Judging from their remarks to her in years past, U.S. company directors didn’t have much time for activist investors, Maria Castañón Moats recalls.
“I got a sense that the activists’ questions and the like were not a good thing,” says the Governance Insights Center leader with PricewaterhouseCoopers (PwC).
How times have changed when it comes to activists, who push for changes at publicly traded companies after purchasing a sizable minority stake. “Where you are now is, it’s understood, anticipated, and the directors and the companies are trying to find common ground with the activists,” Dallas-based Moats says. “You even have directors now who meet with investors. So I would tell you that it’s not a bad thing, and it’s one of those things where you engage.”
For boards, the question is how to engage constructively with an activist investor—and to be proactive about preparing for their attentions.
In the wake of the pandemic, shareholder activism is picking up again. “During COVID, activists were unwilling to put some of their dry powder into some of these investments, especially with a lot of companies that were in pretty tough shape a couple of years ago,” says David Farkas, a New York–based managing director in the activism and M&A solutions practice at business advisory firm FTI Consulting. “But we’re finally seeing them put their money to work.”
FTI Consulting just published the latest edition of its quarterly Activism Vulnerability Report, which includes trends in shareholder activism. Activist investors launched 321 campaigns involving U.S.-based companies in the first half of 2022, a 23% jump over the same period last year. Activists gained 31 out of 71, or 44%, of the board seats they sought in the second quarter, versus 14 out of 43 (33%) during the same period in 2021. Among the 10 sectors covered in the report, technology, media, and telecom (TMT) was the most targeted in the first half, accounting for 25% of all U.S. campaigns.
Increasingly, boards face scrutiny from activists, says Michael Useem, William and Jacalyn Egan Professor Emeritus of Management at the Wharton School of the University of Pennsylvania. “They have put the boards in a spotlight like almost nothing in recent years, except if you go back 15 or 20 years, when there was a series of corporate scandals beginning with Enron.”
Activism is now omnipresent, says Scott W. Bell, a member at Nashville-based law firm Bass, Berry & Sims. Large-cap companies “used to be like some huge, Jurassic, sauropod dinosaur,” notes Bell, whose practice includes shareholder activism defense. Given the vast sums needed to build a stake, such businesses were once too big for activists, he adds. No longer: “Those kinds of large-cap campaigns have gone up in recent years.”
Activist investors, who might own 1% or 2% of a company’s stock, are seeing institutional owners join forces with them to pressure companies, Useem explains. “The big institutional holders and the equity analysts they work with have become part of the high-octane fuel that has propelled activist investors, who are typically much smaller.”
Useem cites last year’s successful effort by Engine No. 1, an activist hedge fund, to name three Exxon Mobil directors. “The big non-activist investors said, ‘You’re right.’”
Bell also points to the “democratization” of activist investing. The usual-suspect hedge funds—such as Elliott Investment Management, Starboard Value, and Third Point Management—used to dominate. “In the past couple of years, we’ve seen a huge growth in first-time or relatively inexperienced activists, or shifts from private equity into the realm of activism.”
The upshot for boards? “It doesn’t matter how big your company is, and there’s a limitless number of potential activists out there,” Bell says. “Any company, at any time, can get tagged with one of these engagements.”
Useem’s advice: Think like an activist, and don’t put your head in the sand. “The activist may have some great ideas, could have some terrible ideas,” he says. “But sit down with the activist—or at least your chief executive should be doing that, and your board chair—and find out what their analysis is saying.”
Boards must think about activists in a continuum, says Moats, noting that PwC covers this approach in its new Director’s Guide to Shareholder Activism. For example, one activist could be an institutional investor seeking to learn more about the company, while another could be a hedge fund asking tough questions on strategy.
“You have to, as a director, have management think through all of the different types of activists and questions that you could get from them,” Moats says. “You need to understand, as a director, who owns the stock and why they own the stock—and therefore, what types of questions you are going to get related to the strategy and how it’s being executed.”
The real reason to gird for potential questions is to focus on risk factors, Moats maintains. “Underperformance is something that’s going to get questioned. And so, why? And what’s the plan? And how are you going to turn this around? All those questions should be asked in the boardroom with management.”
Boards should be honest about governance weaknesses, too, Moats suggests. “First, look toward the composition of the board,” she says. Shareholder rights—or lack thereof—is another potential vulnerability.
Something else to consider: executive compensation, where nonfinancial metrics such as diversity, equity, and inclusion have entered the mix, Moats observes. “At the end of the day, the shareholders vote,” she says. “There’s a say on pay.”
Farkas has always favored engagement with shareholder activists. “Being hostile with them is just going to get them angry, and then they’re going to go about their own agenda,” he says. Farkas also encourages boards to learn about an activist’s past behavior and track record—a task that’s less rewarding with first-timers.
The board’s role is to sort out an activist’s good-faith, well-informed arguments from their other ones, Bell says. Directors should avoid fixating on defense, he counsels. “It’s important not to get sucked too deeply into the tit for tat with an activist,” Bell says. “Shareholders like to see responsiveness from their board, but they don’t want to feel like the board is becoming obsessed with the battle or taking it too personally.”
Bell also offers this advice for fending off activists: “Cultivate and maintain good relations with your investor base as an ordinary course-of-business item.”
That requires discipline, but it can pay big dividends when an activist criticizes the company, Bell says. “Your credibility with investors when you’re trying to make your case in an actual proxy contest, for example, is going be a lot greater if they know the company well, they feel like they have a voice in the boardroom already, and you’ve heard and maybe incorporated their concerns into what you’re doing.”
Looking ahead, what should boards watch out for on the activism front?
Moats singles out the environmental and social aspects of ESG. The Securities and Exchange Commission has proposed new rules that will prompt more climate-change–related disclosures, she notes. Moats also recommends focusing on the second element of diversity, equity, and inclusion. “If I’m a director, what are we doing as a company across everything we do with our talent, across how we work with vendors and the like, on the equity part?”
Bell agrees that companies will keep facing environmental and other ESG-themed arguments from activists, both valid and otherwise. “Again, the best defense will be lowering your vulnerability by maintaining good ESG practices and reporting, and a good dialogue with shareholders about this stuff before an activist shows up.”
He and others also flag the SEC’s new universal proxy rules on director contests, which took effect in September. “These new rules are likely to increase the number of potential contests by lowering the costs to activists to mount them,” Bell says, “and also probably to increase the ability of activists in some circumstances to win board seats.”
Boards should remember that “activists are always finding new ways to attack companies and push for new things,” Bell warns. Meanwhile, the line between traditional activist hedge funds and private equity firms has blurred, with the latter backing hedge funds’ takeover bids and buying their own stakes in public companies. “It all increases the feeling that it could come from anywhere at any time.”