Over the last three years the U.S. market has witnessed a substantial rise of activist investors. According to Schulte, Roth & Zabel’s Activist Investing 2015 Annual Review, a total of 344 companies worldwide were subjected to activist demands in 2014, up 18% from the 291 recorded in 2013. And the movement is gaining acceptance as a mainstream investment strategy. No longer is the term “activist” associated with the corporate raiders of the 1980’s. Instead, activism is now more often thought of as a value-based strategy that optimizes untapped shareholder wealth. This is showcased by a recent announcement from State Street Global Advisors, one of the largest index investors in the world, saying that they are completely willing to partner with activists. Neuberger Berman also announced earlier in the year they took a 20% stake in JANA Partners.
The success of an activist strategy is contingent upon placing a management
in an extremely reactive, frenzied and compromising position. Because by the time the activist has engaged senior management, they have already performed extensive due diligence on the company and have a detailed strategy they intend to pursue. And they are usually not apprehensive about replacing the current management team to boost efficiency and performance. Their ultimate goal is to evaluate whether management is deploying resources effectively to maximize shareholder value, usually in the shortest amount of time possible.
Thus, it is critical for senior executives to be prepared for these investors. This means first objectively assessing the company’s vulnerabilities and how they might attract an activist’s attention. Second, leaders should learn about the activist’s mindset, track record, and methodology. Based on my work studying activist strategies, I’ve outlined four hypothetical scenarios below (based on actual events) that demonstrate the different strategies an activist could pursue. Understanding these approaches will help curb the uncertainty that executives face when an activist investor approaches.
The Investor Focused on Optimizing Yield
This activist looks at how management is currently allocating capital, and how different strategies might better optimize shareholder yield (dividend yield plus buyback yield). This typically means they look to re-engineer the balance sheet to increase shareholder yield, over the shortest amount of time possible, which typically ranges between six to twelve months.
Example: Jolly Inc. is a top performing S&P 500 listed company whose two-year total return outperformed the market by over 60%. Despite metrics showing impressive overall company performance, the company’s capital deployment strategy was not maximizing shareholder dividends and/or buybacks. Jolly Inc. also continually traded at a multiple (forward-looking PEGY) that lagged the S&P 500. All public indications implied management remained content with maintaining large amount of excess cash and preferred to remain relatively under-levered. Therefore, the argument could be made shareholder yield was not as high as it could be. The activist in this case would convince senior management to issue debt and reallocate free cash towards a higher/special dividend and a significant share repurchase.
The Investor Who Combines Closely Tied Competitors
Sometimes it doesn’t make sense for companies operating in the same space to continually compete. Especially within volatile sectors, such as Industrials and Materials, this can be counterproductive. Activists look to see if opponents could be combined to form a more productive single entity, one that can capitalize on economies of scale and monopolize a given sector.
Example: Acme Industries and Widget Co. operate in an extremely competitive (borderline oligopolistic) industry. Both firms offer essentially identical services, maintain similar client bases, and pursue comparable prospects. In recent years, both companies exhibited compressed margins, flat revenue growth, and lagging returns. However, free cash flow per share remained impressive at both companies, and fixed cost ratios remained somewhat intact. It was clear that combining the two firms would be far more beneficial to overall shareholder value. The activist in this situation engaged with Acme Industries to reconfigure the Board, alter the composition of their capital structure, and merge with Widget Co.
The Investor Who Separates Different Divisions
When a company operates in non-complimentary divisions, it can be difficult to maintain a single balance sheet that optimizes overall shareholder return. Even if both divisions are profitable, the capital requirements of one may be completely different than the other. So an activist would seek to split the divisions so that they have individual capital structures that would allow each to optimize performance.
Example: Happy Co. was a leading provider of both capital-intensive machinery and consumer-based services. Revenue derived from the machinery business was highly cyclical, whereas the consumer-based services revenue was recurring and more stable. Macro-economic factors also affected each division very differently. The capital requirements of the two businesses were so different that the balance sheet could never be structured in a manner that best suited both. As a result, the activist’s strategy would be to carve out the consumer-based services business to form its own entity, so that it could be capitalized in a way that optimizes performance. With two separate balance sheets, management could plan around the risk variables (i.e. revenue composition, economic factors, etc.) more efficiently.
The Investor Who Gets Rid of Dead Weight
Typically, activists pinpoints struggling business units that weaken the performance of the overall firm and pursue spin-offs to eliminate dead weight from the company.
Example: MineMe Inc. operated in a competitive industry that had been continually condensed, primarily through mergers, in recent years. Eventually the firm was maintaining two distinct complimentary business units, but while one was displaying above market median levels of growth, the other was becoming obsolete. It displayed a 10% decrease in revenue growth while the other unit exhibited sales growth of 75%. The lagging unit also required a notable amount of capital expenditures while the growing unit was extremely scalable and capital investment was minimal. So an activist engaged the company to sell off the lagging unit. Along with proceeds of the sale, the newly freed up resources could be reallocated to support the company’s overall growth.
What Can Managers Do?
If an activist decides to engage a company, there is usually little management can do to change the strategy he or she plans to pursue. For that reason, it is imperative for a management team to, at the very least, have two critical maneuvers in place as early as possible. First, executives need to conduct an objective appraisal (emotions often lead to blind spots) to determine where the company’s vulnerabilities lie. This kind of preemptive scenario analysis should center on the specific fundamental profile of the company and highlight any parallels to traditional activist targets. In other words, would an activist see a need for yield optimization, a merger, a capital structure reorganization, or a spin-off?
Throughout this process, management must concede that alternative strategies could potentially help the business. This doesn’t mean executives shouldn’t also question how pragmatic each scenario is, but tense public disputes typically arise when management goes on the defensive and ignores what current shareholders may consider reasonable demands by the activist. Carrying out an early preemptive screen for vulnerabilities will lessen the sting should an engagement take place. The negotiating process with the Activist could still be painful, but it won’t be unmanageable.
Secondly, based on different scenarios, management should create a corresponding activist response team that is well-trained in the potential vulnerabilities identified in the analysis. The importance and make-up of the team is critical, as activists have a tendency to attempt to “divide and conquer” between senior management, the board, and top shareholders. At the very least, the team should include the CEO, CFO, IRO, Board Members and General Counsel. Whether the activist is relatively collaborative or hostile, the situation will already be stressful, so allowing the Activist to rile dissent only plays into their hands.
A managerial front that is continually united also weakens one of the activist’s most effective tactics – garnering support from shareholders. Keep in mind there is rarely a clear winner or loser with an activist engagement – the outcome is usually the result of compromise. A regimented team that is already prepared will not be caught off guard and will not lose as much leverage with shareholders during the compromise. Activists have been known to contact existing shareholders to present their proposed strategy prior to the engagement in order to garner support. The response team will be able to potentially offset this effect by proactively reinforcing management’s strategy to the shareholders. Further, they will be able to better evaluate the risk/reward of the activist proposal in a concise and impartial manner, along with continuing their own messaging to top shareholders.
Activists do share a common universal behavioral trait with the rest of us – they prefer the path of least resistance. There isn’t as much blood in the water when it becomes clear management is prepared and has already preemptively addressed activist scenarios. The frenzied, fast-paced, and nerve-racking universe of the engagement becomes manageable, methodical and, in some cases, avoidable, when vulnerabilities are dealt with proactively.