What Every Small-Cap CEO Needs to Know about Shareholder Activism (Part 1 of 4: Who Are They, and Why Are They Here?)
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. Also see parts 2, 3, and 4.
It’s hard to look at a business publication these days and not see a new announcement of shareholder activism. Statistics confirm that activism is on the rise and here to stay. In a 2018 report, Sullivan and Cromwell LLP reported that in 2017 alone, activists won an additional 76 board seats, raising their five-year total to 642. But frankly, that figure significantly under-reports total activity, since many activist challenges are settled quietly and do not rise to the level of proxy battles or board seats. In fact, despite the fact that media attention is understandably focused on activism involving name-brand companies, estimates are that as much as 80 percent of activist campaigns are in small-cap companies.
Why me? I’m “just” a small-cap!
Seeking Alpha lays down the “Six Laws of Small-cap Investing.” The first three illustrate why small-caps are such attractive targets for activists:
- Outperformance. Research shows that, on average, small-caps increased in value by more than 12 percent per year between 1927 and 2007, versus 10 percent for large-caps. And because small-caps are, well, small, you can invest smaller amounts, requiring less capital outlay with a proportionately higher return. Significantly, it’s also operationally much easier to double the size of a $250M company than a $25B company, and these two factors help to compound the investor’s rate of return. In financial terms, a $1000 investment over the period above would have resulted in a return of $16M if invested in small-cap stocks, versus a return of $3M if invested in large-caps.
- Underfollowed. Because Wall Street and analysts go where the money is, small-caps are not well-researched. This means there are many more opportunities for mis-pricings, creating opportunities for investors who carefully do their homework to identify and capitalize on potentially large discrepancies between the stock prices and the actual value of the companies
- Investor exclusion. But it isn’t just the media and analysts that don’t cover small-caps – many of the large institutional investors simply can’t invest due to their funds’ requirements. That is, some funds can’t invest in stocks below a minimum share price, or they might have a minimum size of investment coupled with regulatory requirements to be below a certain level of ownership. For example, if the minimum required stake for a fund is $15M, and the fund can’t own more than 12 percent of any company, that investor simply can’t take a position in a $100M market cap company.
Moreover, small-cap companies frequently have less experienced management teams and board members, and therefore are not as well equipped to combat activists as large-caps. This also makes small-caps such lucrative targets for many activist campaigns.
The best starting point for small-cap CEOs is to first understand the different types of activist investors. Ultimately, the best defense requires understanding what the activist wants.
Activism is no longer just limited to a few activist hedge funds
The first thing to understand is that shareholder activism is no longer the sole purview of the well-known large-cap activists – the ones whose names are always in the news targeting large well-known companies such as Yahoo, eBay, and others. Large-cap activists with familiar names such as Carl Icahn, Nelson Peltz, Daniel Loeb and others may gain most of the attention, but the vast bulk of activism is targeted at small-cap companies, and small-caps are far too small to gain their attention.
When small-caps do get targeted, the activism will most likely come from specialized investors known as activist hedge funds, or simply activist investors.
An activist hedge fund is simply a type of investment fund which uses unconventional investment strategies and takes an active role in realizing the value of their investments. An active role can include: engaging with the board to add board members and/or change strategies or management; fighting a proxy battle to replace some or all of a company’s board members; forcing companies to sell some of their assets or the whole company; or, any number of other actions. They do this by buying shares in your company and then influencing other shareholders to support them.
If an investor acquires more than five percent of a company – with the intent to influence management – it is considered an activist investor, and must publicly file a Form 13D filing with the U.S. Securities and Exchange Commission (SEC). In addition to alerting management and the board of the investor’s ownership stake and intentions, a 13D filing will also alert other investors that an activist is targeting your company. This could result in other investors buying stock in the company, who are either sympathetic to the 13D-filer’s arguments or simply believe that the stock will rise as a result of the activist’s involvement.
However, increasingly, activism is coming from institutional shareholders that already own your stock. An institutional investor is just what the name implies – large institutions such as banks, pension funds, mutual funds, and other types of investment vehicles that buy and sell stock for their investment portfolios. According to Broadridge’s 2018 Proxy Season Review, institutional investors own, on average, 70 percent of public company shares (the remainder are owned primarily by individual, or retail investors), with small-cap companies having a slightly lower percentage of institutional ownership. However, institutional investors account for 91 percent of shareholder voting participation, versus only 28 percent voting participation by retail investors. This means that even if you have a lower than average ownership of your stock by institutional investors (and therefore more retail investors), from a voting perspective, institutional investors wield voting power that is significantly larger than their percentage ownership.
Despite their disproportionate voting power, institutional investors have historically been passive, meaning they listen to management presentations and ask questions, but won’t take steps to change what management is doing. Typically, they buy your stock if they think its value is going to increase, and sell if they lose confidence in the company or think they might get a better return elsewhere. Historically, passive investors indicated disappointment with a company’s performance in only one way… by selling their stock.
All that has now changed, probably in a permanent fashion. Passive institutional shareholders can and do turn active, either on their own behalf, or in conjunction with an activist investor if they are sufficiently unhappy with your company. Sometimes, they will call in an activist hedge fund to target your company, but will themselves stay in the background while the activist takes the lead. But that doesn’t mean they will stay passive when it comes to a vote to add or replace board members.
Why do passive investors become active? They become active because they have reached a “point of no return” in terms of unhappiness with the company’s performance. There is usually not a single triggering event, but rather a combination of factors, including strategy, financial performance, executive compensation, poor governance, or “shareholder unfriendly” practices.
“The bottom line is that happy shareholders do not become activists.”
For a more granular understanding of different kinds of activist investors and their motivations, read Part 2.
(1) Sullivan & Cromwell, Review and Analysis of 2017 U.S. Shareholder Activism, https://www.sullcrom.com/siteFiles/Publications/SC_Publication_Review_and_Analysis_of_2017_US_Shareholder_Activism.pdf
(2) The Risks and Rewards of Small-Cap Boardrooms, https://adamjepstein.com/risks-rewards-small-cap-boardrooms/
(3) Broadridge-PwC ProxyPulse: 2018 Proxy Season Review, https://www.broadridge.com/_assets/pdf/broadridge-2018-proxy-season-review.pdf