Activist Investors and Target Identification


Value Screening

  • One-, Three-, and Five-year Total Shareholder Return (TSR): activist investors and proxy vote advisory firms such as ISS often compare a company’s TSR to defined comparable companies and a relevant stock market index such as the S&P 500 Index in an attempt to evaluate how a business is performing over time
  • P/B: often used by value investors to obtain a comfort for their investment based upon the liquidation value of the company’s tangible assets
  • P/E: one of the oldest and most frequently used metrics for valuing a company and is done by measuring its current share price relative to its earnings per share
  • EV/EBITDA: unlike a P/E ratio, this ration takes into account a company’s debt and is often used by activist investors to determine what a potential acquirer might pay for the business in the event it can be sold
  • Price to Free Cash Flow (P/FCF): compares a company’s market capitalization to its annual free cash flow generation, which is similar to a company’s “cash flow” metric but in this case reduces a company’s operating cash flow by the amount a company spends on capital expenditures to maintain its operations
  • Current ratio: quick down-and-dirty way to gauge a company’s ability to pay its short-term and long-term obligations
  • Return on invested capital (ROIC): used to determine the effectiveness and efficiency of management’s capital allocation decisions

13F Disclosure Analysis

  • With the advent of technology trading systems and elaborate quantitative algorithms that are used to track hedge fund holdings, well-regarded value investor disclosures have become a breeding ground for idea generation
  • A lot of activist investors will analyze 13F filings with the SEC to find increased ownership positions and new purchases from other like-minded investors
  • Activist investors will find a new stock position being built by a smart value investor during the previous quarter and, upon further examination, can uncover potential activist investment opportunities for themselves

High Trading Liquidity

  • An important aspect of any activist play is amassing a critical number of shares in a timely fashion
  • Some activist investors have a following of other investors and thus have legitimate concerns about others inadvertently driving up the cost of acquisition before they themselves acquire the appropriate ownership threshold needed for change

Sum-of-the-Parts Analysis

  • Many activist investors will look for companies with multiple business units, often with no synergies between them
  • Investors will dissect the company into separate business segments and value each by itself, applying different valuation metrics to each business unit. Combining the derived intrinsic valuation calculation from each segment generates a SOTP valuation price for the entire company
  • Tax-free spin-offs have grown widely in popularity, mainly because activist investors have pushed for them more frequently than in the past. The theory is that a new standalone business segment will get 100% of a management team’s focus

Net Cash Availability

  • One telling sign of inefficiency for many activist investors is a large net cash balance, especially as a % of market cap
  • Activists recognize that cash held on a company’s balance sheet in the current economic environment yields zero percent return for investors and better opportunities may exist elsewhere to maximize the value of that investment

Excess Debt Capacity

  • Activists are also attracted to companies with unused debt capacity
  • Investors view companies that are fairly consistent in their cash generation to be a prime candidate to add debt

R&D Expenditures

  • Activist investors tend to stay away from companies reporting high R&D expenditures because translating research into realized market potential is more often an art than a science, particularly for outsiders
  • It is hard for an outsider to run an activist campaign and provide insights on a company they do not fully understand

GAAP Accounting Masks

  • GAAP accounting methods used in target company financial statements can misrepresent underlying profitability and value in several ways, including depreciated real estate assets, complex conglomerate financials, underperforming business units reporting through consolidated holding company P&Ls, and large tax benefits such as NOL carryforwards
  • Such masked financial statements can cause a company to trade for less than its full value, and activist investors will look to exploit these opportunities to get the market to recognize them fully and generate shareholder value

Laws of the State of Incorporation

  • Some of the more important provisions related to shareholder activism include:
    • A board’s capacity to amend company bylaws, adjust advance notification provisions, and install supermajority voting requirements
    • The flexibility to employ various forms of anti-takeover devices such as classified boards, poison pills, and poison debt provisions
    • The ability for shareholders to call special meetings
    • The ability for shareholders to act by written consent in lieu of a formal shareholder’s meeting

Impact of Proxy Voting Advisor Recommendations

  • Board member age/tenure: While US public companies generally do not have specific term limits on director service, some companies indicate in their bylaws a mandatory retirement age typically between 72 and 75 years of age; ISS has stated that it views a director’s tenure of more than nine years as “excessive” and “potentially compromising a director’s independence” and has adopted a policy to scrutinize boards where the average tenure of all directors exceeds 15 years for independence from management and for sufficient turnover to ensure that new perspectives are being added to the board
  • Board size: ISS will vote against proposals that give management the ability to alter the size of the board outside of a specified range without shareholder approval
  • Classification/declassification of the Board: both Glass Lewis and ISS will recommend shareholders vote against the classification of a board (to stagger a director’s terms, typically over 3 years) and for proposals to repeal classified boards or elect all directors annually
  • CEO Succession Planning: ISS says it will generally vote for proposals seeking disclosure on a CEO succession planning policy considering, at a minimum, the following factors:
    • Reasonableness/scope of the request
    • Company’s existing disclosure on its current CEO succession planning process
  • Independent Chair and Separation of Chair/CEO roles: ISS will often recommend shareholders vote for proposals that require a chairman’s position be filled by an independent director
  • Majority Vote Standard: Requires directors to be elected by at least a majority of the votes cast for their election; while ~84% of S&P 500 companies use the majority vote standard for uncontested elections, thousands of US companies still use the plurality vote standard
  • Proxy Access: shorthand for providing shareholders with the right to place their nominees for directors on a company’s proxy card; while proxy access has yet to be fully embraced by activist investors, several larger companies targeted by activists have amended their bylaws to permit investors the ability to nominate directors using the company’s proxy materials
  • Poison Pills: poison pills have proven to be an extremely effective takeover defense but are scrutinized much closer today than ever before; many large investors have clear policies relating to the adoption of a poison pill defense tactic and often require that the pill be put to a shareholder vote as soon as practical; common parameters include:
    • No lower than a 20% trigger
    • Term of no more than 3 years
    • No dead-hand, slow-hand, no-hand, or similar feature that limits the ability of a future board to redeem the pill
    • Shareholder redemption feature such as a “qualified offer clause” which states that if a board refuses to redeem the pill 90 days after a qualifying offer is announced, 10% of the shares may call a special meeting or seek a written consent to vote on rescinding the pill
  • NOL Protective Amendments: under Section 382, NOLs can usually be carried forward for up to 20 years to offset a company’s future taxable income but will become impaired if a change of ownership occurs; in order to protect these assets, a company may install an NOL poison pill with a trigger threshold below 5%
  • Director Overboarding: concept of overboarding refers to a director who sits on too many boards; in November 2015, ISS adopted the following changes to its US policy:
    • Vote against or withheld from individual directors who sit on more than five public company boards
    • Vote against or withheld from individuals who are CEOs of public companies who sit on more than two public company boards other than their own
  • Additional Corporate Governance Analysis
    • Advance notice provisions which determine how and when an investor can submit proposals, including director nomination proposals, for shareholders to consider at a company’s annual meeting
    • Executive compensation ties to performance and problematic pay practices
    • Share ownership and the expectation that executives and directors acquire sufficient personal stock ownership has become the norm for public companies and provide comfort to investors that a company’s leadership has aligned themselves with other shareholders in becoming beneficiaries of improved share value
    • Company policies regarding board-shareholder communications
    • Impact of employment contracts and golden parachutes in a change of control
    • Existence of an employee benefit plan and its voting authority
    • Cumulative voting rights

Analyze the Shareholder Base

  • Activists may consider the proportional ownership of institutions, retail investors, hedge funds, or “insiders” of the target
  • Since institutional shareholders are almost always the largest owner of a target company’s stock, it’s important to examine the % of shares held by these groups, their level of investment fatigue, voting tendencies, and underlying governance policies to help build early vote projections
  • Anticipated impact of institutional voting recommendations coming from proxy vote advisors such as ISS and Glass Lewis can be important considerations
  • Ability to build and exit a significant ownership position, taking into account daily trading volume, the amount of shares held in short positons, and potential liquidity events necessary to exit the investment can also be an important factor

Determine the Ownership Threshold for Change

  • Public filing requirements with the SEC
  • How to disclose and manage the ownership of convertible debt, options, and other derivative instruments
  • Possibility or necessity of teaming up with other shareholders, which may require additional SEC disclosure if the group owns more than 5%, as well as a contract outlining how the parties will be voting shares, negotiating settlements, communicating publicly, and sharing expenses
  • Ownership in excess of 10% which exposes the investor to “insider” disclosure issues, short-swing profit liabilities, and other matters that may be determined by a company’s state incorporation statuses
  • HSR ownership value threshold, disclosure, and clearance process

Harvard Law School Forum on Corporate Governance and Financial Regulation: Activist Investors and Target Identification, June 2016

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