Martin Steward talks to activist investors about how they justify the costs and risks of engaged ownership

During a recent debate in the UK Parliament, pensions minister Steve Webb acknowledged the "step in the right direction" represented by the UK Stewardship Code published by the financial Reporting Council in July 2010. Institutional investors like pension funds were "powerful players", he observed. "The idea that these billions of pounds are not having an influence on company behaviour seems to me implausible. We therefore have an incentive to have a proportionate regime that maximises the beneficial impact of that activity."

"Maximising the beneficial impact" of anything is a bit motherhood and apple pie. The question is: which benefit, and whose? As a fiduciary, the pension fund's answer is simple - the financial benefit to members - and that presents a problem. Adding any technology, process or expertise to your investment programme - ‘stewardship' included - involves costs that must be balanced either by improved risk-adjusted returns or by cutting costs elsewhere.

Harlan Zimmerman, senior partner at €3bn public market activist investor Cevian Capital, identifies two basic types of shareholder engagement: reactive and integrated. The first, associated with conventional asset managers, is about dealing with problematic events or specific SRI issues, and is generally handled by a dedicated governance team working separately from the other investment professionals. The second, largely the preserve of specialists, is about engagement as investment strategy. "In those cases engagement is not a cost, it is a tool," he says.

But the fact is that if I buy a hammer I cannot use the same cash for a screwdriver. I pay my money, I take my choice. That choice seems to have paid off handsomely for investors who bought into Cevian Capital II in July 2006 - they are up 103% at end-2010 while the MSCI Europe index has fallen by 0.4% - but that simply means that the costs associated with Cevian's engaged investment style have been amply rewarded. So what can the strategies of boutiques like Cevian tell traditional institutional investors about the cost-benefit structure and added value of more engaged company ownership?

The word ‘value' gives one clue. Being prepared to engage potentially opens up a new universe of opportunities that are off-limits to traditional value investors - because they have already dismissed them as ‘value traps'.

"There have been a couple of occasions where we have transacted with a counterparty that has reached a point of such exasperation that they simply want to sell," says Robert Machell, partner and investment director at Governance for Owners (GO). "At that point markets no longer reflect fair value, they merely reflect that institutions don't want to own a stock - but that is precisely when we can add the most value by changing things. In those cases it is relatively easy to transact sizeable blocks at a price that really does compensate us for the risks."

Indeed, for Ralph Whitman, founder of the $3bn (€2.3bn) US activist manager Relational Investors, a company does not even have to be ‘undervalued'. As long as it is broken - and fixable - it is a target.

"We don't accept that these are mistakes by the market, as a classic value investor does," he explains. "We first assume that the market is correct. Then we find out what the cause of the valuation is, whether or not that is something we can change, and whether that won't change unless we, or someone like us, gets involved. So the risk is that our assessments are wrong or that our engagement programme is unsuccessful."

At least, this is the risk to the strategy's alpha. But the strategy also has a beta - a systematic, value-like style bias. "This is not a style for all seasons," admits Machell. "The reason you get involved in the first place is that you think there is a problem - a flight to quality in the middle of your engagement programme is clearly going to be quite tough. As one activist put it, anyone who posted good performance in 2008 can't have been a very engaged investor."

Adam Steiner, CEO of SVG Investment Managers, which describes itself as applying private equity techniques to public equity investments, agrees, but adds that there is a limit to what engagement can achieve during a crisis, when management is fighting to keep the business alive. "Now, with a bit of a tailwind building up, we can point to recovering competitors who are seeing earnings upgrades that our target companies are not seeing," he says. "It's a lot easier to say to a board, ‘Don't you think you should be doing better?' Our focus is moving back towards more aggressive improvement stories, as opposed to the straightforward financial engineering stories we were concentrating on a year ago."

As he implies, activists can diversify portfolio risk by pursuing different kinds of engagement project, but ultimately their longer-term relationships with portfolio companies expose them to the volatility of market, credit and business cycles that do not necessarily coincide with their engagement cycle. Over time, this volatility can usually be ridden out and the superior returns associated with activism realised - most engagements average about three years to completion, with Relational refusing to invest if it thinks that more than two years is required to realise value, and others more open to 6-12 month projects. But that is not always the case. Zimmerman says that Cevian has realised losses on two investments since 1996, and that seems representative - Relational has owned 85 companies since inception in the same year, and experienced just three "big losses".

"In the three big cases where we've experienced extraordinary losses, it has been exogenous factors that have come into play," says Whitworth. "Two were associated with the financial crisis and the other was a loss from an energy company related to a precipitous drop in oil prices in 1998 - all of the engagement objectives were completed and met, but it was all washed out by that exogenous factor." Strategy-specific risks - real value traps, management or investors becoming emotionally involved and not acting in their economic self-interest, deterioration of relations and litigation - can be managed, he says, but not these exogenous risks.

But one might argue that these risks are indeed strategy specific, as they are essentially illiquidity risks. While everyone else is running away activists have to think about the sunk costs of an engagement programme and maintain a position large enough for them to continue that programme. When underlying positions are really illiquid, investors tend to be paid a premium for taking that risk; it is not clear that activists' self-enforced illiquidity gets the same premium. But far from the worst of both worlds, the activists argue that they enjoy the best: they can employ some of the techniques of the private equity world, but their positions are not as illiquid - and they exploit the liquidity they have.

This works from the earliest stage of investment. A potential private equity owner has to conduct due diligence as an outsider, before taking a very big controlling stake in a company - ugly discoveries at this point are catastrophic. A public-markets activist has much more information before investing, and can establish what Machell calls a "toehold" position as it gets to grips with the situation before building a bigger stake if it sees an opportunity - or bailing out if not. Similarly, if the market decides to take your portfolio stock skywards in the middle of your engagement programme, you have the flexibility to take profits even though there is still work to do.

"In that situation you have a fiduciary duty to ask if there is a return left in it for your clients - and if you don't think there is you have to start reducing," says Machell. "Companies are pretty understanding, and if you have done your job well those companies will still want to talk to you." That good work has not gone to waste, so when the market comes over gloomy again the activist can re-build to its full position without having disrupted its engagement programme.

Whitworth takes this further by arguing that the informational advantage enjoyed by a properly engaged long-term investor can significantly improve its tactical trading. By way of example, he imagines a traditional value investor considering the toy manufacturer Mattel in 1999-2000, just after its disastrous acquisition of The Learning Company and its slump to 20% of its value at the height of the market. He would have started to analyse whether or not this new price undervalued the new cash flow expectations, then begin to factor-in possible solutions to the acquisition problems, before surveying the likely management candidates who might come in and implement them.

"He starts buying, but his strategy is really little more than crossing his fingers in the hope that these various elements would fall into place," Whitworth notes. "We made the same assessments and bought in, too - but we bought from people who didn't have the information that there was, in fact, a plan in place that Mattel believed that it could execute over a relatively short period of time. That meant that we were able to time our entry much closer to the catalytic activity, holding a smaller position while the company is still underperforming and thereby incurring much less risk than the traditional value investor. How come? Because we were the ones executing the plan."

Whitworth joined Mattel's board in 2000, replacing ex-CEO Jill Barad. Did Relational incur greater costs than fellow investors in Mattel? Of course. But it also had much greater insight into when to be fully invested to realise the value of the engagement project that it had developed - and, of course, when to move on.

This is an important point, because it addresses another problem that a fiduciary might have with engaged investing: the ‘free rider'. How do we justify costs from which other investors benefit? Surely our net gain is greater if we sit back and let others engage on our behalf? The justification is that while free riders might benefit from the same return, they can only do so by bearing greater risk - the risk associated with their information deficit.

That other investors take extra risk to share the same return perhaps explains why activists tend to see them less as free riders and more as ‘brothers in arms'. After all, if you are overweight a stock largely because Relational or GO has someone on the board, you are unlikely to ignore their resolutions, much less oppose them. "The Stewardship Code doesn't go as far as a strategy like ours, but having institutions more minded to be active owners is definitely a good thing," says Machell. "There's nothing more dispiriting than to find other outside shareholders totally apathetic about the company. If they put a little of their resources behind the more engaged shareholder they are more likely to be successful."

However, like activist investing, this is a strategy. The activity recommended by the UK Stewardship Code is more like a philosophy of ownership for all investments. To hear Steiner describe it, an investor cannot align with the code simply by undertaking to exercise its voting rights and report decisions, nor even by engaging only on its most significant holdings. Instead, it must accept its responsibilities as an equity owner to the market, and the economy as a whole.

"The UK Stewardship Code is groundbreaking stuff," he says. "The key points identify the major misunderstanding that most fund managers have of fiduciary duty - the asset managers think their job is to beat the index and their peers while the client thinks that the asset manager's job is to create wealth for them. Particularly the point that says that just because you are underweight a company does not give you the excuse not to engage properly with them is a really profound blow to the heart of that school of asset management."

That is bread and butter to activists, but that is because their starting point is to identify specific opportunities where shareholder engagement can deliver high risk-adjusted value. Their portfolios are correspondingly very concentrated, tilted towards value, with low turnover. We might argue that pension funds should have low-turnover value portfolios - but risk management (and their role in global capital markets) clearly prohibits concentration.

Shareholder engagement only works in fiduciary terms as an alpha strategy, otherwise there is no systematic attempt to achieve compensation for the costs and risks involved. And just as pension funds allocate rational budgets for their alpha risk - more in emerging markets, less in developed markets, for example - so they should allocate their shareholder engagement budgets rationally.

If an investor is able to discriminate at the first stage, like an activist fund manager, it can comply with the UK Stewardship Code to the letter and beyond. But if it cannot discriminate at that first stage, does the letter and the spirit of the code allow it to discriminate thereafter, to direct engagement only to those companies where the benefits would be most pronounced, or its holdings are most significant? If it does not, how can investors justify its costs and risks in fiduciary terms?