Beware, Board of Directors! Activist investors’ clout is growing

Activist investors have been storming the Boards of top US listed companies, and bringing about sparkling changes. The developments have phenomenal significance for India – more of that a little later. But first about the developments pertaining to activist investors in the US.

A report in The Economist praises the efforts of activist hedge funds in improving governance among listed companies in the US. Such entities acquire “small stakes in firms and act like political campaigners, trying to win other shareholders’ support for their demands: representation on companies’ boards, cost-cutting, spin-offs and returning cash to shareholders”.

“Activists run funds with at least $100 billion of capital, and in 2014 attracted a fifth of all flows into hedge funds,” according to the report. “Last year they launched 344 campaigns against public companies, large and small. In the past five years one company in two in the S&P 500 index of America’s most valuable listed firms has had a big activist fund on its share register, and one in seven has been on the receiving end of an activist attack.”

Among the achievements of activist investors listed by the report are:

·       Trian Fund Management, led by activist Nelson Peltz, secured a Board seat at Bank of New York Mellon in December 2014.

·       The Economist’s analysis of the 50 largest activist positions in America since 2009 has shown rise in profits, capital investment and R&D in many cases.

Ram Charan, Michael Useem and Dennis Carey  list out the following achievements of such activist investors in their article, Your Board Should Be Full of Activists in Harvard Business Review (February 2015):

·       Backed by institutional investors, Starboard Capital ensured the exit of the entire Board of Directors at Darden Restaurants over a spin-off issue in 2014.

·       In 2012, a similar development took place at Canadian Pacific Railway.

Ram Charan is a business advisor to CEOs and corporate Boards, and co-author of the book, Boards That Lead, with Dennis Carey and Michael Useem. Useem is Professor of Management and Director of the Center for Leadership and Change, Wharton School, University of Pennsylvania, while Carey is Vice Chairman of Korn/ Ferry International and specializes in the recruitment of CEOs and corporate directors.

In their report, Preparing for Bigger, Bolder Shareholder Activists, Joseph Cyriac, Ruth De Backer and Justin Sanders of McKinsey, write, “Activist investors are getting ever more adventurous. Last year, according to our analysis, the US listed companies that activists targeted had an average market capitalization of $10 billion -- up from $8 billion just a year earlier and less than $2 billion at the end of the last decade. They’ve also been busier, launching an average of 240 campaigns in each of the past three years -- more than double the number a decade ago.” 

The support of traditional investors has been increasing the clout of activist investors. “The backing of the traditionalists like Vanguard Group is often giving activists like Trian — the latter with just 2.7% of DuPont’s shares — the extra clout they need,” write Charan, Useem and Carey. “Vanguard holds more than $3 trillion in assets, making it the equivalent of the world’s fifth largest country in GDP, ahead of France. Along with its heavyweight brethren like Fidelity and Blackrock, it packs enormous punch. Vanguard owns some 5% of most publicly traded companies in the US.”

 

In their article, How to Outsmart Activist Investors (May 2014),  Bill George, Professor, Management Practice, Harvard Business School and Jay W Lorsh, Professor, Human Relations, Harvard Business School, write, “We remain unconvinced, however, that hedge fund activism is a positive trend for US corporations and the economy; in fact, we find that it reinforces short-termism and excessive attention to financial metrics. But because activists -- and the institutional investors who often follow their lead -- are generating positive returns, there is likely to be more rather than less of it in the future. In the interest of their corporations, CEOs and Boards should be preparing for activist interventions rather than complaining about them.”

They cite examples such as that of Indra Nooyi, Chairperson and CEO, PepsiCo, who managed such activist onslaughts well. With her ‘Performance with Purpose’ strategy, Nooyi had, among other things, introduced a couple ‘good for you’ products in the PepsiCo range.

Before proceeding further on activist investors, it is pertinent to say a few words about a book which delves into the concept of ‘Performance with Purpose’. The book is Jim Stengel’s book, Grow: How Ideals Power Growth and Profit. “Maximum growth and high ideals are not incompatible,” says Stengel. “They’re inseparable.”

As for tackling activist investors, George and Jay present several options, which could be considered by managements and Boards.

Joseph, Ruth and Justin of McKinsey identify the weak spots which could trigger an activist attack. 1. under-performance relative to industry peers, rather than absolute declines in performance; 2. large cash balances and recurring restructuring charges; 3. executive compensation; and 4. a gap in consensus earnings. 

 

Charan, Useem and Carey urge companies to “renew their Boards before an activist changes it”.

The three experts quote Raj Gupta, former CEO, Rohm and Haas, as saying that the Board and top management “should think like an activist”. With an “outside in” view of the company -- rather than an “inside out” view -- directors should pose the same questions that an activist investor would ask, according to Gupta. “Is the company’s portfolio too complex? Is management top-notch? Is the cost structure too high? Has the firm missed an inflection point?” Gupta was also on the Boards of Delphi Automotive, Hewlett-Packard, Tyco and Vanguard. 

The advice is more relevant for India, where 77 of the 155 BSE-200 companies (excluding banking and financial ones) have either reported a decline in their market value since March 2008 or the rise  in market capitalisation has lagged the increase in capital employed in the business, according to a report in Business Standard (February 2014).

“In all, since 2007-08, the 155 BSE-200 companies in the sample have together destroyed over Rs 22 lakh crore of shareholder wealth, or nearly 46 per cent of their combined market value in January 2014. The figure would shoot up by half, to nearly Rs 35 lakh crore, if the figures for IT, pharma and FMCG companies were excluded.”