by Beatriz Infante

Part 1 of this primer covers why small-cap companies can frequently be magnets for activist challenges.  Part 2 discusses the different kinds of activist investors in greater detail, and what motivates them.  Part 3 discusses concrete steps CEOs and boards can take to avoid triggering activist activity.  And Part 4 discusses what to do if activist engagement with your company becomes unavoidable. 

What CEOs and boards do when an activist knocks at the door will differ depending on the types of activist investors we discussed in Parts 1 and 2 – Passive-to-Activist Institutional Investors, Activist Hedge Funds with Improvement Plans, and “By the Playbook” Activist Hedge Funds – because the strategies they employ differ and therefore the company’s response needs to adapt to the activists’ approach.

Passive institutional investors turning activist

As we discussed in Part 1, a company’s existing shareholders who are normally passive institutional investors can turn activist when they have begun to approach “the point of no return” in frustration with a company’s performance.  However, unlike many of the hedge funds who specialize in activism (see below), these investors will typically first approach the company – either the board or the CEO – to discuss their issues, frequently through a letter to the board.  This communication may initially be private, versus a public filing. 

This is the critical point at which small-cap companies with inexperienced CEO’s and/or boards frequently make a mistake.  Many boards’ and CEOs’ first reaction is to hunker down and ignore the outreach from the shareholder, or worse, send a letter from their legal department rebutting the issues the shareholder has brought up.  That approach is – almost certainly – the path to a nasty proxy battle. 

Instead, the correct approach is to immediately reply via a phone call, and suggest an in-person meeting between the shareholder and the chair or lead independent director.  The company may be pleasantly surprised that the issue is resolved subsequent to this personal conversation, along with possibly some modest and reasonable changes on the part of the company. 

More likely, the shareholder will request that new blood be inserted into the board – not an employee of the shareholder – but another independent director with experience.  They may suggest some names.  The company should seriously consider these nominated candidates – and run them through their normal board recruitment process – and add them to the board if they are qualified.  

A qualified candidate or two who are added to the board often satisfy two purposes: bringing additional, objective expertise to the board, and also creating a shareholder who will be supportive of the company. Adding the candidates to the board could also be instrumental in keeping activist hedge funds at bay.

In general, normally passive investors don’t have the infrastructure of an activist hedge fund to develop additional plans for the company – their primary strategy will be to insert new experienced directors on the board and hope that they will be able to impact change at the company.  Only if the company rejects the added directors, or completely ignores them, will subsequent action be taken by the institutional investor – likely at the following year’s shareholder meeting, and likely looking to replace the entire board rather than just add one or two directors (and possibly acting in concert with a hedge fund activist).

Note – as we discussed in Part 1 – any investor that acquires more than 5 percent of a company, with the intent to influence management, is considered an activist investor and must file a Form 13D with the SEC.  If a passive investor, who has previously filed a Form 13G (indicating 5 percent ownership or greater, without intent to influence management), decides they want to influence management, they must file a new Form 13D that supersedes their original Form 13G. 

Activist hedge funds

As we discussed in Part 1, not all activists have the same approaches, nor are their objectives identical.

Activists with improvement plans

Activists with a longer-term value creation horizon, who have deeply studied a company and have specific improvement plans in mind, will behave rather similarly to passive institutional investors who turn active, at least in their initial approach to the company.  That is, they will frequently first approach the company and board privately, though that is usually shortly followed by publication of their letter to management and the board. 

Unlike passive institutional investors who only occasionally turn active, turning companies into profitable investments through active involvement is 100 percent of what activist hedge funds do.  What this means is that in addition to the senior partners who interact with the company, they have a number of junior staff available for research and financial analysis, as well as experienced former operating executives as advisors.  And unlike passive institutional investors who turn active (who cannot take board positions themselves), activist hedge funds may either nominate two or more independents to the board, or personnel from their fund.  Because of this depth of expertise, in addition to very deep pockets, it is not infrequent that a longer-term activist hedge fund actually has a better understanding of the company’s business, market, and likely outcomes, than the company itself does.

For these multiple reasons, it is often in the company’s best interest to acquiesce to most of this type of activist’s demands, because their involvement frequently leads to an increase in company performance/share price. 

From a practical standpoint, it’s important to be mindful of the alternative to such acquiescence. If this type of activist investor is rebuffed by the company, but their demands are viewed as reasonable by other shareholders, as well as by ISS and Glass Lewis, the next step may be a proxy battle in which ISS, Glass Lewis, and existing shareholders all support the activist.  The result is most frequently a proxy win on the part of the activist, landing the company in approximately the same (or potentially worse) spot they would have been had they initially accepted the activist’s demands, but now with some level of residual acrimony, and an activist who will almost certainly wage another proxy battle the following year if the company further resists. 

“By the playbook” activists

With the more aggressive activists, frequently the first warning the company will receive is a notification of a Form 13D filing by the activist, indicating they now own at least 5 percent – and possibly a great deal more – of the outstanding equity of the company. 

As indicated in Part 2, the “cohort effect” is quite real, and can create especially difficult dynamics for companies. Smaller cohort members – other investors that support the activists filing/involvement – can easily accumulate small percentages of shares that might elude the company’s attention.  Since institutional investors are allowed to delay their disclosures of quarter-end holdings for up to 45 days, the total voting power lined up against the company may be much larger than the company contemplated.

This is a situation where having established excellent relations with your current shareholders is paramount.  In deciding the company’s response to the activist’s letter to the board and the filing, it will be important to understand the implications of the demands being made by the activist hedge fund, and whether their requests are in the interest of all shareholders, or just the activist and their cohort.  Do you fight, or do you fold?  The answer depends on your institutional shareholders.

To put this into a concrete example, think back to the “one product company” described in Part 3.  The activist playbook accompanying the Form 13D filing would detail the following plan for the company:  shut down all development on product #2, use a significant portion of all the cash on the balance sheet for a large share buyback, and sell the company (primarily its installed base) to a competitor.

Now, suppose the share price that most the company’s current institutional shareholders bought their positions at is $10 per share, on average.  Due to the reasons attracting the activist, the company’s stock is now at $5, and the activist and its cohort have built a substantial position at that price or slightly below.  Since the activist is demanding the company find a buyer immediately, let’s use a generous 1.5X M&A premium to the company’s current stock price, which results in an offer of $7.50 per share.  This constitutes a 50 percent return to the activists’ share basis, which is a pretty compelling return for a few months’ work.

But what does this do for your existing shareholders?  If the CEO and the board have followed shareholder engagement best practices, and shareholders are aware that the company’s plan over the next three years is intended to drive a level of EBITDA that, with average industry multiples, could drive a $12-$14 per share price, then the existing investors will likely side with management and against the activist.  That is, approving an immediate acquisition will, with certainty, result in a loss, whereas sticking with management may net them a 20 to 40 percent return in three years.  If the investors believe in the company, they will take the chance of upside in the future versus certainty of loss today.

If, on the other hand, the company has ignored its shareholders, or communicated poorly with them, or has not provided a vision for the financial return the company could generate for them in the future, the institutional investors’ logic might be different.  They might think:

“The company’s stock has lost half its value since we bought into the company, and we haven’t been given any visibility or optimism that the company is doing anything to change that.  So, the stock could drop half its value again, and then we’d be at $2.50 per share.  We’re better off cutting our losses now, and taking the $7.50 per share, rather than rolling the dice again with a management team that hasn’t really shown us any reason to do so.”

Effective, transparent shareholder engagement can make all the difference in activist situations. 

The key takeaways from this four-part series are: 

1. The CEO, CFO, and the board should all engage with shareholders, spending most of the time listening, but also clearly communicating the company’s long-term strategy to drive increasing shareholder value. This is different than telling them your product roadmap and hoping they’ll figure out their stock will double in value – the onus is on the company to show that connection.
2. If you don’t engage actively with your normally passive shareholders, in today’s environment, there is a strong likelihood that they will turn from passive to active to improve their chances of shareholder value increases.
3. Not all activist hedge funds are “bad” for a company – there are a number of activists who could add value and benefit all shareholders.