“I am not a destroyer of companies. I am a liberator of them! The point is, ladies and gentleman, that greed, for lack of a better word, is good. Greed is right, greed works. Greed clarifies, cuts through, and captures the essence of the evolutionary spirit. Greed, in all of its forms; greed for life, for money, for love, knowledge has marked the upward surge of mankind. And greed, you mark my words, will not only save Teldar Paper, but that other malfunctioning corporation called the USA.”
This famous speech of Gordon Gekko, in past, had left a long lasting impression of shareholder activist in our minds as someone, who is avaricious, cold-hearted, and a brasher. Critics have long been claiming that interventions by activist shareholders, and in particular by activist hedge funds, are destroying the long term shareholder value. They further claim that activist hedge funds are focused more on financial engineering and less on operational engineering, meaning they want to extract benefits from short term financial changes in the firm, and are less focused on the improvements in the operations of the target companies. However, so far these claimers have been unable to provide any empirical evidences to justify their claims.
My interest in shareholder activism grew when I first read a post titled “Bite the Apple, Poison the Apple” by Mr. Mark Lipton, a well-known corporate lawyer, in the Harvard Law School Forum on Corporate Governance and Financial regulation. In that post he had argued that the voting power of institutional investors is being harnessed by a gaggle of activist hedge funds who troll through SEC filings looking for opportunities to demand a change in a company’s strategy or portfolio that will create a short-term profit without regard to the impact on the company’s long-term prospects. His argument was further supported by Andrew Sorkin in a New York Times article titled “Shareholder Democracy can Mask Abuses”. Next few sections of this blog piece will be focused on verifying how true are Mr. Lipton’s claim in the real world.
Back in 1970’s and 1980’s, activist shareholders were known by less flattering sobriquets such as corporate raiders, bust-up artists, or asset strippers. Their primary bent was in acquiring majority stake in an underperforming company, liquidating the company, and leaving the employees, other shareholders, and community with nothing. In some cases, these raiders even threatened the management to expose their incompetency in running the firm to the public. Management would persuade raiders to go away by paying them well above the market prices for their shares. This would come at the cost of other shareholders, and hence this greenmailing stopped later because of the regulations. However, the situation has changed a great deal since then. Activists since then have started buying chunk of shares (mostly less than 10%) in the target firm, publishing their thesis behind the required shakeup, and then bringing other shareholders of the target firm in confidence. Also, the motivation behind the activism is no longer limited to increasing the shareholder value. Many times the motivation is non-economic such as addressing environmental or social issues.
Figure 1: Motivation behind the shareholder activism
Source: Stanford Rock Center Series on Shareholder Activism
However, just as in 1970’s, company defenses against the activist investors are surrounded by the myths that often get in the way of reality.
PERFORMANCE AND EMPERICAL EVIDENCES
1. Operating Performance:
The likes of Mark Lipton have been claiming that the improved operating performance of the target firm post activist intervention fizzles out after some time period. The short term improvement in the operating performance comes at the expense of the long term one. However factually this not true. In fact it was empirically proven to be wrong by Lucian Bebchuk, a professor of Law, Economics, and Finance at Harvard Law School, and his team mates. Industry adjusted Returns on Assets (ROA) and Tobin’s Q were calculated for 2000 firms, which had activist interventions by the hedge funds from 1994 to 2007. Tobin’s Q measures the effectiveness with which a firm converts its book value to the market value accrued by the investors. It was found that both the measures did exceedingly well post intervention for next 5 years. Also ROA and Tobin’s Q for each of the 5 years were greater than the ones at the intervention year. In below figure, t represents the year during which intervention happened, while t+1 to t+5 represents subsequent years.
Figure 2: The Evolution of ROA and Q over the period.
Source: Lucian A. Bebchuk, Alon Brav, and Wei Jiang, The Long-Term Effects of Hedge Fund Activism
2. Stock Price:
The opponents of shareholder activism further claim that the spike in the stock price is extremely short term, and it reverses back to its original value (price before the intervention). However, this also does not hold true. Empirical study proves that the stock price on an average of the target firm for the three years and five years post activist intervention was higher than the three year average price pre-intervention.
Figure 3: Firm level performances using CAPM and Fama French four-factor model
Source: Lucian A. Bebchuk, Alon Brav, and Wei Jiang, The Long-Term Effects of Hedge Fund Activism
Above table shows that alphas (excess returns) calculated using CAPM and Fama French model were better for first 36 months and 60 months period post intervention than those for the 36 months period pre-intervention. Negative alpha for [-36,-1] period i.e. three years period prior to the intervention, also proved that shareholder activist target the firms that are already performing badly.
3. Short holding period:
Detractors of shareholder activism claim that the hedge fund activists use activism as a pump and dump scheme, meaning they hold the stock for short period, wait for the price to spike and sell immediately to make a quick buck. However, this claim was debunked by the few academicians, who found that the average holding period was around 20 months. Nelson Peltz (holding period of over 6 years in Heinz), David Einhorn (holding period of over 4 years in Apple), and Dan Loeb (holding period of around 2 years in Yahoo) are few such examples that clearly shows that hedge fund activist are definitely not short sighted.
SUCCESS AND FAILURES
Having said that activist investors on an average were able to bring success to underperforming companies, does not directly imply that most of the raids were successful. In fact in the recent past, we have seen equal amount of success and failures in the world of activism. Activist investors, who have explicitly focused on returning excess cash sitting on the balance sheet to the shareholders, restructuring the balance sheet, reducing cost overheads, or getting a seat in board of directors have usually been successful in extracting the shareholder value. However, on the flip side, activist investors who tried revamping the entire business have failed dramatically in unlocking the value.
ValueAct Capital Management was successful in ousting Microsoft’s (MSFT) then CEO Steve Ballmer, who was responsible for various horrible investment decisions such as Skype ($8.5B), aQuantive ($6.3B), Yammer ($1.2B) at MSFT. Also, under him MSFT didn’t make any real innovations as 85% of its revenues were coming from only two products Windows and Office. Despite owning mere 0.8% stake in Microsoft, ValueAct Capital Management was able to pressurize the board of directors mostly by bringing other shareholders into confidence and threatening for a proxy battle.
David Einhorn started his journey for Apple almost three years back, when Greenlight Capital bought stake in Apple with an intention to be a passive shareholder. However, he realized that situation got out of hand, when Apple management was happy hoarding the cash despite the drop in market valuation. He sued Apple in early 2013 for not distributing the cash to its shareholders. Eventually he succeeded, and Apple management agreed to distribute the $100B of cash to its shareholders.
- JC Penney:
We have seen the disastrous failure of JC Penny, where Bill Ackman’s Pershing Square Capital got actively involved from buying 18% stake in JC Penny to spending 17 months in transformation of the company. In the transformation process, he handpicked Ron Johnson as new CEO, went to remake the business, give new strategic direction, revamp the stores, and change its customer base. Instead of simply focusing on financial engineering, he focused on extreme makeover. In this process, he forgot that he had no hands on experience in retail management. Finally, in August 2013, his firm took hit of $700 million, when he sold his entire stake in JC Penney.
- Sears and Kmart:
Eddie Lampert, the hedge fund manager who bought Sears and Kmart made similar mistake as Bill Ackman. Rather than unlocking the value of the company, he started running the company from the ground. Plunging sales and closing stores of Sears speak volumes about the failure of Mr. Lampert.
As even the policy makers have started appreciating the role of activist investors, we will see a rise in the interventions by the activists. Going forward, activist investors will have equal focus on corporate governance along with the capital related issues. While the US continues to account for bulk of the interventions by the activist investors, other parts of globe are starting to feel this rising tide of wave. Countries like Japan and Germany have started to see outside activist investors looking for value in their firms, while Canada, Australia, and UK have their own domestic groups.
Whatever your opinion might be for Icahn’s, Einhorn’s or Loeb’s activist investing world, one thing is for sure that they are no longer the cold-hearted corporate raiders of 1980’s. They have been trying their best to bring the companies in their best shapes. When Carl Icahn questioned – “Is it fair that CEOs make 700 times what the average worker makes, even if the chief executive is doing a terrible job and thousands of workers are laid off? Why do CEOs get awarded huge bonuses by friendly boards when the share prices are down by double digits and then get their options reset to lower levels as an ‘incentive’?”, he undoubtedly struck a chord with institutional investors, policy makers, and the retail investor.
2. Lucian A. Bebchuk, Alon Brav, and Wei Jiang, The Long-Term Effects of Hedge Fund Activism
3. Schulte Roth & Zabel, Activist Insight: An annual review of trends in shareholder activism