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Calls for Curbs on Activism Will Hurt Institutional Investors

Efforts by investors to reign in activists like William Ackman and Carl Icahn could have a negative impact on investment returns.

With activists William Ackman, Carl Icahn, Nelson Peltz and Barry Rosenstein making headlines with their battles against public companies, it’s easy to imagine the collateral damage to longer-term investors from these fights. But activists have been successful of late. Their funds rose 6.5 percent during the first six months of 2014, almost double the average hedge fund’s return in the same period, according to data provider eVestment.

The consensus at Delivering Alpha — where Ackman, Icahn, Peltz and Starboard Value CEO Jeffrey Smith all mounted a rousing defense of activism as an investment strategy — was that when an investor shakes up corporate managers who aren’t doing enough to raise the share price, all stakeholders win.

“Activists are doing this for the benefit of the people who own the business,” said Peltz.

Still, activists have no shortage of critics. Laurence Fink, CEO of New York–based asset management colossus BlackRock, said earlier this year that activists often push for immediate changes that they can profit from at the expense of companies’ long-term research and development efforts. Recently retired Judge Jack Jacobs of the Delaware Supreme Court has called for three-year terms for corporate directors, making it more difficult for activists to have sway over companies.

It’s no surprise that investors and others are calling for curbs on the influence of activists on public companies. Activists, many of them commanding powerful hedge fund firms that the public loves to hate, are viewed as short-term profiteers. But there’s little evidence that activists are just bounty hunters in search of a quick buck or that CEOs and boards of directors of public companies are always smart stewards of shareholder capital.

When an activist reaches the point of trying to nominate board members, it can be because they believe the managers and directors aren’t looking out for the company’s long-term interests. Icahn, who has never claimed to be a diplomat, said at Delivering Alpha that the problem is not that activists are trying to make a profit but that “the wrong guys are running the company.” He said some CEOs are little more than “frat presidents” who stack the board with old friends, “and the guy at each level below is always a little dumber.”

“If I can make this kind of money, it's proof there’s something wrong,” said Icahn.

Reducing shareholders’ ability to gain control of a company and have a say in corporate strategy may very well hurt such long-term shareholders as pension funds, endowments and mutual funds. That is a view defended by Peltz, CEO of the $7 billion-plus activist hedge fund firm Trian Fund Management. He has been pushing Pepsico to spin off its beverage and snacks business for more than a year. In February Pepsico CEO Indra Nooyi dismissed his plan, calling it a costly distraction, and Peltz said he hasn’t spoken with her since. Instead, however, he has taken his case to other shareholders.

“We definitely haven’t disappeared. We’ve met with about 100 of the top shareholders,” said Peltz of his battle with Pepsico. “Watch this space.” When pressed, he said a proxy contest is a possibility.

Still, it is becoming increasingly common for activists to try to talk with senior managers of a target company before they attack. Peltz said that is what he’s doing now with Bank of New York Mellon Corp., an activist position he disclosed on June 30. “We’re are having what I hope will be constructive conversations,” he said. “We want to give them first choice in responding to our proposals.”

Activism is on the rise because it’s harder to find alpha — risk-adjusted returns above a market benchmark. Economic growth is still paltry five full years after the height of the financial crisis, whereas the markets are filled to capacity with hypercompetitive and smart institutional investors looking for an edge and unique information on potential investments.

The Ontario Teachers’ Pension Plan has identified activism as a large source of future alpha. It’s dangerous to ignore strategies embraced by Ontario Teachers’. The pension plan is known for ground-breaking investment programs, including direct private equity investments. In 2012 the pension plan partnered with Rosenstein’s Jana Partners hedge fund firm to push media conglomerate McGraw-Hill Cos. to restructure. Jim Leech, CEO of Ontario Teachers’ at the time, said future equity returns would likely be meager and investments such as infrastructure and private equity wouldn’t deliver the same types of outsize returns that they have historically. But activist investing, he argued, could provide good returns. Companies can always be run better. Activists are third parties who can objectively assess the value of a subsidiary, whether it should be retained or sold and whether a potential acquisition makes sense.

Robert Pozen, a nonresident fellow with the Washington-based Brookings Institution and a former vice chairman of Fidelity Investments, says most governance proposals to quell activism, such as those that would lengthen directors’ terms, would actually hurt institutional investors by undermining the accountability of company management. He says that corporate plans need to be scrutinized as well, as academic research has shown that the vast majority of mergers and acquisitions don’t succeed in creating value, adding that building moats around companies isn’t the answer. “Let’s reduce shareholder rights because shareholders have too much say?” asks Pozen. “That is gross overkill and not relevant to the problem.”

Activists’ plans to unlock value in companies, such as by selling a barely profitable division or pushing management to distribute cash to shareholders as dividends, benefit other investors. Most activists own less than 10 percent of a company — Ackman’s Pershing Square Capital Management, for example, owns 9.7 percent of Allergan, which the hedge fund manager is trying to merge with Valeant Pharmaceuticals International — and need other investors in the company to back their plans to be successful. That’s a natural check on activists’ power and a way to distribute restructuring gains among a larger pool of investors.

Pozen emphasizes that hedge funds have succeeded in their plans only about 50 percent of the time, an indicator that big investors have the power to say yes or no. “These hedge fund activists can’t succeed unless their program gets the support of institutional investors,” he says. “Big investors know these public companies well, and they are the ones who decide whether a program will succeed or not. They won’t support long-term initiatives that don’t make sense.”

Pozen says there are simpler and much more effective ways to ensure that management takes the long view and that investors who seek short-term profits can’t damage companies. Lengthening the time horizon of management compensation packages, reducing the time it takes the market to learn about an activist’s stake in a company and pushing companies to stop projecting quarterly earnings are just three measures that he proposes.

Most companies base compensation for CEOs and other executives on performance over one year. Pozen says a three-year time frame would encourage longer-term, results-oriented behavior and is more logical. “You can get lucky in one year,” says Pozen. “But if you do a good job for three years, it probably means you have skill.”

Critics of activists want to know quickly when an investor has acquired a 5 percent stake in a company. Now the acquirer has ten days to file a report with regulators. The Securities and Exchange Commission is expected to soon issue a concept release that would reduce the disclosure period to two days.

Although people love to hate activists for seemingly milking public companies for immediate profits, corporate managers themselves have long played a dangerous short-term game: projecting quarterly earnings. A 2005 paper titled “The Economic Implications of Corporate Financial Reporting,” by John Graham, Campbell Harvey and Shiva Rajgopal, found that 80 percent of corporate executives were willing to suspend R&D to avoid missing earnings’ estimates. Companies, however, can refuse to give quarterly earnings estimates, or they can instead provide a broad range of earnings over a longer time period, such as a year. “If you do quarterly earnings, then you get an investor base that is interested in quarterly earnings,” concludes Pozen.

Follow Julie Segal on Twitter at @julie_segal.

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