about our adventure nearly a year ago in The Atlantic, but as we thought more about our interaction with Tejon Ranch’s managers, we realized there were valuable lessons that we wanted to share with the corporate leaders who are likely to confront the risk of an activist campaign.

We still believe the executives at Tejon Ranch made some mistakes, as did we, but our biggest collective mistake was thinking in terms of threats rather than opportunities. Like so many managers today, they responded to shareholder activism defensively. Then, as is also typical of activists, we felt boxed in and went on the attack. As the tension built, the chance of working together positively and constructively to add value for the benefit of all shareholders slipped away. Our activism became, as it often does, a zero-sum game, in which the activists’ win is the company’s loss, and vice versa. The potential for a true alliance fizzled as the battle was joined.

We have written extensively on shareholder activism, and one of us coauthored a study in the Journal of Finance showing that, on average, activists produce value for targeted companies. Because of the empirical evidence, and also as a result of our experiences and observations, we believe that instead of viewing shareholder activists as meddlesome outsiders, managers should view them as a source of potential value — albeit one with both great potential risk and cost. After some reflection, and many conversations with managers, employees, and shareholders about our campaign, we wanted to offer our insight.

Think Positive: Where Does the Activist Fit as a Shareholder?

One popular view of activists is that they are short-term, cut-and-run operators who are looking for a quick profit. Yet our empirical research shows that the median activist holding period is greater than one year (as was ours). By contrast, World Bank data suggests that the average holding period in 2015 for public company shares globally was just over seven months.

To their credit, Tejon Ranch management was initially welcoming and agreed to meet with us in person. The team was polite and respectful. They were also cautious. They seemed surprised, for example, that we had performed a detailed valuation of their various business segments and had a specific set of suggestions for how they could help investors see that the company’s stock was undervalued. But they also seemed genuinely open to hearing what we had to say. Though the talks weren’t always smooth, and management never took the substantive operational steps we requested, the company ultimately improved some of the practices we complained about: Today, Tejon Ranch’s disclosures are more robust and its managers are more investor-friendly, with increased time at road shows and improved dialogue.

In contrast, many activist interventions turn nasty from the beginning, and the early tensions can easily close off the potential for constructive give-and-take. Moreover, early hostility can make any later proxy fights and recriminations seem inevitable. Indeed, any chief executive has good reason to fear an activist. Think of how often activists have pressed for the sale and restructuring of firms and for the dismissal of CEOs. One reason stock prices increase so much when activism is announced is that market participants perceive an increased probability that the company will be sold at a premium, or at least be shaken up.

But managers shouldn’t assume that activists are targeting them personally. Activists are significant shareholders. If they can help boost the stock price by working with current management, they are often happy to do so. We understand why CEOs may feel defensive about the announcement that an activist has acquired a large stake, particularly if the activist has a scorched-earth track record. But the best strategy, at least initially, is to welcome any input activists can provide and balance it against the interests of other shareholders and stakeholders.

The traditional metaphor for activism has been that of a battle: shareholders versus managers. This narrative dates back to the “separation of ownership of control” thesis of Adolf Berle and Gardiner Means in their 1932 book, The Modern Corporation and Private Property. Managers are agents of shareholders, and this principal-agent tension is inevitable in the large public corporation. According to this narrative, the goal of corporate governance is to constrain and channel the principal-agent relationship to ensure that the agents (officers and directors) do not betray the principals (shareholders) who cannot fend for themselves due to the dispersed nature of their ownership. This story has dominated the debate about activism.

Yet this narrative is breaking apart as the structure of our capital markets continues to change. There is no longer a simple split between agents and principals. Today most boards comprise independent directors, and companies frequently have strong institutional shareholders as owners. Index funds own large stakes in companies. Yet, at the same time, a whole class of companies has disenfranchised shareholders with dual-class and even nonvoting stock. There is, in the words of Leo Strine, Delaware’s chief justice, a separation of ownership from ownership.

Most companies today have significant shareholders with very long-term horizons; it is not uncommon for BlackRock, Vanguard, and State Street to each hold a stake of more than 5% in companies. Like many activists, we occupied a middle ground at Tejon Ranch, not as fickle or short-term as many shareholders, but not as passive as those who planned to hold forever. There is value in this kind of intermediate perspective. Moreover, for a company like Tejon Ranch, with several significant long-term shareholders, an activist cannot easily play a hostile role. We would have needed to persuade many other shareholders in order to take any major corporate action. Indeed, most activists need to persuade a significant portion of the shareholder base in order to run a proxy fight or sell the company. Activists are not very powerful on their own.

A manager who understands that activists really only have power when they have a lever to persuade other shareholders should engage early to learn whether the activists’ concerns resonate with the rest of the shareholder base. For example, index funds sometimes side with activists, but sometimes reject their demands. The key for managers is to understand where a particular activist might add value, and then focus on those areas. For example, we know disclosure and securities markets. Other activists have expertise in development and commercial real estate. Some activists are good at selling divisions. All of these are shareholders, but they are potentially valuable in very different ways. Every activist should fit somewhere; the task of managers facing an intervention by a particular activist is to figure out where.

The point for a modern CEO is that public companies today have many categories of shareholders, each of which has different interests. Pension funds differ from mutual funds or index funds, which differ from retail. Your best first thought when an activist knocks at the door should be a positive one: Here is a significant new shareholder; where do they fit?

Don’t Go Nuclear (Unless You Absolutely Have To)

It is tempting to look down on activists. Many don’t have much operational experience; we certainly didn’t. As we recounted in the Atlantic article, Tejon Ranch management was polite and respectful. They also seemed genuinely willing to meet with us whenever we asked, even if they were not willing to do all we wanted.

But even when activists seem powerful, in fact they have only a few weapons. Shareholders of public companies can vote to oust directors, sue for certain grievances, or sell their shares. Many of these tactics, like running a proxy fight, are last-ditch weapons. Shareholders, even activists, do not really want to undertake the expense and trouble of a proxy fight unless they absolutely must. Managers who understand that activists are armed with nuclear weaponry, but lack much conventional artillery, would be well served by avoiding escalation. The key is balance. On one hand, companies that have not established basic defenses against activism should gird themselves and understand the potential threats. On the other hand, once the basic defense is in place, the primary goal should be the same as the goal with real-world nuclear weaponry: Avoid any situation in which you would actually have to use it.

Unfortunately, when a CEO learns that an activist has bought a substantial stake, they typically call outside counsel to mount a defensive strategy. What we can tell you, based on our expertise as lawyers and experience as investors, is that the moment one party calls in outside counsel and puts that counsel forth openly and in meetings, any hope for good relations walks out the door. We appreciate how difficult it is for CEOs and activists to avoid having a relationship turn toxic. CEOs need to engage activists, but without capitulating to every demand. Truth and transparency can do much to head off unnecessary toxicity. We can say with confidence that it is often better not to call in the lawyers. Calling them in benefits the company’s law firm, to be sure, but it often doesn’t help the company.

Prepare, Prepare, Prepare

While we believe that it’s important for CEOs to approach activists constructively, it’s just as important that they know who — and what — they’re dealing with. Remember that an activist shareholder probably has been preparing for months before announcing a campaign. Their securities filings will give you some information, but it is worth digging for more. Ask them: Are they simply planning an easy fix or trick, like a capital structure change or dividend payout? Or do they have valuable operational insights? Is there some preemptive action you might take to address their concerns?

These preparations should include the annual meeting as well. The annual meeting can be a sleepy affair, but the dynamic is different when an activist attends. CEOs can be forced into a more defensive posture. Senior managers should practice how they will behave in meetings with activists. Preparing for an activist includes thinking about transparency and media scrutiny. Ask yourself what would happen if all of your conversations with shareholders became public. Many employers train their employees to assume that emails and conversations can be discovered. Of course, managers must walk a tightrope when meeting with shareholders. They need to take care to comply with Regulation FD, meaning they should not make selective disclosures to a shareholder of information not generally available to the public. But managers also should take care to communicate in ways that those not involved directly in the conversation would deem sufficiently respectful if, and when, they learn of the conversations. Word travels fast among shareholders.

Managers should be clear and open about important strategic initiatives, including selling the company, even though such transparency can feel uncomfortable at times. Roughly 20% of activist interventions result in sale, and managers are understandably defensive about the prospect of selling the company. It is important to have a planned approach to questions about sale, not merely lip service about long-term value. Managers should be transparent with the board about the extent to which they have been approached by potential acquirers. Just saying no to a proposed sale remains a viable defensive option in most cases, and even companies that do not have a poison pill in place can easily and quickly adopt one. Greater transparency can help avoid the kind of hostility that ultimately leads to a proxy fight. But being open is difficult: The key is to be prepared to be as transparent as possible.

Activism as an Opportunity

Ultimately, the best approach is for executives to view activism first and foremost as an opportunity rather than a threat. We are not suggesting that CEOs ignore the extent to which uninformed activists might disrupt a company’s long-term strategy. But we want to emphasize that not all activism is negative. And not all activism is aimed at the CEO personally.

Engaging with an activist requires diplomacy and wisdom. It also requires caution. Sometimes battle cannot be avoided. But our point is that there is positive potential as well, and managers should recognize that, instead of simply framing activists as the enemy.

We aren’t done with activism. Like many investors, we are on the lookout for undervalued companies, where we might be able to help managers create more value for the company overall. If we or some other activists come knocking on your door, remember: It is probably with good reason.

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