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Advisor to corporate managers debunks standard activist defense playbook

 

Source: The Harvard Law School Forum on Corporate Governance and Financial Regulation, June 22, 2016 posting

Seven Deadly Fallacies of Activist Investing’s Critics

Posted by Charles Nathan, Finsbury LLC, on Wednesday, June 29, 2016

Editor’s Note: Charles Nathan is a senior advisor at Finsbury LLC, and an adjunct professor at Yale Law School and Columbia Law School. This post is based on a commentary by Mr. Nathan. Related research from the Program on Corporate Governance includes The Long-Term Effects of Hedge Fund Activism by Lucian Bebchuk, Alon Brav, and Wei Jiang (discussed on the Forum here), The Myth that Insulating Boards Serves Long-Term Value by Lucian Bebchuk (discussed on the Forum here), The Law and Economics of Blockholder Disclosure by Lucian Bebchuk and Robert J. Jackson Jr. (discussed on the Forum here), and Pre-Disclosure Accumulations by Activist Investors: Evidence and Policy by Lucian Bebchuk, Alon Brav, Robert J. Jackson Jr., and Wei Jiang.

Attacks on activist investing often tread a familiar and well-worn road, long on inflammatory rhetoric and specious arguments and short on reason and respect for the facts. A recent example is a commentary by two Wachtell Lipton lawyers entitled “Corporate Governance Update: Holding Activists and Proxy Advisory Firms Accountable,” published in the New York Law Journal on May 26, 2016 (and discussed on the Forum here).

The article’s message, like so many criticisms of activist investing, is built on seven fatal fallacies.

Fallacy One: The terms short-term and long-term are used confusingly to mean different things at different points in the discussion.

Frequently, the terms short-term and long-term are used to refer to the period of time activists are reputed to maintain their ownership stake in a company. The implication (and frequently outright assertion) is that because activists are mere short-term holders, they are not entitled to the same voice in a company’s governance as obviously more virtuous and deserving long-term holders.

There are two fatal flaws in this reasoning. First, many studies have demonstrated that, on average, activist investors maintain their position for a matter of years, not months. Second, there is no rational reason to think that long-term shareholders have special insights into or understanding of corporate decisions and strategy. Indeed, if the long-term holder is, as increasingly is the case, an index fund, by hypothesis its investment has nothing to do with a company’s strategy or business decisions, and the investment manager has no basis to claim any knowledge or insights.

Confusingly, critics of activist investors also conflate the putative holding period of the activist with the implementation period for the program advocated by the activist investor. Castigating a corporate strategy as short-term, rather than long-term, simply misses the point. The issue is not the duration of time required for implementation, but rather the value creation potential of the program. No rational investor, or company manager, would (one would hope) advocate adoption of a longer-term strategy over a shorter one, if the shorter one had a higher value creation opportunity. The confusing use of the terms short-term and long-term lead directly to the second major fallacy of the anti-activist literature.

Fallacy Two: There is nothing inherently good or bad about short-term or long-term.

There is nothing innately virtuous about long-term, whether it be the duration of a portfolio position or a company strategy, nor is there anything innately evil about a short-term holding period or implementation period for an alternative company strategy. It is ludicrous to claim (or worse, believe) that anything long-term is by its very nature good, while anything short-term is by its very nature bad. Notwithstanding this obvious truism, anti-activist shareholder critics consistently assume short-term is bad and long-term is good. Repetition of these baseless assertions may have its purposes, but describing reality is not one of them. The reality, of course, is that there are both good and bad short-term strategies, just as there are good and bad long-term ones. The only relevant issue is determining which strategy will create more net present value for the company and its constituencies, not which one will take longer or shorter to implement.

Fallacy Three: Activist investors do not possess “unprecedented influence” or “immense financial power.”

The truth, of course, is that as large as some activist funds may be, they are utterly dwarfed by the size of the equity investor universe. A few activist funds may exceed $10 billion and total activist funds may approach $150 billion in the aggregate, but activists are hardly a blip when compared with the $18,668 billion size of the US equity market. Another way to measure the relative insignificance of activist investors is to compare the size of their funds (say, $10-15 billion for the largest) to the leading asset management firms in the US, starting with BlackRock ($4,770 billion under management), Vanguard ($3,148 billion), State Street ($2,448 billion) and Fidelity (a mere $1,974 billion).

Activist investors simply do not have the financial resources or desire to own vast portions of the stock of any company. It is rare that an activist’s holding in a company exceeds 10% and many are well below 5%. While activist holdings are not insignificant and surely entitle the activist to be heard, activists simply do not have the power or share ownership to compel a company to take any action, good, bad or indifferent.

Fallacy Four: Activists do not use “unscrupulous” tactics nor do they “hijack” the system, as is so often alleged.

Activists are not alchemists who nefariously transmute relatively small share ownership positions into the power to compel companies to adopt wrong-headed policies rightly opposed by their boards and managers. Rather, activists are ultimately dependent on the support of at least a majority of a company’s other shareholders to achieve their goal of changing some aspect of a company’s business or strategy. The activist investor’s typical game plan is simple and consistent.

  • First, identify a company that is undervalued in the market because it is not fully realizing its potential.

  • Second, propose a solution to management that the activist believes will unlock the full value of the company.

  • Third, if management is unwilling to work with the activist to improve the company’s operations or strategy, bring the activist’s proposed plan to the company’s shareholders who own the company and have the final say on company policy though their ability to vote at shareholder meetings.

There is nothing nefarious about giving the owners of a company a choice between competing strategies or alternative business plans. Nor is there anything wrong if a majority of shareholders agree with the activist, rather than management. To suggest the contrary is to advocate a corporate system in which management has the final say on all matters, and shareholders have no power to vote managers out of office—a model that might be conventional in Russia but is antithetical to the very premises of our corporate system.

Fallacy Five: There is nothing wrong with shareholders deciding an activist’s program has more merit than management’s.

Put simply, the argument against activist investing boils down to a classic case of blaming the messenger. Activists don’t possess some magical power which allows them to bewitch shareholders. Rather, they present a case for their proposed solution to what they perceive as a company’s shortcoming, and management presents its case. Whether management’s case is in defense of a long-held strategy adopted in good faith by the board, or a recently created attempt to “be your own activist,” the bottom line is that shareholders are the ones who get to decide. If they decide against management, it is hardly the fault of the activist. Viewed rationally, it is the fault of management, either because their program is not as persuasive or because they fail to articulate it successfully.

In the same vein, if shareholders opt for a shorter-term program and reject management’s longer term proposal, the outcome is not wrong because management disagrees. Even if shareholders are predisposed to favor shorter-term programs for extraneous reasons (such as concern for quarterly and annual performance rankings on the part of active money managers), it is not because of something inherently bad about activists. Nor is the solution to penalize activists for their success in harnessing shareholder wishes.

Fallacy Six: Activist investors do not selfishly line their pocketbooks at the expense of workers, communities and, more generally, the entire American public.

Activist investors cannot prosper unless the other shareholders prosper. To be successful, an activist investor’s program must produce sufficient value to increase the price of the company’s stock. This is not to say that every activist program will raise the price of the company’s stock, but only that to make money the activist has to be right more often than wrong. As a result, the value created by an activist investor is shared among all shareholders. Indeed, this is the reason why shareholders so often support activist investors’ initiatives.

Those other shareholders are, largely, institutional investors who manage a very large part of the combined wealth of the American public. The funds institutional investors manage comprise the largest part of the life savings of our nation held in countless public and private pension funds and innumerable 401K and Roth plans. Put simply, activist investors succeed only when institutional investors likewise benefit, thereby increasing the value of the holdings of the various pension plans and individually owned accounts managed by institutional investors.

Fallacy Seven: Company management and their experts do not have a monopoly on wisdom entitling them to prevail over the views of a majority of shareholders.

The ultimate fallacy of the anti-activist mantra is that somehow, for some reason, it shouldn’t matter that a majority of shareholders often embrace activist campaigns. There is no principled reason to believe that boards, management and their advisers know better and should be freed from the distraction, stress and risks of a debate over their corporate stewardship. The paternalistic and patronizing view that management always knows best is simply an inversion of the reality of shareholders’ ownership and rights under our corporate governance system. Defenders of management against activist investing all too often dismiss the reality that boards and management are accountable to shareholders on at least an annual basis and that our corporate governance model is based on the fundamental principle that shareholders are the owners of the company with the ultimate right to decide their company’s future.

 

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