Much has been written recently about the role of activism in the modern financial world. Activism is an investment strategy where an investor buys a controlling stake in a company in order to invoke a proxy fight (not always) where he or she can obtain seats on the board to then become the catalyst of change by replacing CEOs and working on the improvement of the company’s performance. It is certainly healthy for competition, although not so healthy for some CEOs. The question is: Is it a positive force of capitalism? Activism has become so popular that there are now entire websites dedicated to tracking and posting daily about new stock positions initiated by activists. But where did it all begin?
Activism, in its purest form dates back to the buyout boom of the 1980s. At first, however, it was not seen as something positive. Times were better known for the emergence of bootstrap deals (later known as LBOs). Leveraged buyouts, where an outsider investor typically teams up with existing management, to buy the entire company in order to create value for both the shareholders (as the companies were bought at premium to their current market value) and themselves, blossomed in the 1980s. The deals involved pledging the acquired company’s assets as collateral for a loan and then selling them off as soon as possible in order to payback the debt and make money from the deal. These deals were often financed through junk bonds, the lowest graded bonds with the highest risk attached, and the equity in some of the deals was sometimes as low as 2%. The junk bond market at the time was dominated by a bank named Drexel Burnham Lambert and its main powerbroker – Michael Milken. For quite some time this business was incredibly profitable for all parties involved along the chain – from the private equity firm, through to the lawyers and bankers that earned hefty fees, all the way to the bond salesmen from Drexel.
The hustle and bustle and amount of deals marked the 1980s as one of the most exciting times on Wall Street. However, this short-term ‘value creation’ would later prove to be a fling. The act of buying an entire company was not as profitable to the shareholders in the long-run, as selling off a company’s assets – “asset stripping” – may not always be as easy when economic conditions are not favorable. This is where the main difference with activism lays.
Activism captures the evolutionary spirit, as it aligns incentives with performance.
The activists, at the time, were known as corporate raiders, the most famous being Carl Icahn. A corporate raider is someone who buys a large number of shares in a corporation whose assets appear to be undervalued and this large share purchase would give him significant voting rights, which could then be used to push changes in the company’s leadership and management. This would increase share value and thus generate large returns for the raider. The main difference with buyout deals is the fact that activists would not buy the entire company and sell it in pieces, but instead would rather fight for a seat on the board of directors and then try and invoke incremental changes in the way in which the company is managed to enhance its performance. Of course, bad practices such as greenmailing – where raiders initiated takeover bids with no intention of following through on the takeover – were also present, but overall the difference between a buyout and an activist strategy is clearly in the value creation process, as the activist role is geared more towards long-term value creation. Current activist investors such as William Ackman are proof of this. Most of Ackman’s investments have a 3 to 5 year time frame where the entire business is sometimes turned around for the sake of improving performance.
‘Corporate raiding’ has gone a long way since the 1980s but it is still seen as every CEO’s worst nightmare and every shareholder’s dream. In that respect, activism captures the evolutionary spirit, as it aligns incentives with performance. By keeping CEOs on their toes, activist investors are contributing to the increase in management efficiency, and therefore the overall productivity of the companies in which they manage. Driven by the desire to make a profit on every deal, activist investors have to pick their targets very carefully. There are numerous ways of increasing value. One is by forcing management to pursue inorganic growth through mergers & acquisitions; another is through divestitures, which might unlock hidden value from within a company; many other ways exist but ultimately all revolve around changing management’s practices and improving the utilization of a company’s capital.
Activist hedge funds are preying on American corporations.
Looking at the returns of the top activists, we can see that their unique strategy has not only proven to be more than effective, but has also been extremely profitable. Bill Ackman, CEO of Pershing Square Capital, has compounded his firm’s capital at 21% per annum since inception in 2004. Carl Icahn’s performance since inception (1978) is 16% per annum. Nelson Peltz, Dan Loeb and other successful activists have also had incredible returns and the major players’ funds have even become incumbents for newcomers.
There is, however an opposing view. Martin Lipton, a lawyer famous for advising companies defending themselves from a corporate raid, still views activism as the 1980s’ short-term-value chase where usually a greenmail or a poison pill sends the corporate raider on his way: “In what can only be considered a form of extortion, activist hedge funds are preying on American corporations to create short-term increases in the market price of their stock at the expense of long-term value”. It is questionable how objective Mr. Lipton is – his business involves defending the companies in question – nevertheless it is still a view supported by some.
But what is the future of activism? Given the growth in assets under management of funds that pursue an activist strategy, it is clear that activism will probably become an even larger force in the investment world as larger corporates become the target. Carl Icahn’s Apple position and Nelson Peltz’s DuPont proxy fight are evidence of that. Given their remarkable performance, more competition will undoubtedly emerge, but over the long run, the strategy of rigorous due diligence for potential targets will prevail while less prudent investors fade away over time.