In a Crowded Field, Activist Investors Choose Dialogue over Diatribes

Changing conditions create opportunities for kinder, gentler activists who can work with boards, CEOs and institutions.


Proxy season is under way, stirring the usual boardroom battles. One of the more anticipated struggles will unfold on May 6 at Sotheby’s annual shareholder meeting in New York, where hedge fund activist Daniel Loeb will push a slate of three director nominees — one of whom is himself. Investors in the 270-year-old auction house will wrestle with the issues that often accompany aggressive activist campaigns. Has Loeb, who is loosely aligned with another activist, Richard (Mick) McGuire, already pushed Sotheby’s far enough? Will the pair try to replace William Ruprecht, Sotheby’s CEO for 14 years? Will Loeb’s presence on Sotheby’s board produce destructive acrimony, or will he instigate enough change to boost the share price, then cash out and stroll away, as he did with Yahoo last year after winning three board seats and helping to install Marissa Mayer as CEO?

Activist investors are ubiquitous these days. But the Sotheby’s campaign run by Loeb, CEO of $14 billion-in-assets, New York–based Third Point, and McGuire, who heads $2.7 billion Marcato Capital Management in San Francisco, is activism at its most hyper. Sotheby’s is what activist investors seem to like best: a company that is not severely troubled but lacks a plan for putting assets to more-productive use — and boasts a pile of cash that can be channeled into dividends and share buybacks.

Corporate cash hoards may be the biggest reason activism has thrived. But what’s become obvious is that a dividend and buyback strategy won’t suffice forever, particularly given the powerful run-up in stocks. Companies will have to invest their cash in R&D, new products, geographic expansion or M&A to spur growth. Those demands, in turn, will put pressure on activists to engage boards and managers in more-complex, longer-term strategies.

There are signs that the climate is already changing. M&A and capital spending are up in the first quarter, and the stock market has grown more discriminating. Activism has been so successful as a strategy that new funds have launched to join the fun. Relatively easy targets like Sotheby’s are more rare than they were, and they tend to attract crowds, driving down returns over time. That overcrowding — a familiar dynamic in finance — has pushed activists to look further afield, to companies that require tough operational turnarounds or to larger businesses operating on much brighter stages.

For instance, the largest companies that have drawn activists — Apple, Microsoft Corp., PepsiCo, Yahoo — demand far more in resources and time than a midcap industrial or tech company. Trying to turn around a larger company requires getting support from major investors for a turnaround plan. And that means activists have to conduct dialogues with boards and CEOs. In fact, many boards may want that conversation with activists, if only to placate the institutional investors that stand quietly behind them.

That’s not to say there won’t be a place for high-profile activists. Activism has made lots of money for some larger-than-life personalities — some of whom have been around for decades — whose fans cheer their victories and bemoan their losses as if they were athletes. Almost daily a Dungeons & Dragons–like game featuring William Ackman, David Einhorn, Carl Icahn, Nelson Peltz or Loeb plays out on cable television. These outsize personalities dominated the most recent phase of activist investing. But it’s an open question whether they will cast quite as long a shadow in the years to come.


There’s no doubt that activist hedge funds have been top performers. According to Chicago-based Hedge Fund Research, activist funds returned 16.6 percent in 2013, well above the average hedge fund performance of 9.3 percent. They were also top performers over the preceding five years, with annualized returns just under 15 percent. An October 2013 study by Citigroup’s corporate and investment banking division found that since 2006 almost one sixth of S&P Composite 1500 index companies had faced public shareholder activism campaigns, with some buffeted by multiple forays. The Citi study also found that since 2009 the number of campaigns targeting $10 billion-plus large-cap companies had more than tripled.

A highly visible campaign can quickly devolve into a publicity stunt. Last year that renowned (and finely chiseled) financial guru George Clooney stepped in to defend Sony Corp. against Loeb, who was demanding that the Japanese company spin off its entertainment unit. After Clooney called Loeb a “carpetbagger ... trying to spread a climate of fear,” the hedge fund manager insisted that he and the movie star actually wanted the same thing. Loeb reduced his stake, and Sony announced a plan to spin off its TV division into a separate subsidiary. Loeb sort of won and sort of lost.

At Sotheby’s, Loeb, an avid collector of contemporary art, has the advantage of knowing the product. His board nominees are a restructuring expert, Harry Wilson, and a former Lazard M&A banker, Olivier Reza, chairman of family-owned Reza-Gem, a French company that owns a major collection of rare gems and jewelry. Loeb and McGuire contend that CEO Ruprecht has been “administering” Sotheby’s rather than driving it, according to people familiar with their thinking. Sotheby’s has lost ground in the global art market since Steven Murphy took over in 2010 as Christie’s International CEO and pushed the company in a more commercial direction.

When they launched their campaign, both fund managers argued that Sotheby’s had nearly $1.9 billion in “trapped” capital, and both saw potential for better earnings through cost-cutting, real estate sales and an overhaul of the lending business to art dealers and buyers. But the campaign developed a nasty — if standard — tone, beginning with Loeb’s public denunciation of Sotheby’s as “an old painting in desperate need of restoration” and of CEO Ruprecht’s $6.3 million in compensation and perquisites as a throwback to “the long-gone era of imperial CEOs.” On October 2, Loeb sent a letter to Sotheby’s accusing management of being out of alignment with shareholder interests and noting that Third Point’s stake of less than 10 percent was nearly ten times the number of fully vested shares held by Sotheby’s directors and executive officers. He offered to join the board and recruit others.

The next day Sotheby’s announced the adoption of a shareholder-rights plan that would effectively dilute Loeb’s stake in the event of a takeover attempt — a poison pill, which Loeb called “a relic from the 1980s.” He threatened a proxy fight and is suing over the pill.

Ruprecht and other senior managers met with Loeb and McGuire separately and agreed to some of their demands, including hiring former Goldman Sachs Group investment banker Patrick McClymont as Sotheby’s chief financial officer and returning $450 million to investors through a share buyback and special dividend. McGuire has said he thinks Sotheby’s should return $1 billion to investors; that remains open to negotiation. Sources say Loeb and McGuire believe Sotheby’s is about one third of the way toward unlocking its capital. Their preference is to create greater urgency about releasing value to drive growth, with more dividends and buybacks as a fallback position.

The Sotheby’s case demonstrates why some activist campaigns are tempting: The global nonfinancial corporate sector is sitting on more than $2.8 trillion in cash reserves, estimates Deloitte, so an activist can show up, demand cash be put to work and look like a crusader for shareholder rights. Though Loeb and McGuire offered Sotheby’s a growth plan, the company’s cash reserves minimize the risk.

Easy cash pickings, however, might mask a shortage of companies truly in need of significant change. According to the Citi study, not all companies subject to activism lag their peers in performance. Over one third had outperforming stocks before they were targeted. “Therefore, share-price outperformance does not automatically insulate a company from activism threats,” the study said. “More importantly, the trend of activists targeting well-performing companies is intensifying, particularly in the U.S., where 56.7 percent of activist campaigns against S&P 1500 companies in 2013 involved companies that had outperforming share prices.”

Much of the enthusiasm for activism finds justification in “The Long-Term Effects of Hedge Fund Activism,” a study published last year by Lucian Bebchuk of Harvard Law School, Alon Brav of Duke University’s Fuqua School of Business and Wei Jiang of Columbia Business School. The authors’ findings supported activism and suggested that stock returns following the initiation of a campaign were, on average, positive and continued that way for five years.

The Citi study, however, found that although that was true for an average of all targeted stocks, most companies did not enjoy long-term gains. “In fact, 52 percent of targeted firms actually underperform market benchmarks over both a one and two-year horizon,” the Citi study said. “Therefore, the large average improvements are driven by a relative minority of activist efforts that result in outsized stock price gains as opposed to share price improvements at a majority of companies.” Citi’s conclusion: “Since activists tend to invest in several firms at a time, they can achieve superior portfolio performance even if only a few of their targets outperform substantially. From a company’s perspective, however, the activist agenda may not necessarily always be in the company’s long-term interests.”

Many investors trace the roots of activism to the hostile-takeover wars of the 1970s and 1980s. Though that era did see the emergence of “raiders” like Icahn, Peltz, Ronald Perelman, T. Boone Pickens and Saul Steinberg, it was a very different time. Some of these raiders were in the business of buying large stakes in companies, threatening takeovers, then in many cases walking away after the targets had paid a premium for their shares: greenmail, now illegal. A number of raiders succeeded in acquiring sizable companies, including Icahn with Trans World Airlines and Perelman with Revlon.

Icahn and Peltz never really went away; they reinvented themselves as shareholder tribunes. The business of challenging the corporate status quo didn’t go mainstream until the early 2000s. A succession of disasters — the tech bubble, the corporate scandals, later the financial crisis — led to “the big bang that changed any view of corporate America’s omnipotence,” said G. Mason Morfit, president of $12 billion activist hedge fund firm ValueAct Capital, in a lecture he gave at Stanford Law School in 2012. Morfit was joined by Abe Friedman, former head of corporate governance and responsible investing at BlackRock and managing partner of CamberView Partners, which advises companies on working with shareholders. “It was outrage that drove shareholders to say, ‘We’re not going to tolerate companies behaving this way,’” Friedman added.

The past decade or so has seen a steady, if often subtle, push and pull between shareholder and board prerogatives. The Sarbanes-Oxley Act of 2002, a response to the Enron Corp. and WorldCom scandals, focused mostly on disclosure and accountability but paved the way for a shareholder-friendly regulatory environment. Rule changes made it easier for minority shareholders to file board resolutions and express their views on pay more clearly. And various defensive strategies, like staggered boards and poison pills, fell out of favor.

But corporations are hardly defenseless. The Delaware courts still embrace the business judgment rule, which gives boards leeway in determining corporate policy. The Securities and Exchange Commission has long mandated that investors that buy more than 5 percent of a company’s shares disclose the holding within ten days, making sneak attacks difficult to launch. Proxy solicitation rules prohibit investors from asking other shareholders how they plan to vote until after the proxy has been filed.

In 2010 shareholder groups persuaded the SEC to enact a proxy access rule requiring companies to list shareholder board nominees on proxies, saving investors the expense of mailing out separate ballots. But the U.S. Chamber of Commerce and Business Roundtable sued, and the U.S. District Court for the District of Columbia overturned the rule.

Still, it is a significant development that managements today feel they have to listen to outsiders, says Marcel Kahan, a professor of corporate law and governance at New York University School of Law. “We have an erosion of power of CEOs to shareholders and independent board members,” he says. Even with limitations on proxy solicitation, there are ways to gauge reactions. “Rumors fly around, and some investors will communicate their intentions publicly,” Kahan notes. “If you’re staging a proxy contest and the stock price goes up, it’s an indication that investors like your idea.”

For Thomas Sandell, founder of New York–based activist and event-driven hedge fund firm Sandell Asset Management Corp., the opportunities are largely in companies where “management is either not hungry enough or not qualified enough or seems to not care.” Adds Sandell, “A common theme is executives who act as if they own the company, yet 90 percent of the time they own only 1 percent of the company.”

That’s a theme Icahn has often decried, among many others. When Icahn decides to go after a company, he thinks the world should know about it immediately. His Twitter account states, in place of a standard profile: “Some people get rich studying artificial intelligence. Me, I make money studying natural stupidity.” Icahn also operates a website, Shareholders’ Square Table. In March he posted a letter to eBay stockholders denouncing CEO John Donahoe and director Marc Andreessen. Icahn contended that Andreessen defrauded eBay when, as a board member, he urged the sale of Skype to an investor consortium with which his venture firm, Andreessen Horowitz, was affiliated. That group then sold Skype to Microsoft at a much higher price a year later.

On April 10, however, Icahn agreed to a few concessions. He withdrew his demands that eBay spin off its PayPal unit and give him two board seats; in return, eBay will bring in former AT&T CEO David Dorman as a director, an appointment Icahn supported. Not that the compromise has made Icahn any less feisty: He has said publicly that he still believes PayPal should not be part of eBay.

“Corporate governance, with many exceptions, is dysfunctional in this country,” Icahn declares. “I strongly believe that bringing accountability to corporations, which is what I do, is important for the future of our economy. While there are many exceptions, the problems in our economy will exacerbate because of lack of accountability, which creates corruption that inevitably will lead to the decline of our hegemony.”

Icahn invests his own money. Some fellow activists quietly say that although he’s always been a brilliant stock picker, Icahn seems to be practicing activism in part to entertain himself. It is that entertainment aspect that might be threatened in changing times, mostly because it often sits uneasily with other investors. Until a few years ago, the major institutions — BlackRock, Fidelity Investments, TIAA-CREF, Vanguard Group, the big public pension funds — generally acted as passive investors. John Bogle, founder and retired CEO of Vanguard, famously said big providers of mutual funds didn’t want to make demands on management for fear of alienating their own client base for retirement plan investments.

That view may be changing. Barry Rosenstein, founder and managing partner of New York–based activist firm Jana Partners, says institutional portfolio managers used to consider it risky to talk to activist investors, but they’ve begun to see it as irresponsible not to. The change can be measured in the number of institutions that return his calls. “We have an open dialogue now with big institutions that typically decide the outcome of activist situations, because they’re trying to get to the right result for shareholders, just like us,” he says. Most institutional managers, however, prefer to keep low profiles about measures they support, letting activists make the noise.

Martin Lipton, a pioneer of modern M&A and a founder of New York law firm Wachtell, Lipton, Rosen & Katz, has long supported managerial and board prerogatives and in 1982 invented the poison pill — for years the most effective takeover defense. Lipton asserts that activists have won institutions over for reasons that have more to do with short-term gain than with good governance. “It’s kind of an unfair contest,” he says. “The institutions that own 80 percent or so of the stock are under tremendous pressure to support the activists’ efforts to drive the stock up, because they’re under pressure not to have a downturn in any quarter. That doesn’t create long-term value.”

But institutional shareholders have shown in a number of cases that they are perfectly willing to resist activists. Rosenstein lost a very public battle last year with other shareholders of Agrium, a Calgary, Alberta–based agricultural and fertilizer supplier. He believed he had the votes to replace at least two board members, then reacted with fury at the shareholder meeting when management’s slate narrowly won. He accused Agrium of contacting shareholders at the 11th hour to urge them to change their votes. Rosenstein would not comment on Agrium.

In December the California Public Employees’ Retirement System, the largest U.S. pension fund, chose not to support Icahn in his demand that Apple return more cash to shareholders than CEO Tim Cook had already promised. A month earlier Anne Simpson, CalPERS’s head of corporate governance, told the New York Times that “shareholder activism is evolving from barbarians at the gate to acting like owners.” Simpson said Apple was doing enough and called Icahn a raider and a Johnny-come-lately. She described his tweets about dinner conversations with Cook as “unseemly.”

Lipton is not necessarily opposed to kinder, gentler activism. Though he maintains that the threat of activism can make executives overly cautious, causing them to slash capital investments, he has supported effective engagement between asset managers and companies they invest in, with all parties acting as corporate stewards. Recently, at an M&A conference in New Orleans, Lipton offered up a list of activists he respects: Ralph Whitworth and David Batchelder of Relational Investors; Peltz and Peter May of Trian Partners; and Jana’s Rosenstein.

MARC GILES is an executive who lived through an activist campaign that he believes left his company stronger. Giles is a former CEO of Gerber Scientific, a maker of automated manufacturing systems based in Tolland, Connecticut. In August 2009 he received the letter every CEO dreads. It came from James Mitarotonda, CEO of New York–based activist hedge fund firm Barington Capital Group. The letter was, as Giles describes it, “highly critical,” saying Gerber should examine the viability of its four divisions and crack down on spending. Mitarotonda, who owned about 5 percent of Gerber shares, demanded three board seats.

“Everybody was upset,” Giles recalls. “But [chairman Donald Aiken] said, ‘Let’s calm down.’” Lipton always tells CEOs that burying their heads in the sand is the worst way to react. The Gerber team met with Mitarotonda, who considers himself a gentleman activist but often starts campaigns with harsh letters that he hopes will pave the way for constructive dialogue. “It’s almost standard that an activist slaps you in the face, then lays out what their thinking is,” Giles says. “We met and were surprised to find that our views about the company were more or less aligned. After that, all the tension went away.” He thought Mitarotonda had some good ideas.

The demand for three board seats turned out to be a tactic to get the company’s attention; the board agreed to bring on a Barington representative. Mitarotonda was already serving on too many boards, so Barington portfolio manager Javier Perez, a former McKinsey & Co. consultant, took the seat instead, and a year later Mitarotonda joined him. Gerber’s board agreed to spin off two smaller and less profitable business lines — something Giles had already been considering — but Barington pressed Gerber to do it in six months rather than several years. The stock had fallen from a high of $28 to $3 when Barington bought it; the restructuring lifted it to $9. That’s a point at which some activists might cash out, but Mitarotonda prefers to advise companies on the next step.

The spin-offs left Gerber smaller. Giles says one of the issues with a sale was that the board knew that shrinking would mean Gerber couldn’t remain publicly listed. Ultimately, Mitarotonda helped set a valuation, and San Francisco private equity firm Vector Capital acquired Gerber for $11 a share.

Giles has stepped down as CEO but remains a director. Mitarotonda and Giles spoke on a panel at an activist investor conference in New York last year, along with Barington COO and general counsel Jared Landaw and former Gerber general counsel William Grickis Jr., presenting the experience as a case study in constructive activism.

Today, Mitarotonda is best known for his involvement with casual-dining operator Darden Restaurants. Barington and another activist investor, New York–based Starboard Value, want the company to spin off real estate it owns through its chains, particularly Red Lobster and Olive Garden, and create real estate investment trusts or lease space to the restaurants. Starboard has argued against Darden’s plans to spin off Red Lobster without a separate sale of its real estate and has called for a special shareholders’ meeting to vote on a nonbinding resolution against the plan. In late March, Barington sent a letter to Darden’s independent directors asking them to consider replacing CEO Clarence Otis Jr., though in conversations that week no one at the hedge fund firm seemed happy about taking that step.

Mitarotonda now sits on the boards of three companies he helped turn around: apparel company Jones Group, resin and plastics maker A. Schulman and auto supply retailer Pep Boys: Manny, Moe & Jack. “I’ve seen corporate boards where activists come in and are just interested in wringing out cash or selling the company,” says Joseph Gingo, a former Goodyear Tire & Rubber Co. executive, whom Barington helped install as chairman and CEO of A. Schulman. “When I came in, Jim thought A. Schulman should be for sale. But after we turned around a lot of the operational problems, he said it would be foolish to sell, so we didn’t. He really represents the shareholder interests.”

Increasingly, U.S. activist investors seem to be borrowing from the playbook of European activists, the largest of which are $13 billion Cevian Capital, which operates out of Stockholm, Zurich and London, and $7.6 billion The Children’s Investment Fund Management (UK) in London. Lars Forsberg and Christer Gardell, the Swedish founders of Cevian, come from private equity backgrounds and have in recent years helped Denmark’s Danske Bank shed distressed assets and Volvo’s truck division raise operating margins. They are now trying to turn around troubled German conglomerate ThyssenKrupp. They have taken board seats at half the companies they’ve invested in, always by asking politely. It is easier in Northern Europe and the U.K. — the only places Cevian invests — which have governance structures that hold boards and CEOs accountable to all stakeholders.

Even so, playing nice pays off in the U.S. more and more, asserts ValueAct CEO Jeffrey Ubben. His one proxy battle since launching the hedge fund firm in 2000 — over Acxiom Corp., an information management company in Little Rock, Arkansas, in 2006 — taught him a valuable lesson. “We felt the company’s strategy was flawed, but the managers wanted nothing to do with our suggestions,” he recalls. “I wanted to separate the information business from the data business, but it turned out the two were entangled and you couldn’t separate them. You don’t know all the details if you haven’t been inside the company, but a proxy contest forces you to put forth a plan. Once we settled and got two board seats, it was clearly us against them. So I was never totally trusted. It took four years to make changes, and by then the company had kind of lost its way.”

Today, Ubben works hard at building networks with investors who are likely to support his demands, and that helps him win board positions. ValueAct has placed representatives on some 32 boards.

Ubben and others say good relationships breed good relationships: If you call on institutional investors to vote for your proxy slate or shareholder resolution, they’re more likely to back other activists known for being long-term supporters of target companies.

William Ackman, CEO of $11 billion Pershing Square Capital Management in New York and a high-octane news maker for his campaigns to destroy Herbalife and team up with the pharmaceutical company Valeant to take over Allergan — a move that Ubben’s ValueAct is also backing. Among institutional investors, however, Ackman has gained a reputation for not sticking it out, particularly since his experience with J.C. Penney Co. In 2010, Ackman began buying Penney’s stock with a plan to change management and make the company a hipper retailer — but it all ended with the firing of the CEO Ackman had championed, former Apple retail chief Ron Johnson. Last August, after protracted arguments with the board, Ackman resigned and sold his 18 million shares at a loss of nearly $500 million. On the one hand, he looked shrewd; he unloaded shares at $12.91, and the stock fell as low as $5 in early February. But many now remember Ackman for muscling his way onto the board, then walking and leaving the company in worse shape than ever.

While pension funds have embraced some activists, a few have tried the strategy themselves. The $163.7 billion California State Teachers’ Retirement System recently joined with $6 billion Relational Investors in an effort, ultimately successful, to get Canton, Ohio, specialty steelmaker Timken Co. to separate its two main businesses. Aeisha Mastagni, an investment officer in CalSTRS’ corporate governance unit, says the pension presented its case to institutions and won their support. “We have relationships with all of them, and without their backing you wouldn’t have seen our shareholder proposal pass,” she says.

Still, CalSTRS makes most of its activist investments through a hedge fund portfolio. “This space has grown for us,” Mastagni says. “As with any particular asset class, there are ebbs and flows. Right now there’s a lot of M&A, and corporations have cash. We also have long-term passive investments in a lot of the companies that our activist managers are holding [too]. This is a way we can ensure that companies are making the right M&A decisions and spending their cash wisely.”

CalSTRS’ allocations include Relational, Starboard Value, Trian, European activist manager Knight Vinke Asset Management and Blue Harbour Group. The last, a $2.4 billion fund based in Greenwich, Connecticut, is run by Clifton Robbins, a 15-year KKR & Co. veteran who started the fund in 2004. He believes in approaching a target like a private equity manager: meeting with senior managers rather than accumulating shares and announcing he wants to change things. He likes companies with large cash reserves, but he says he’ll bow out if he meets a CEO who doesn’t seem interested. “Sometimes after meeting with a company, we might realize there’s a tax or structural impediment to what we want to do or the company isn’t as undervalued as we thought,” he says. Among his biggest holdings are women’s clothing retailer Chico’s FAS, which he believes is being valued based on its largest, oldest business (overlooking three growing brands), and Internet server operator Akamai Technologies, which he has urged to return capital to shareholders and make acquisitions that boost earnings.

Mastagni says that before investing with an activist, CalSTRS portfolio managers review past campaigns to see how many came to fruition. It’s a sign of what activists increasingly will have to prove in a crowded market. “I think there’s a specialized skill set in doing activist investing and being successful at it,” she says. “Anyone with financial acumen can identify undervalued companies. But you have to find levers that extract what’s undervalued and communicate it to management. It takes very patient capital.” • •