Shareholder activism is a way for minority shareholders to pressure management to change company policies and/or practices. Activists use different tactics to achieve their goals.
Depending on the company, activist approaches range from aggressive hedge fund campaigns to less aggressive dialogues with management and boards of directors. Understanding the different types of shareholder activism is essential for companies to respond effectively.
Identifying a Target Company
As the number of shareholder activism campaigns increases, it is becoming increasingly important for investors to understand which companies are likely to become target companies when an activist is active. Activists may look at several factors to identify a target company trading at a discount to intrinsic value or undervalued compared to similar companies.
Common metric activists use is operating margins, which indicate how much management is spending to create revenue and profit. Using this information, activists can evaluate whether management is spending too much or not allocating capital in the most efficient way possible. Alternatively, they may be looking for companies with high research and development spending because these investments can yield new products that can be sold more effectively.
Another indicator that activist investors are interested in is excess cash on a company’s balance sheet. These investors view cash held more than total debt outstanding as an opportunity for management to utilize that extra capital more efficiently, such as through dividend distributions or share repurchases.
Likewise, activist investors are interested in companies with large tax benefits or other significant non-cash assets. These investors believe these assets can be utilized to create additional shareholder value by repurchasing shares, acquiring other companies, or paying out special dividends.
Identifying the Activist
When shareholder activism occurs, boards of directors need to identify the activist. This can be achieved by reviewing their track record and previous campaigns to determine the risk they might pose to the company.
The activist can also be identified through their strategy and approach to shareholder engagement. Activists often start with a series of meetings with senior management to discuss their concerns and develop a clear agenda that is expected to be met.
Often by the time the activist engages with management, they have already developed specific proposals for unlocking value. These ideas are then discussed with shareholders and sometimes revised before they are revealed to the public through a press release or other announcements.
Boards that can manage this process proactively can keep the focus on the company’s business and minimize the damage caused by the activist. This also allows boards to build their credibility with the activist’s shareholders and strengthens the company’s reputation with the broader shareholder base.
The current environment is a fertile breeding ground for activist investors; not all companies are immune to such threats. Even those with strong financial performance and who are widely recognized as industry leaders may be targeted.
Identifying the Issue
When shareholder activism occurs, a company must determine what is at the root of the issue. The answer to that question will help a company develop an appropriate strategy to address the issue promptly.
Investors often turn to activist activities to improve a company’s long-term value and address governance practices that they believe are hurting its long-term performance. Activists may seek to break up the company, sell certain assets, return capital to shareholders, or retain an advisor to evaluate alternative ways to increase shareholder value.
Many institutional investors participate in shareholder activism, as do retail investors. These investors generally are long-term investors with a broad investment objective and are accustomed to leveraging their ownership rights to drive change.
One common type of shareholder activism is related to executive pay, often referred to as “say on pay.” This involves a subset of voting shareholders expressing their views about the executive compensation plans of companies they invest in. These shareholders are particularly likely to express these views if they believe the pay structures are not aligned with company performance, if the plan contains objectionable features (e.g., certain vesting terms), or if the compensation plan uses inappropriate performance metrics.
When shareholder activism is on the horizon, a key challenge facing management teams and boards is preparing for the inevitable arguments that activists will use to defend their perspectives. Developing a set of response documents that can be easily adapted if an activist successfully gains a seat on the board is critical to maintaining control of the narrative, which is essential for a company’s long-term success.
Developing a Strategy
Shareholder activism is a powerful tool for minority shareholders to influence the board of directors and executive management actions. However, it is not for everyone and requires a firm strategy.
While hedge funds account for much of the activist action, other investor groups use shareholder proposals and other tools to push for company change. These include religious groups, nonprofits, and advocacy organizations.
Activists typically have short investment time horizons, which means they want quick-hit actions that can drive up the stock price in the near term. This is a problem for long-term investors, as the increased share price could negatively impact future returns.
As shareholder activists become more focused on environmental and social issues, boards need to pay attention to their companies’ ESG profiles, ratings, and broader governance weaknesses. For example, a poor record on environmental or sustainability issues can trigger an activist campaign, as do executive compensation practices that are not aligned with the company’s performance.
The best defense against activist attacks is to proactively assess the company’s vulnerabilities, looking at the business from an activist’s perspective and considering whether alternative financial or business strategies (such as a divestiture, spinoff, or enhanced return of capital) could boost value for all shareholders. This approach can help reduce the risk of an activist campaign while strengthening the company’s credibility with shareholders.