 Loving Critics or Critical Lovers?
Activist fund managers make being public a private battle
by Mark W. Sheffert
October 2007
If you are the executive leader of a public company, you probably assume that the benefits of being public are in the strategic best interests of your company: benefits such as the ability to go to the public market to raise capital when you need it, having the liquidity and the flexibility that capital markets provide, and—last but not least—having the enhanced respect and reputation that goes with being part of a market system that values your company. Aside from the increased expenses of being public due to governmental regulations stemming from the Sarbanes-Oxley Act, being public is generally a win-win situation for companies and their shareholders.
And most of the time, even when outstanding shares are held by institutional investors, such as private-equity funds, pension funds, and hedge funds, the managers of these funds tend to be more passive investors and allow company management to be in control. If fund managers aren’t happy with the company’s results or its direction, they generally “vote with their feet” by selling their shares and moving on.
However, it’s not unusual for a handful of institutional investors to control the majority of the outstanding voting stock. A growing number of activist fund managers are attempting to get institutional investors to join with them in order to influence a company’s decisions and get the best returns for their fund investors. Sometimes, that tactic isn’t in the best long-term interests of the company or its other shareholders.
Trends in Extreme-Value Investing
Let’s examine hedge fund managers more closely, because they are the fastest-growing group—it’s a $1.5 trillion industry—of activist fund managers. The number of hedge fund managers who are activists is still a minority, but it seems to be a trend that’s here to stay because of their success in getting healthy returns for their investors.
Unlike the corporate raiders of the 1980s, who generally took controlling interests in their targets, today’s hedge fund managers take relatively small positions in companies to maintain the diversification their investors seek. However, they flex their muscles by gaining seats on the boards of directors of companies, soliciting and aligning other institutional investors with them, and pushing for change that will quickly boost the company’s stock price. Their goal is to force the company to make a highly visible strategic move, such as a change in management, sale of assets, or a large stock buyback or dividend, which creates a short-term increase in the company’s stock value.
Most of the time, activist fund managers will work behind the scenes to pressure management to make the change they are seeking. Occasionally, their efforts are more visible, such as those of hedge fund manager Carl Icahn of Icahn Partners, who took out a full-page ad in the Wall Street Journal in May asking Motorola shareholders to vote him onto its board because current management had a “critical failure in oversight and leadership.”
Some activist fund managers have been successful
at making money for their investors. According to a recent study led by Duke University, when news of potential fund manager activism hits the headlines, a company’s stock price can jump 5 to 7 percent, with no apparent reversal of the trend for a year after the fund announces its intentions.
A larger force in the market than hedge funds are the approximately 8,000 mutual funds, which make up an $8.5 trillion industry. Yet mutual fund managers are traditionally a quiet force in the boardroom because of strict rules on a fund’s ability to influence companies. I believe mutual fund managers are afraid of being perceived as nasty, headline-grabbing activist investors. But some are beginning to say that mutual fund managers act like renters instead of owners, and should be more aggressive on behalf of their investors. So we may be seeing more activist mutual fund managers, too.
Duties of the Board
While I’m obviously supportive of fund managers investing directly into companies, I’m concerned with the conflict that activist fund managers create for the company’s board of directors. They don’t seem to understand or care that while the board of directors is responsible to its shareholders, it also has a fiduciary responsibility to the company’s employees and creditors (depending upon its financial condition), and a responsibility to the communities in which it operates. Directors have to balance different stakeholders’ interests in the company, and short-term returns for investors aren’t always the most important thing at any given time.
But when an activist fund manager—or a group of fund managers who join together—starts to pressure management and its board of directors, the board can lose control of the company’s immediate strategic decisions as well as the company’s long-term strategic vision, direction, or mission. That’s not why companies go public, is it?
Fighting Back
There are a few things that companies can do to fight back. One of the cardinal rules of crisis management is having laser-beam focus on the priority at hand, so you should create a response team to tackle the problem head on. Members of the team could include a special committee of board members, selected members of top management, securities legal counsel, and investment bankers.
Also, don’t allow your company to be in a situation that attracts this type of investor. In other words, good results speak louder than words. Do your job well, and your shareholders won’t have any reason to pressure you to do something else. Don’t overcompensate your executives or put up with their poor performance. Don’t let obvious strategic alternatives pass you by. Be engaged and be prepared.
Another way to fight back is to be constantly aware of the real value of your company. Begin with a solid strategic plan. Create financial forecasts that reflect the results of the successful execution of that plan, and use a discounted cash-flow method to determine the net present value of the company’s future cash flows and stock price. With that information, you’ll be much better prepared to defend your strategic plan and vision for the future of the company against activist fund managers who may try to get the shareholders to move in a different direction. Too many companies are unprepared to respond to activist investors with confidence because they don’t know their companies’ worth. As a result, they become emotional and reactive instead of fact-based and proactive.
If you do find yourself the target of an activist fund manager despite all your precautions, don’t get into a public relations battle. Watch carefully what you say and control who speaks to the media. Try to develop an open line of communication with the activist manager and to build a relationship on honesty and trust. Don’t be a shrinking violet! You must be able to articulate why your board of directors and management is doing a good job of representing the interests of all shareholders, and why your strategy and its execution will result in respectable returns for all investors. If the activist investor continues to fight after that, engage your response team to effectively push back.
Having active investors is good for business, when they are loving critics. But extreme activist investors whose only interest are their own short-term profits, which they create by being critical lovers, are not good for the long-term health of businesses. Loving critic or critical lover—there is a difference.
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