Transcript Shareholder Activism - University of Rhode Island

Shareholder Activism
Shareholder Activism
 Certain hedge funds focus on shareholder activism as a core investment strategy
 An activist shareholder acquires a minority equity position in a public
corporation and then applies pressure on management in order to increase
shareholder value through changes in corporate policy
 Some of the common changes advocated by activist shareholders include
reducing corporate costs, repurchasing common shares, increasing corporate
leverage, increasing dividends, reducing CEO compensation, reducing cash
balances, and divesting certain businesses
 In addition, activist shareholders will sometimes campaign against proposed
acquisitions or allocation of cash for purposes that are not perceived to create
shareholder value
 Activists sometimes also pursue a sale of a target company or a breakup of the
company through a piecemeal sale or spin-off of significant operations
Shareholder Activism
Shareholder Activism
• Some corporations are vulnerable to hostile initiatives by activist shareholders
• Hedge funds can be vocal investors who demand change in the corporate governance landscape in a
number of ways:
o Publicly criticizing/challenging Boards and managements
o Nominating Board candidates and pursuing their agenda through proxy contests
o Supporting other activists
• Hedge funds’ activist strategy has been successful by taking advantage of:
o Like-minded hedge funds’ herd mentality
o Ability to overcome reputation for short-term focus
o Ability to skillfully use a deep arsenal of securities and financial instruments
o Familiarity with M&A and legal regulations and rights
o Readiness to go to battle and devote significant resources to full-blown public relations battles
Source: Morgan Stanley
Shareholder Activism
 Activist shareholders usually acquire between 1% and 10% of a target
company’s shares, or create an equity exposure by entering into equity
derivative transactions, such as purchasing call options on the company’s stock,
simultaneously purchasing call options and selling put options on the company’s
stock, entering into forward transactions to purchase the company’s stock, or
entering into equity swaps in relation to the company’s stock
 A relatively small share holding or equity derivative position established by an
activist shareholder may enable the investor to launch a campaign to make
significant changes in the company, without the added cost and time required by
a complete acquisition
 To be effective, however, the activist shareholder generally must obtain the
support of other large shareholders through large-scale publicity campaigns,
shareholder resolutions or, in the extreme, proxy battles for control over the
board of directors
Shareholder-Centric vs DirectorCentric Corporate Governance
 A key issue in corporate governance is whether the corporate board of
directors will survive as the governing organization of the public
corporation, or if shareholder activism will ultimately invalidate the role of
the board
 In other words, will corporations become more shareholder-centric and
less director-centric in their governance?
 Some critics of shareholder-centric governance indicate that this movement
is causing a shift in the board’s role from guiding strategy and advising
management to ensuring compliance and performing due diligence
 This shift can create a wall between the board and the CEO, removing the
“trusted advisor” role of board members, as CEOs become increasingly
wary of sharing concerns with investigative and defensive boards
Shareholder-Centric vs DirectorCentric Corporate Governance
 Based on concern about litigation, directors sometimes become so focused on
their individual committee responsibility that they are less able to focus on the
broad objectives of maximizing shareholder value and they become “Balkanized”
into powerful committees of independent directors, unable to broadly
coordinate the focus of the entire board
 Even when the board is able to focus on the business of the corporation in
cooperation with the CEO, activist investors create pressure on boards to
manage for short-term share price performance rather than long-term value
creation.
 This may result in short-changing the company’s relationships with its
employees, customers, suppliers and communities, as well as reducing
investment in R&D and capital projects that are critical to a company’s longterm success
Shareholder-Centric vs DirectorCentric Corporate Governance
 Another criticism of shareholder-centric governance is that
shareholder activists could ultimately wrest substantial control
from boards, causing companies to bring almost every important
decision to a shareholder vote
 This would largely shut down the normal operating procedures of
the company, slowing down decisions and creating competitive
disadvantages, as previously confidential decisions that were made
by the board are put in the public domain
 There is also concern that activist shareholders can create
inappropriate pressure on boards through non-documented
alignments between different activists to achieve their objectives
Activist Shareholder Returns
Comparison of All Hedge Fund Returns vs. Activist Hedge Fund Returns, 2005 – 2008
Annualized total return, %
26.3%
17.8%
9.3%
4.2%
2.7%
5.0%
All hedge funds (HFRX Global Hedge Fund Index)
-23.3%
Activist hedge funds (HFRX Activist Index)
2005
Source: Hedge Fund Research, Inc.
2006
-30.8%
2007
2008
Activist Shareholder Tactics
Potential Activist Tactical Approaches
Activist required to
file for HSR clearance
if intention is to
accumulate a stake
>$63MM or >50%
Activist
approaches
Board and/or
shareholders
c) Announces “Plan” directly in a press
release / 13D filing
d) Submits shareholder proposal
regarding “Plan”
e) Submits shareholder proposal
nominating Board candidates
Public Assault
Activist required to
file Form 13D after
accumulating stake of
at least 5%
b) Sends letter outlining “Plan” to Board
only
Private Discussion
a) Calls Chairman/CEO to arrange
meeting
Activist quietly
accumulates stake –
no contact with
company
Primary Campaign Type: 2008 Proxy Fights
Board representation 63%
Within 18 months of an initial
activist 13D filing, more than
50% of targets are involved in
an asset-sale and/or change in
capital structure/corporate
governance related outcome
Board control 31%
Withhold vote for director(s) 2%
Vote for a stockholder proposal 2%
Vote/activism against a merger 2%
Maximize shareholder value 1%
Vote against a management proposal 1%
• Activists aggressively use the public domain to communicate and play out their intentions
• There is also a “herd” phenomenon in which funds will collaborate informally to increase influence
• This phenomenon means that a situation can destabilize quickly amid a churn in the investor base,
despite small individual investments
Source: Morgan Stanley
Activist Hedge Fund Strategies
 For an activist investor, timing is everything
 Their objective is to accumulate enough ownership in a
targeted company to influence change, but they want to
accumulate shares without drawing attention from the
target and without attracting tag-along investors, whose
purchases can drive up the stock price, making it too
expensive to accumulate additional stock
 Some activist investors have utilized derivatives to help
them create a large exposure to a company, without
alerting either the target or other potential investors
Accumulating Shares Through An
Equity Swap: CSX
 The SEC requires investors that own 5% or more of a company’s
equity to disclose their ownership through a 13D filing within 10
days of acquisition
 To avoid tipping their hand, however, some activist investors have
used cash-settled equity swaps (which do not require 13D
disclosure) to create an equity exposure to the target
 An equity swap is typically entered into with an investment bank
counterparty, which causes the bank to buy shares as a hedge
against their obligation to pay the returns of the stock ownership
(appreciation or depreciation, plus dividends) to the activist hedge
fund in exchange for payments that are based on a floating rate of
interest (typically LIBOR) plus an appropriate credit spread
More on Equity Swap
 Example: take a simple index swap where Party A swaps £5,000,000 at LIBOR + 0.03%
(also called LIBOR + 3 basis points) against £5,000,000 (FTSE to the £5,000,000
notional). In this case Party A will pay (to Party B) a floating interest rate (LIBOR
+0.03%) on the £5,000,000 notional and would receive from Party B any percentage
increase in the FTSE equity index applied to the £5,000,000 notional.
 In this example, assuming a LIBOR rate of 5.97% p.a. and a swap tenor of precisely 180
days, the floating leg payer/equity receiver (Party A) would owe
(5.97%+0.03%)*£5,000,000*180/360 = £150,000 to the equity payer/floating leg
receiver (Party B).
 At the same date (after 180 days) if the FTSE had appreciated by 10% from its level at
trade commencement, Party B would owe 10%*£5,000,000 = £500,000 to Party A. If,
on the other hand, the FTSE at the six-month mark had fallen by 10% from its level at
trade commencement, Party A would owe an additional 10%*£5,000,000 = £500,000
to Party B, since the flow is negative.
Accumulating Shares Through An
Equity Swap: CSX
 In some equity swaps, the hedge fund has the right to purchase the
underlying shares from the counterparty under certain
circumstances, at which point the hedge fund would disclose
ownership of the shares (but not before the shares are delivered)
 The key question under this arrangement is who controls votes
attached to the shares that are the subject of the equity swap?
 Since the activist does not own the shares, they technically do not
own the voting rights, and therefore may not be required by the
SEC to disclose ownership under 13D rules
 However, since the hedge fund might be able to receive these
shares before a future vote on the election of directors, the activist
can theoretically own the shares when it matters most
Accumulating Shares Through An
Equity Swap: CSX
Equity Swaps on CSX Shares
Assume CSX share price of $40 when equity swaps were executed on 62.5 million shares (a notional amount of
$2.5 billion)
Total returns paid on
Equity Swap involving
62.5mm CSX shares
TCI and 3G
Interest payments
@ Libor + 50 b.p. on
$2.5 billion
Investment
Banks
62.5 mm
CSX shares
$2.5 billion loan
Lenders
Interest payments
@ Libor + 25 b.p. on $2.5
billion
$2.5 billion
CSX
Shareholders
The outcome of this transaction is:
• TCI and 3G receive economic exposure to 62.5 million CSX shares since they receive/pay total returns from/to
investment bank counterparties (quarterly appreciation/depreciation of CSX share price + dividends)
• Since TCI and 3G don’t own shares (investment banks purchased 62.5 million CSX shares to hedge their equity
swap position) the hedge funds may not need to report beneficial ownership of these shares to the SEC
• The investment banks receive a spread of 25 basis points between their cost of borrowing $2.5 billion and the
payments received from TCI and 3G under the equity swap
• The hedge fund may have the right to unwind the equity swap in the future before a proxy vote by paying $2.5
billion to the investment banks in exchange for 62.5 million CSX shares
Accumulating Shares Through
Equity Collars: Yahoo
 During February 2008, Microsoft offered to buy Yahoo at $31 per
share, but Yahoo’s CEO and founder rejected the offer
 Following this rejection, Carl Icahn started accumulating a
position in Yahoo stock, attempting to benefit from an eventual
sale to Microsoft
 During May 2008, Icahn initiated a proxy fight against Yahoo after
acquiring an equity equivalent position of 59 million Yahoo shares.
This position was comprised of 9.9 million common shares and
equity collars on 49 million Yahoo shares
 The equity collars were created through the purchase of call
options on Yahoo (American style calls with an unknown strike
price and maturity) and the simultaneous sale of put options on
Yahoo (European style puts with a strike price of $19.50,
maturing in November 2010)
Accumulating Shares Through
Equity Collars: Yahoo
 The equity collars provided the following potential benefits for Icahn
 The estimated cost for the equity collars could be zero, compared to the
over $1.23 billion cost that Icahn would have paid to purchase 49 million
Yahoo shares at the $25.15 opening share price on the date the collars were
entered into
 Entering into a collar transaction was less visible than purchasing 49 million
shares, enabling Icahn to secure his position without competing directly in
the market for shares
 The options can be settled physically, by delivery of shares, or if Icahn does not
want to buy Yahoo shares if options are exercised, he can “cash settle” the
options
 Cash settlement means that, if an option is exercised, the economic equivalent
of a physical settlement will be paid in cash (payment to Icahn if Yahoo’s share
price exceeds $32.85 or from Icahn if the share price falls below $19.15)
Accumulating Shares Through
Equity Collars: Yahoo
Equity Collars on Yahoo Stock
• Assume Yahoo share price of $25.15 when the equity collar is executed
• Put options on 49 million Yahoo shares at a strike price of $19.15 and an 18 month maturity can be sold for
proceeds of:
(i)
$2.14/option
• Call options on 49 million Yahoo shares at a strike price of $32.85 and an 18 month maturity can be
purchased for a cost of:
(ii)
$2.14/option
• Total cost for a “Cashless Equity Collar” = (i) - (ii) = $2.14/option - $2.14/option = $0
Sell Put Options
Economic
Value
+
$2.14
$0
Economic
Value
Buy Call Options
$0
-$2.14
$19.15
$25.15
$25.15
= Costless Equity Collar
Economic
Value
vs.
$32.85
Purchase Yahoo @ $25.15
Economic
Value
$2.14
$0
$0
-$2.14
$19.15
$25.15
$32.85
$25.15
Activism Summarized
 There is disagreement on whether hedge fund shareholder activism makes
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companies stronger or merely generates short-term gains that principally
benefit the activist at the expense of long-term shareholders
During 2008, there were more than 75 U.S. hedge funds dedicated to eventdriven, activist-style investing and these funds managed more than $50 billion
in assets
Some institutional investors have lined up with these hedge funds to push
boards to be more responsive to shareholders
In a number of cases, it appears that improvements have been made in
companies that, in the absence of shareholder activism, may not have occurred
In other cases, large share repurchases pushed by activists and created large
opportunity costs when the repurchases occurred before subsequent steep share
price drops
In addition, some acquisitions pushed by activist shareholders have seen
significant share price drops since closing