- Vincent Maire
Shareholder Activism: Don’t Shoot the Messenger
2020 has been of a singular vintage for shareholder activism. While publicly reported activism has dropped in the U.S. by 13% in the overall number of companies targeted in 2020 (due to a strong rebound in the fourth quarter), Europe witnessed a record year with a 21% increase in activist campaigns compared to 2019. As the world recovers from disruptions caused by Covid-19, and ESG being officially elected prom queen of 2021, shareholder activism is expected to be very active in 2021, with hedge fund activists likely to take advantage of weakened stock prices, and press companies for social and environmental changes at the same time.
History has proven that regardless of how harsh crisis can be on companies’ businesses and organizations, they are often a great time for them to reflect on their strengths and weaknesses, feel how society’s pulse is changing, and make the required changes to adapt to these new expectations. The Covid crisis is no exception in this respect, having sharply underscored how the role companies assume in our modern societies can no longer be reduced to a mere quest for profitability. Instead, over the last few months, a strong consensus has been reached among corporate leaders, politicians, finance players, academics, and NGOs, urging corporations to confront challenges of sustainability, resilience, and corporate purpose that, even though not completely new, have somewhat crystallized during the pandemic.
Hedge fund activists, despite how violent and disruptive their campaigns can be to companies, act as watchmen of the stock market. By targeting underperforming companies and/or companies with poor governance practices, activists merely bring the attention of the public to problems in identified companies, acting as a conspicuous manifestation of existing problems, not the problem themselves. At the end of the day, and because activists seldom have enough voting power to weigh in on the final vote, the decision often rests with long-term asset owners and asset managers who will have to decide whether to commit to the corporate activist or stick with the incumbent management.
Activist shareholders are often vilified for pushing companies to take short-term actions that come at the expense of the companies’ long-term health. This analysis has led hedge funds’ opponents to advocate for measures that would impede their campaigns and, instead, protect corporate leaders from pressures that could induce short-termism. Not only these arguments are misconceived, notably because activist campaigns need the support of long-term stockholders to be successful, but several empirical studies have established that such arguments are also not supported by strong evidence. Instead, those arguments overlook substantial benefits that outside-investor oversight produces, especially when it comes from players with the time, financial resources and expertise, that hedge funds have.
Because of the dispersion of ownership in U.S. corporations, the logic of portfolio diversification, and the fact that costs of monitoring would often exceed the expected benefits of oversight, the incentives for minority shareholders to oversee management are weak, and instead encourage them to “free-ride.” In this regard, activist threats are a cornerstone of management discipline in the way that they discourage managerial slack and underperformance, and fill the gap of information asymmetries between management and the shareholders.
Additionally, in companies where the controlling shareholder is either a descendant of the founder or merely a historic stockholder, they may be opposed to making changes in the corporate strategy that would be vital for the company, because that would mean breaking free from family legacy or changing the company’s DNA. Since management is often handpicked by the controlling shareholder, and then appointed by the general meeting on the controlling shareholder’s recommendation, minority shareholders bear the risk of having a management beholden in some respect to the controlling shareholder, thus implementing the controlling shareholder’s vision for the company instead of focusing on what is best for it. Here, hedge fund activists also have an important role to play to protect both minority shareholder’s interests and the company’s interests.
Today companies are at crossroads, with no option but to resolve whether they will, and how they will, address challenges such as racial injustice and broad-based socioeconomic inequality, discrimination, climate change, technological innovation, etc., as part of their operations and organizations. It is very likely, seeing how these issues have triggered passionate debates across the whole spectrum of our society, from social media—today’s agora—to the floor of our beloved institutions, that corporations failing to engage effectively in those fields will see their intrinsic value drop inevitably, with potential increased litigation and financing hurdles, as well as consumer boycotts.
Many companies have already started remodeling their businesses to embrace this new vision of sustainable capitalism, but others are either still trying to figure out how to accommodate their businesses with these new expectations or simply are unwilling to deviate an inch from what they have always been doing. For the latter, shareholder activists are maybe the best allies minority shareholders have to protect their companies’ financial performance and mitigate long-term risks. In fact a new form of activism with a different set of rules, called “stewardship activism,” has gained traction over the past ten years, aiming to apply the skills of corporate activists to companies that remain deaf to the demands of their stockholders, despite a deterioration of their financial performance, and where traditional tools of engagement with the management have failed to produce meaningful results.
Stewardship activism will most likely thrive in the coming years, with ESG being seen as a driver for financial performance, and new funds already set up to engage on ESG related matters, but more importantly, because ESG-focused activists will be able to get support from large institutional investors and asset managers who have committed to this new form of activism, and for whom selling the stock is simply not the best way to deal with reluctant companies.
Unlike individual investors, institutional investors have to take into account at least two factors in their investment strategies: the financial performance of each company, on an individual basis, and the impact that each company they invest in can have on the others, on a consolidated basis, which can affect significantly the return that an institutional investor or asset manager makes across its portfolio. Therefore, selling the stock of an underperforming company or a company that is reluctant to take into account ESG metrics in its business strategy will not be enough for an institutional investor, since the negative contributions of that company may be reflected on other companies’ financial performance in the institutional investor’s portfolio. Additionally, there are risks that institutional investors and asset managers cannot diversify away because of their systemic nature, such as climate change, racial injustice, discrimination, and socioeconomic inequality. Thus, this particular kind of investor has no choice but to adopt more rigorous methods to change the management and put the company on the right path.
Recently we have seen how ESG-focused hedge fund activists and long-term investors’ interests can intersect. The partnership between Jana Partners LLC and the California State Teachers' Retirement System (CalSTRS) to push Apple Inc. to confront concerns about iPhone addiction among teenagers in 2018, or the recent partnership between Engine No.1 and CalSTRS in the “reenergize Exxon” campaign, are striking examples of how activist campaigns and long-termism are not exclusive from one another. Instead, they display how using the skills of an activist can help press companies to deliver additional shareholder value while, at the same time, adopt a more sustainable approach in the long-term. In the face of the challenges that companies will have to confront in the coming years, we can hope that companies will cease looking at activists as systematic foes—but instead as potential allies to help them make the right decisions for themselves and their stockholders—and that lawmakers will refrain from adopting too many impediments, either legal or regulatory, in response to the development of shareholder activism, particularly in France where this debate is currently underway.
Vincent Maire serves as a Graduate Editor of the NYU Journal of Law & Business. He is an LL.M. candidate at NYU School of Law where he focuses on Corporation Law and Capital Markets. Prior to attending NYU, Vincent interned at several international law firms in Paris.