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. 

Many companies lump all activists into one category, but in reality, there are many different types of activist hedge funds, each with different investment models and different objectives in terms of the timing and size of their investment return. 

Though the range of desired activist outcomes is quite diverse, an easy way to look at it is to group them into two broad categories: activists with a longer-term and collaborative approach to underperforming companies, who have a concrete turnaround plan developed just for that company; and, activists with much shorter time horizons and more of a one-size-fits-all “playbook” to generate quick returns. 

In all cases, however, there will be a couple of initial steps that are common to all activists:

• The activist will begin accumulating stock. Particularly in the case of companies with more illiquid stock (i.e., low daily trading volume), they may do so over a period of time to avoid unintentionally raising the stock price, while they continue examining/analyzing the company.  Since a 13D filing is only necessary after they accumulate 5 percent or more, a company may have activists in their stock for several weeks – or longer – before they realize it.
• Either privately at first and then publicly, or publicly at the same time as the 13D filing, the activist will issue a letter to the board and company detailing the reasons for the activism and detailing their demands.

Activist hedge funds with improvement plans

The activist hedge funds with the best reputations have a multi-year view of value creation in the companies they target and can materially improve the companies they work with.  They typically research their targets deeply, and usually don’t approach them unless they have a very detailed operational plan for their improvement, which they make public. Since their plans are generally well-thought out and available for any other shareholder to see, they frequently garner support from existing passive investors.  That is, investors who are frustrated with some aspect of the company’s performance, who decide that the activist’s plans for the company are better and more detailed than the plans presented by management.  In that way, the activist gains support for their proposals; the combined voting power of the activist, plus supportive existing institutional investors, puts tremendous pressure on a company to accept the activist proposal(s).

One generally well-respected activist, Starboard Value, targets selected small-caps as well as numerous mid- and large-caps.  They have a reputation for careful research, not just of the issues the company is facing, but of ways to solve the problems.  They frequently approach the company privately first and prefer if they are invited in. 

Sometimes, the changes they are seeking are extensive; for example, with Darden Restaurants, they replaced the entire board. But in nearly all other cases, the changes they are advocating are more modest.  They will typically add a couple of directors, do their work, and then exit peacefully a few years later. 

For example, in the case of small-cap IDT (NYSE: IDT), Starboard took a position in 2012, when the stock was around $5.  They added two directors – one a partner at Starboard, and the second a well-respected independent industry executive – and worked collaboratively with the board and company.  When they sold their position a few years later and exited the board, the share price had increased to $16.

ValueAct Capital’s founder, Jeff Ubben, is known by some as “the friendly activist,” and in general avoids public battles in favor of gaining board seats and working collaboratively.  After having made a significant investment in their target, ValueAct sets out to work productively with management and/or the board of directors, to develop a strategy that aims to maximize returns for all shareholders.  Like Starboard, they have a longer-term view and have a reputation for adding value.

“By the playbook” activist hedge funds

Other activists have a more aggressive approach to their targets.  They are typically looking for a shorter timeframe to returns, and their go-to playbook usually includes more disruptive actions, such as taking the company private, selling the company, or drastically reducing operating expenses – like R&D spending – to achieve near-term improvements in the company’s financial performance. 

Not infrequently, the level of cuts demanded are incompatible with the long-term health of the company, so the playbook also frequently includes plans for sale of the company either to a larger company, or to private equity, or divestiture of lines of business followed by M&A.  The activist “playbook” also frequently includes using a significant portion of the company’s cash to buy back shares, increasing dividend payments if the company pays dividends, and other forms of returning cash to shareholders.  Unlike the longer-term view activists discussed above, these activists frequently stick to their playbook, sometimes with little consideration of the company’s specific circumstances.

There are a number of these type of activists who particularly target small caps – Elliott Management, Eric Singer’s VIEX Capital, and Northern Right Capital (formerly Becker Drapkin Management), are notable small-cap activists.  As one of the most active and aggressive activist funds, Elliott Management launched more than three times as many campaigns as any other major fund in 2017, and has been enormously successful in achieving its goals.  With more than $55B of AUM, Elliott is roughly twice the size of the next biggest fund and unlike less aggressive investors, shows little hesitation in engaging in protracted proxy battles to achieve its goals. 

With these more aggressive activists, frequently the first warning the company will receive is a notification of a 13D filing by the activist, rather than a private outreach.  Because these firms have proven so successful, there are numerous smaller activists who do not lead activist campaigns but will “pile on” once they see the 13D filing.   This can create a substantial cohort, as mentioned earlier, that can force the company to acquiesce to the lead activist’s demands with consolidated voting power that a single investor cannot bring to bear.  And, of course, keep in mind that there may be one or more existing passive, unhappy shareholders, who were the origin of the company becoming an activist target in the first place.

To learn more about concrete steps CEOs and boards can take to avoid triggering activist activity, continue to Part 3.