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. 

The best advice for avoiding activism altogether is to have stellar operating performance coupled with stellar share growth, and never miss an earnings forecast.

“For the remaining 99.99% of companies that don’t fit that description, let’s discuss the signs that you are, or will shortly become, an attractive target for activism.”

There are two over-arching things to keep in mind about the conditions that are conducive to bringing about activist interest.

First, activism is triggered by the belief that there is inherent and “unlocked” value in the company.  That is, management and board could be doing a lot more to create value; i.e., increase the share price.

Second, activism is triggered by a continuing pattern of events or actions that make investors unhappy, versus one catastrophic event.  For example, significantly missing one quarter in the midst of a general pattern of decent results may bring litigation, but rarely activism.  Activist involvement in a company’s stock happens when management and board credibility erodes to such an extent that investors are motivated to take matters into their own hands.

Key warning signs that signal your company may become a target of activists are:

• A continuing pattern of declining revenue and/or profitability. When such a pattern is accompanied by little in the way of explanation, and in a market where your competitors’ businesses are growing, activists will take note. Examples include:
  • Your revenue is declining 5 percent quarter over quarter, but your top two competitors are growing at 15 percent, and the industry index you belong to is growing at 10 percent; and
  • Your revenue declined 15 percent year over year, while your sales expenses grew 20 percent and overall expenses grew 18 percent.
• A continuing pattern of missed guidance. For example, you guide to cash-flow breakeven by end of the year, and instead your cash burn accelerates every quarter, with no obvious explanation about why the company appears to be going in the opposite direction it indicated.
• “Bad” governance. There are a whole host of management and/or board situations that trigger activism when coupled with the performance examples above.  For example:
  • You’ve had the same five directors on your board for ten years, while your revenue and stock price stayed flat or declined;
  • Your directors are your golf buddies, or people you went to college with; and
  • Miscellaneous practices which are viewed as investor unfriendly, such as lack of proxy access (the ability of shareholders to add items to your proxy card), and taking no action when directors receive majority “no” votes on the company’s annual proxy card.
• High executive pay. CEO, executive, and board compensation can become the key trigger point to activists, because it’s been proven to be the fastest way to get management’s attention. Fact patterns may include:
  • Insufficient “at risk” compensation for named executive officers;
  • A CEO selling shares annually despite receiving additional stock grants; and
  • Excessive perks (e.g., $100K car allowance for CEO) on top of already-high compensation, or single-trigger change of control agreements.
• Bad ISS or Glass Lewis governance scores^[1] . Institutional Shareholder Services (ISS) and Glass Lewis (GL) are proxy advisory firms that nearly all institutional investors rely on.  ISS and GL each publish recommendations for proxy voting (e.g., for or against the election of each director), as well as detailed reports that include “governance scores” and “say on pay” scores on the companies they cover.  It is important to note that a majority of activist targets have received a “no” Say on Pay recommendation from ISS and/or Glass Lewis, so if your company has received a “no” recommendation from them, your chances of future interactions with activists increase significantly.

Avoiding activism

The best way to avoid activism is to take corrective action on as many of these warning signs as possible.  

Compensation is a disproportionately significant red flag that is relatively easy to deal with.  It may require that the CEO have extensive conversations with their team to ensure retention while taking away some perks.  That said, the alternative to the CEO taking action to right size compensation is action taken by an activist, which will be significantly more unpleasant than if the CEO or board proactively address the issues in a forthright manner.

Likewise, refreshing/reshaping the board to address poor governance isn’t simple or easy, but it can bring new perspectives to the boardroom and serve as a deterrent to activism.

In addition to recognizing key warning signs, there is an even more basic tenet of avoiding activists – maintaining an ongoing, transparent relationship and clear communications with your largest investors.

Some of the items on the red flag list may be less easy to deal with than compensation and board diversity.  For example, the company may be a one-product company, and the market for that product is flat.  A new product is under development, but not yet contributing to revenue.  The competitors have that product, so their revenue is growing, while the company’s revenue is flat to declining.  In the meantime, R&D spending has significantly increased in order to develop the new product.  Part of maintaining a clear dialog with shareholders may mean disclosing those details – which may be more information than the CEO might feel is comfortable – but may help to give investors a better understanding of the underlying difficult economics the company is facing.

It’s also important to keep in mind that shareholder engagement should not be limited to just the CEO or CFO.  Shareholder engagement best practices have significantly evolved over the last few years.

The EY Center for Board Matters 2018 Proxy Season Review^[2] indicates that in 2018, 77 percent of S&P companies disclosed engaging with shareholders, up from 56 percent in 2015, and that 33 percent of the companies disclosing engagement indicated directors were involved, up from 10 percent in 2015.

Many directors, particularly of small-cap companies, have an unwarranted fear of violating Regulation FD, if they speak to shareholders directly.  However, it is clear from the E&Y report, and numerous other corroborating sources, that investor expectations of engagement with board and management continue to increase. Companies wanting to maintain positive relations with their shareholders would do well to put in place regular processes for directors to engage with shareholders, rather than relegating the task exclusively to the CEO, CFO, and/or head of investor relations.

To learn more about what do to if activist involvement with your company looks imminent, continue to Part 4.

[1] Proxy advisory firms like ISS and Glass Lewis provide data and research on public companies to institutional investors and hedge funds.  Most importantly, however, they provide recommendations on how to vote the investor’s shares on the company’s proxy (e.g., election of directors, Say on Pay, etc).  Many large institutional shareholders have their own teams that analyze data and come up with independent recommendations for the institutional shareholder’s proxy voting (i.e., they consider ISS and Glass Lewis, but don’t exclusively rely on them). Many smaller institutional shareholders, however, simply vote per the ISS and/or Glass Lewis recommendations.  Now matter how you slice it, proxy advisory firms wield material influence.

[2] E&Y 2018 Proxy Season Review, https://www.ey.com/us/en/issues/governance-and-reporting/ey-2018-proxy-season-review#section4.