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Shareholder Activism. Shareholder Activism. Certain hedge funds focus on shareholder activism as a core investment strategy
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Shareholder Activism • Certain hedge funds focus on shareholder activism as a core investment strategy • An activist shareholder acquires a minority equity position in a public corporation and then applies pressure on management in order to increase shareholder value through changes in corporate policy • Some of the common changes advocated by activist shareholders include reducing corporate costs, repurchasing common shares, increasing corporate leverage, increasing dividends, reducing CEO compensation, reducing cash balances, and divesting certain businesses • In addition, activist shareholders will sometimes campaign against proposed acquisitions or allocation of cash for purposes that are not perceived to create shareholder value • Activists sometimes also pursue a sale of a target company or a breakup of the company through a piecemeal sale or spin-off of significant operations
Shareholder Activism • Activist shareholders usually acquire between 1% and 10% of a target company’s shares, or create an equity exposure by entering into equity derivative transactions, such as purchasing call options on the company’s stock, simultaneously purchasing call options and selling put options on the company’s stock, entering into forward transactions to purchase the company’s stock, or entering into equity swaps in relation to the company’s stock • A relatively small share holding or equity derivative position established by an activist shareholder may enable the investor to launch a campaign to make significant changes in the company, without the added cost and time required by a complete acquisition • To be effective, however, the activist shareholder generally must obtain the support of other large shareholders through large-scale publicity campaigns, shareholder resolutions or, in the extreme, proxy battles for control over the board of directors
Shareholder-Centric vs Director-Centric Corporate Governance • A key issue in corporate governance is whether the corporate board of directors will survive as the governing organization of the public corporation, or if shareholder activism will ultimately invalidate the role of the board • In other words, will corporations become more shareholder-centric and less director-centric in their governance? • Some critics of shareholder-centric governance indicate that this movement is causing a shift in the board’s role from guiding strategy and advising management to ensuring compliance and performing due diligence • This shift can create a wall between the board and the CEO, removing the “trusted advisor” role of board members, as CEOs become increasingly wary of sharing concerns with investigative and defensive boards
Shareholder-Centric vs Director-Centric Corporate Governance • Based on concern about litigation, directors sometimes become so focused on their individual committee responsibility that they are less able to focus on the broad objectives of maximizing shareholder value and they become “Balkanized” into powerful committees of independent directors, unable to broadly coordinate the focus of the entire board • Even when the board is able to focus on the business of the corporation in cooperation with the CEO, activist investors create pressure on boards to manage for short-term share price performance rather than long-term value creation. • This may result in short-changing the company’s relationships with its employees, customers, suppliers and communities, as well as reducing investment in R&D and capital projects that are critical to a company’s long-term success
Shareholder-Centric vs Director-Centric Corporate Governance • Another criticism of shareholder-centric governance is that shareholder activists could ultimately wrest substantial control from boards, causing companies to bring almost every important decision to a shareholder vote • This would largely shut down the normal operating procedures of the company, slowing down decisions and creating competitive disadvantages, as previously confidential decisions that were made by the board are put in the public domain • There is also concern that activist shareholders can create inappropriate pressure on boards through non-documented alignments between different activists to achieve their objectives
Activist Hedge Fund Strategies • For an activist investor, timing is everything • Their objective is to accumulate enough ownership in a targeted company to influence change, but they want to accumulate shares without drawing attention from the target and without attracting tag-along investors, whose purchases can drive up the stock price, making it too expensive to accumulate additional stock • Some activist investors have utilized derivatives to help them create a large exposure to a company, without alerting either the target or other potential investors
Accumulating Shares Through An Equity Swap: CSX • The SEC requires investors that own 5% or more of a company’s equity to disclose their ownership through a 13D filing within 10 days of acquisition • To avoid tipping their hand, however, some activist investors have used cash-settled equity swaps (which do not require 13D disclosure) to create an equity exposure to the target • An equity swap is typically entered into with an investment bank counterparty, which causes the bank to buy shares as a hedge against their obligation to pay the returns of the stock ownership (appreciation or depreciation, plus dividends) to the activist hedge fund in exchange for payments that are based on a floating rate of interest (typically LIBOR) plus an appropriate credit spread
More on Equity Swap • Example: take a simple index swap where Party A swaps £5,000,000 at LIBOR + 0.03% (also called LIBOR + 3 basis points) against £5,000,000 (FTSE to the £5,000,000 notional). In this case Party A will pay (to Party B) a floating interest rate (LIBOR +0.03%) on the £5,000,000 notional and would receive from Party B any percentage increase in the FTSE equity index applied to the £5,000,000 notional. • In this example, assuming a LIBOR rate of 5.97% p.a. and a swap tenor of precisely 180 days, the floating leg payer/equity receiver (Party A) would owe (5.97%+0.03%)*£5,000,000*180/360 = £150,000 to the equity payer/floating leg receiver (Party B). • At the same date (after 180 days) if the FTSE had appreciated by 10% from its level at trade commencement, Party B would owe 10%*£5,000,000 = £500,000 to Party A. If, on the other hand, the FTSE at the six-month mark had fallen by 10% from its level at trade commencement, Party A would owe an additional 10%*£5,000,000 = £500,000 to Party B, since the flow is negative.
Accumulating Shares Through An Equity Swap: CSX • In some equity swaps, the hedge fund has the right to purchase the underlying shares from the counterparty under certain circumstances, at which point the hedge fund would disclose ownership of the shares (but not before the shares are delivered) • The key question under this arrangement is who controls votes attached to the shares that are the subject of the equity swap? • Since the activist does not own the shares, they technically do not own the voting rights, and therefore may not be required by the SEC to disclose ownership under 13D rules • However, since the hedge fund might be able to receive these shares before a future vote on the election of directors, the activist can theoretically own the shares when it matters most
Accumulating Shares Through Equity Collars: Yahoo • During February 2008, Microsoft offered to buy Yahoo at $31 per share, but Yahoo’s CEO and founder rejected the offer • Following this rejection, Carl Icahn started accumulating a position in Yahoo stock, attempting to benefit from an eventual sale to Microsoft • During May 2008, Icahn initiated a proxy fight against Yahoo after acquiring an equity equivalent position of 59 million Yahoo shares. This position was comprised of 9.9 million common shares and equity collars on 49 million Yahoo shares • The equity collars were created through the purchase of call options on Yahoo (American style calls with an unknown strike price and maturity) and the simultaneous sale of put options on Yahoo (European style puts with a strike price of $19.50, maturing in November 2010)
Accumulating Shares Through Equity Collars: Yahoo • The equity collars provided the following potential benefits for Icahn • The estimated cost for the equity collars could be zero, compared to the over $1.23 billion cost that Icahn would have paid to purchase 49 million Yahoo shares at the $25.15 opening share price on the date the collars were entered into • Entering into a collar transaction was less visible than purchasing 49 million shares, enabling Icahn to secure his position without competing directly in the market for shares • The options can be settled physically, by delivery of shares, or if Icahn does not want to buy Yahoo shares if options are exercised, he can “cash settle” the options • Cash settlement means that, if an option is exercised, the economic equivalent of a physical settlement will be paid in cash (payment to Icahn if Yahoo’s share price exceeds $32.85 or from Icahn if the share price falls below $19.15)
Activism Summarized • There is disagreement on whether hedge fund shareholder activism makes companies stronger or merely generates short-term gains that principally benefit the activist at the expense of long-term shareholders • During 2008, there were more than 75 U.S. hedge funds dedicated to event-driven, activist-style investing and these funds managed more than $50 billion in assets • Some institutional investors have lined up with these hedge funds to push boards to be more responsive to shareholders • In a number of cases, it appears that improvements have been made in companies that, in the absence of shareholder activism, may not have occurred • In other cases, large share repurchases pushed by activists and created large opportunity costs when the repurchases occurred before subsequent steep share price drops • In addition, some acquisitions pushed by activist shareholders have seen significant share price drops since closing
