Top 400: Investing under the influence
Activist investing is benefiting from significant tailwinds and we believe the strategy is one where manager alpha can be more tangible and identifiable than other hedge fund strategies. Investors do need to factor into their decision whether to accept the significant net equity exposure inherent in the strategy, as well as their ability to accommodate a level of illiquidity.
Activism can range from a long-only investment manager simply voting their shares at a company’s annual general meeting, through to a private equity manager taking control of companies to effect direct change. There are varying degrees of activism in between that can be classified broadly into two groups:
• Active managers – including long-only and hedge fund managers – whose investment in a company is driven primarily by a valuation rather than their intention to effect change per se. These managers will, from time to time, engage more actively with the management teams of companies that they own in situations where they believe management is not maximising value in some material way. Direct engagement with underlying companies is a secondary driver.
• Active managers – often structured as hedge funds – whose added-value proposition is driven by an activist stance and where the investments they make will be heavily predicated on their view that they can successfully effect change that will add value to shareholders. Direct engagement with underlying companies is a primary driver. Here we focus mainly on the latter group of managers, as well as give our views on the prevailing opportunity set for the activist style of investment.
An activist shareholder uses its stake in a company to apply pressure on management. The goals of activist shareholders range from financial (seeking the increase of shareholder value through changes in corporate policy, financing structure, cost cutting, and so on) to non-financial (for example, disinvestment from particular countries, adoption of environmentally friendly policies, and so on).
We prefer the more collaborative form of activism, where the manager seeks to engage (often robustly) with company management ‘behind the scenes’. Discussions are focused on the implementation of structural changes within a company to improve operating margins over time, and/or lead to a business structure that is better ‘rationalised’ by the market, resulting in higher-valuation multiples. Often, the target companies are established franchises that have undergone a period of poor management and share-price underperformance: as a result, the entry point itself will offer an element of downside protection. Typically, this style of activist is more ‘income statement’ focused in its views and methods of improving the operational efficiency of companies over time.
This contrasts with the more ‘balance sheet’ focused approaches that tend to rely more heavily on the use of leverage to generate return; such approaches tend to be more aggressive in style, involving activities such as proxy fights, public discussions on a company or company management’s failings, and adopting a more adversarial relationship with company management. This carries the disadvantage that investors with the activist manager can be inferred to hold the same adversarial, and in some cases controversial, view of a particular company or company management.
Irrespective of style, an activist is seeking to effect change in a company’s management with the end result of value accretion for all shareholders and/or subsequent re-pricing upward to reflect the improved structure. Whether the approach is hostile (proxy fights and replacement of boards) or friendly, the end goal is to unlock value. The time horizon/duration of investment and opportunity can be a multi-year period with little recourse to interim liquidity, hence it is important that an investor in an activist fund is satisfied that it offers sufficient demonstrable skill to justify an allocation.
Further, activist hedge funds may have more restrictive liquidity provisions than their fundamental long/short equity or long-only peers, since their underlying investments require a longer holding period, due to the time it takes for them to work with company management to implement their plan. As large stakes in target companies are held, it should be noted that exiting positions can have regulatory restrictions or execution challenges.
We have observed that the more collaborative activist approaches seeking to work with, rather than against, incumbent management tend to have an easier route to effecting positive change, although, by its nature, activism is idiosyncratic and situation-specific.
The idiosyncratic nature is also observed in exit routes from positions that can range from a simple share sale to an industry buyer, to divestment of underlying businesses and subsequent cash distribution, share repurchase or corporate structure change, particularly increased or special dividends. The fact that there is no one method of exit grants flexibility to the strategy; also, by investing in publicly listed securities there is always recourse to selling at an established and identifiable market price. This latter option, of course, also applies to being patient in waiting for an entry price rather than being restricted to what is for sale, often quoted as an advantage over the private equity approach.
There are some factors that we believe would make activism a less compelling investment approach, such as significant:
• change in corporate governance/regulatory environment impacting shareholder participation;
• evidence of persistent allocation to cash within a portfolio (signalling a weak opportunity set);
• decline in corporate M&A activity;
• increase in market volatility. Should the volatility persist it could erode the willingness of companies to undertake many of the actions that activists suggest, as high volatility regimes are often associated with company management uncertainty, increasing financing rates/spreads, and a decrease in M&A activity.
Not all activist managers have the experience that would justify using them to implement an activist strategy and they should be chosen with care, to have at least these core skills:
• An investment team with company management experience, often management consultancy or private equity backgrounds
• Evidence through their fundamental research of a strong knowledge of the underlying businesses in which they are invested and why their proposed value enhancement strategies make sense
• Demonstrable reasons why they will have the credibility to influence company management; path dependency is important – prior success in investments and continued positive relationships with prior company management as well as other shareholders, who often act as references
• Awareness of risks – selection of entry point is important
• Appropriate fund terms – a liquidity structure that supports the process as well as a fee structure that ideally addresses the often significant net market exposure.
We believe the portfolio benefits of an active and concentrated approach, when using a highly skilled manager, can make a significant contribution at the aggregate portfolio level – be this either as part of a hedge fund allocation or broader equity long-only layer.
Craig Stevenson is a senior investment consultant at Towers Watson