Imagine you’re a chairman of a listed company and an activist shareholder comes knocking at your door. He has accumulated 7% of your shares within a short period of time and presents a detailed report claiming your margins are too thin, your product range is too broad and your restructuring costs are out of control. He further claims your top management team is short of industry specific skills and concludes that these shortcomings are to be blamed on the board of directors for having failed in its monitoring and strategic advice duties. Consequently, change is needed, continues the activist, the CEO must go and half of the board including the Chairman must be replaced, preferably by one or more of the activists’ representatives. The activist has already given his first interview to the most prominent local business journal and the story has been picked up by a number of alert twitter users spreading the news though the World Wide Web. Before you know, you’re in the middle of a campaign led by an activist investor known for his success in ousting entire leadership teams and credited for his adeptness in boosting shareholder value. How well prepared are you for such a situation?
As flowery as the story may sound, it is not unreal. In 2014, According to Activist Insight, 344 companies worldwide were subject to a public action, an 18% jump compared to the previous year. Activists’ demands were as diverse as the activists themselves: They included spin offs, restructurings, changes in strategy, objections to mergers, dividend increases, and board turnover as the largest category (47%). What is more, Activist Insight estimates that the documented public campaigns represent only the tip of the iceberg and that two thirds of the disputes are settled before they become public knowledge.
Ignoring activists and their demands, then, is not an option. In spite of this, board members typically react to activists approaching with neglect, downplaying or aggression with little thought given to a more strategic and more proactive approach in managing relations with activist shareholders and they tend to denigrate activist shareholders, deny their competence as business experts, and blame them for short-term opportunism. Ignoring activists’ preparedness and determination, however, and allowing the company to become entangled in contentious public attacks can be costly. The damage incurred can be both financial and reputational and may result in the replacement of entire boards, as the case of Darden Restaurants vividly illustrates. Consequently, if your reaction as Chairman is geared solely towards fending off activists, you’re probably enacting the same kind of ignorance and short-termism you’re seeking to fight.
Strategic Shareholder Management – An Action Plan
In order to prepare boards for activists approaching and in order to help directors avoid confrontational situations with disgruntled shareholders, I suggest Strategic Shareholder Management. Strategic Shareholder Management refers to all actions taken to analyze activist shareholders, plan for appropriate answers to their likely questions, and implement procedures aimed at achieving long-term cooperation and interest alignment. Strategic Shareholder Management (see Figure 1) is an action plan that consists of four consecutive steps for boards to regularly undertake in order to minimize the risk of becoming a (public) target of activists’ attacks.
Step 1: Start with a Task Force: Think about People, Process and Budget
Step one in adopting a strategic approach to shareholder management consists of optimizing the company’s interface with its shareholders. The first question that boards should ask themselves is: who is responsible for what? It is about defining who should be involved in dealing with actual and potential activists and to ensure that those people have the skills necessary to assume their roles.
Activists may approach companies in different ways and, depending on their objectives, they may use different channels to do so. Large institutional investors typically start by engaging executives and by demanding a private meeting. Others start by writing a letter at the attention of the boards. While in the former case it is the executives who learns first about a simmering campaign, in the latter case it is the board and the chairman. Executives sometimes wait too long before they inform the board. Boards are, therefore, well advised to designate a “strategic shareholder manager”, a person who knows about the reporting lines and the procedure in place and who must be immediately informed should an activist approach.
It is important to choose someone for this role who has a corporate finance training or a corporate finance “mind”. An essential part of the strategic shareholder manager’s role is the ability to make a sound economic and financial argument supporting the company’s strategy in a language that an activist will respect and understand. Too strong a focus on legal compliance may turn strategic shareholder management into a box-ticking exercise mired in damage control rather than interest alignment and an ongoing dialogue between the company and its investors.
In addition, boards should also think about who is part of the task force responsible for implementing the action plan, for regular monitoring and reviews, and for taking emergency action should a situation escalate. The task force should involve all the potential organizational players who are the touch points between the company and its stakeholders, including corporate secretaries, legal counsels, investor and public relations officers, and compensation and corporate governance consultants who are assigned the tasks of identifying shareholders, performing shareholder and activist analyses, and conducting vulnerability assessments. The team should also be staffed with communications specialists who take care of informing and engaging internal and external stakeholders and nurturing the relationship with the investors’ and activists’ community, proxy advisory services, and regulators. Moreover, C-suite and board-level representation assures that the topic obtains the attention that it deserves and signals to internal stakeholders the commitment by the highest organizational ranks. It also assures that enough financial and other resources will be devoted and that the right processes will be put into place.
Step 2: Know your Friends (and your Enemies): Analyze your Shareholder Make Up
Once the task force is set up and the strategic shareholder manager leading it is designated, it is key to analyze and keep track of the company’s shareholder make up. Particularly in situations that are about to escalate, boards should strive to know their supporters and their adversaries. I recall a situation where I asked a distressed chairman facing a fierce attack by a hedge whether the company’s shareholder based had been identified. He replied that they had just commissioned a service provider that he didn’t recall the name of. From his reaction I could sense that this was new territory for him and that he had not given any serious thought to this issue prior to the hedge fund’s attack. Boards should be familiar with service providers who offer proxy solicitation services and who gather, analyze and interpret investment community feedback. And they should not start doing this only after the battle has begun. Ensuring loyalty by dispersed shareholders is, of course, a long-term endeavor and must be nurtured in the long run. Yet it becomes particularly crucial is in crisis situations when support badly is needed.
Directors too often nurture relationships only with their anchor owners and large patient blockholders with little attention given to other investors who are potential shareholders and potential activists at that. For one thing, given their expertise hedge funds and other activist investors are not always wrong in their assessments of the company’s financial health; for another, mobilizing allies and ensuring support by fellow activists is an integral part of their campaigns. It is reported that many large institutional investors even if passively invested do support shareholder action. Black Rock, for example, the world's largest asset manager with $4.53 trillion in assets under management backed eight activists in the 2014 proxy season. In conclusion, step two in Strategic Shareholder Management is about mapping the company’s ownership structure and identifying its shareholders; be at the pulse of the market sentiment and nurture loyalty by both current and potential shareholders, and understand the balance of power that between player that side with or against each other.
Step 3: Prepare to Be Part of the Solution: Assess your Vulnerability
During the conversation with the distressed chairman it quickly became clear that the company was not only a shining target for hedge fund activism but that the board secretly agreed with the activist on most of the issues raised. Even if reluctant to admit it, the directors were concerned about very similar financial and strategic problems the activist had identified. Where they disagreed was not on problems but on solutions. Objectively analyzing and understanding the company’s vulnerabilities is the first step towards becoming part of the solution.
A vulnerability assessment refers to the process of identification and weighting of factors that make a company susceptible to activists’ attacks. The set of factors refer to the issues that might catch an activist’s eye given their investment strategy and targeting objectives. Shareholders’ investment strategy and their targeting decisions are related. Key, therefore, is to understand what type of activists engages in what type of activism for what reason.
Commentators commonly differentiate between financial activism, strategic activism, governance activism and social activism. Financial activists scrutinize a company’s balance sheet, its financial condition, core assets, and results. Consequently, directors should scrutinize things like earnings estimates, operating margins, and capital deployment decisions, including stock repurchases and dividends.
Strategic activists, on the other hands, are more focused on the company’s income statement and cash flow and scrutinize the company’s cost structure, technology, and products and services. Targeting is triggered when companies accumulate high cash flow reserves; when they have an unfavorable cost structure, high research and development expenses, high restructuring costs, or when they are on the verge of losing market share or competitive advantage to their competitors. The vulnerability assessment should thus include investigating whether the company can be accused of hoarding cash or to have a bad business strategy or poor operational execution.
Governance activists, in turn, investigate a company’s leadership structure and governance, whether it has a poor executive team, CEO, or board. They also become active when dissatisfied with the design of executive compensation or when they don’t see the link between executive pay and company performance. Poor governance in general, such as the appointment of directors that they believe lack sufficient independence, or the implementation of takeover defense mechanisms (such as dual-class shares or poison pills) are also among the factors that make a company vulnerable to governance activists’ attacks. In assessing their vulnerability companies should examine to what extent they abide by principles (and codices) of good governance, and if they don’t what kind of explanation they can reasonably provide for their noncompliance.
Finally, frequently neglected, yet no less important, is social activism. Because social activists often hold only few shares, companies tend to underestimate their impact. However, when their cause finds the ear of a broader audience, they can become a source of almost irreparable losses to company and director reputation. Social activism is commonly mistaken as geared towards pressuring companies solely to increase their social performance. In an investigation of social policy resolutions filed in the US companies over a period of two years, my colleagues and I found that social activists pursue a variety objectives beyond purely social that translate into different targeting strategies (see Figure 2). An important take-away from this research is that social activists differ in their readiness to compromise and engage in dialogue. Many social activists target companies not because of their poor social or financial performance but because certain targets due to their size and visibility are excellent amplifiers for social activists’ messages. Knowing this helps companies devise suitable communication strategies for social activists. A good starting point is to include social rating scores into the vulnerability assessment. A number of organizations, such as Risk Metrics, provide such scores. Companies can then use the movements in these scores as an early warning system and brace themselves with answers should activists come knocking on their doors.
A final step necessary in the vulnerability assessment is the weighting of factors that found their way to the list. Be it due to a different shareholder makeup, company size or visibility, or different industry or sector, the factors discussed above will not be equally important for all companies. Instead, directors should additionally assess each factor according to the impact it has commensurate with its potential to hurt the company’s financial and reputations capital. The factors can then be mapped in a vulnerability scorecard providing a quick insight into the vulnerability level at any given point in time (see figure 3). Needless to say, the vulnerability assessment should be periodically repeated. Movements of factors in the scorecard provide a convenient early-warning system.
Step 4: Create the “Happy Shareholder”: Inform and Engage
On my last meeting with the aforementioned chairman he turned to me and said: “Dr. Sikavica, will we win this?” “I don’t know Mr. Chairman”, I replied, “You agree on the problems with the activist; now you need to find a way to communicate your solution more convincingly than he does.” After the vulnerability assessment, particularly in a situation gone awry, what is important is that the insights of all analysis are synthesized and utilized for formulating the right message, to the right audience in a language that shareholders understand. In the short run, this step is about a communication strategy targeted at key audiences via channels and media that they use and trust. In the long run, it is about knowing when to communicate actively and offensively and when to wait and listen. It is also about communicating consistently, internally and externally.
When it comes to communication and managing their interface with stakeholders companies typically adopt a silo approach: They treat different types of stakeholders investors, customers, employees as if they were separate audiences. Yet shareholders are among all these audiences and shareholders roles may overlap. Some employees, for example, are also shareholders, and loyal ones at that! An institutional investor, say an SRI fund, may care strongly about the company’s reputation in terms of environmental and social factors; and a gadfly activist appearing at annual meetings may have a strong base of followers outside the organization. What is more, shareholders large and small, institutional and individual use digital information and communication channels that cut across corporate silos. Managing these constituencies separately is the wrong strategy for preventing that a campaign goes awry. This even more so as activist shareholders seek publicity to gain supporters particularly when they don’t obtain the ear of management.
This aim of the board should be, ultimately, to create the “happy shareholder” and to ensure loyalty and support not only by large blockholders and institutional investors but also by the grey mass of retail investors whose power becomes visible in situations where every voice counts. An innovative way to achieve this is to invest in digital channels that allow companies to reach out to their shareholders, to communicate with them on a regular basis and to be at the pulse of their sentiment. Sherpany, a Swiss-based startup, for example offers this kind of service. According to Tobias Häckermann, CEO of Sherpany, far from being a tool for agitation and mobilization, Sherpany’s goal is to turn shareholders into ambassadors by creating trust through clear and direct communication. Great boards have understood that shareholders are not just intruders who interfere with matters that are none of their business but that they can be allies who provide the company with financial resources, advice, and support. Strategic Shareholder Management is a framework that helps board achieve exactly this: establish of a constructive relationship and interest alignment with its current and prospective shareholders on an on-going and long-terms basis.
The original version of this article has been published in Ethical Boardroom.