When hedge fund manager and activist investor William Ackman sent a letter to the board of directors of pharmaceutical giant Allergan three years ago, he didn’t leave anyone guessing about his intentions. “Your actions,” Ackman wrote, “have wasted corporate resources, delayed enormous potential value creation for shareholders and are professionally and personally embarrassing for you.”
Ackman’s hello-you-must-be-going note was one of multiple salvos he fired at Allergan leaders when they resisted a push by his fund, Pershing Square Capital Management, to sell the company to controversial rival Valeant Pharmaceuticals. Although the proposed deal eventually fell through, Allergan did end up with a new owner, Actavis—netting Ackman and team a $2.2 billion profit for roughly seven months of work encouraging a sale. (His victory, as it turned out, was short-lived; he later lost $4 billion in a separate investment in Valeant and is being sued over the Allergan deal.)
Variations of that exchange—some just as heated, some more conciliatory—have played out in boardrooms around the nation and across the globe in recent years amid the rapid rise of activist investors in the marketplace. Yet some critics of activist investing see signs of a shift away from the era of “shareholder primacy,” the term used by management consultancy Bain and Company. These critics question whether activist investors are really good for corporations in the long run—especially when draining them of resources for R&D and other urgent corporate growth needs—and point to some pretty damning statistics to back their claims. And yes, they even question activists’ effect on the U.S. economy. Some contend activist investors have contributed greatly to today’s huge income gap between the business class, middle class and working class.
And that begs the question: could a corporate culture shift be in the offing?
At the moment, activists continue to wield outsized power. According to Bain, activists control only about $150 billion in assets under management, a figure dwarfed by the $30 trillion held by mutual funds. Ackman and fellow hedge fund operators—Carl Icahn, Nelson Peltz and Daniel Loeb, among them—typically acquire a 5% to 10% stake in a company, and they move quickly to shake up management, shuffle priorities, spin off divisions or sell the entire company.
Activists contend they bring new energy and a fresh perspective to companies struggling to compete and maintain profitability. But critics contend activists put their short-term interests ahead of the company’s long-term health and push through bad decisions that undermine corporate values like customer service and employee-driven innovation.
It’s probably easier to list the names of companies that haven’t found themselves in a sudden tangle with an activist since the 2008 market collapse. DuPont, Apple, Xerox, Rolls-Royce, Volvo, Yahoo, J.C. Penney, Sony, Wendy’s, McDonald’s, Macy’s, Sotheby’s, Whole Foods, Nestle—all those, and more, have been the focus of activist investor campaigns.
The pace is so frenetic that some companies attract return visits. In late 2012, Peltz’s Trian Fund Management successfully pushed Kraft Foods to spin off its snack food business, creating Mondelez International. A little over a year later, Mondelez became a target of Ackman’s activism.
Prior to the recession, a few dozen companies were subject to activist demands each year, but activist campaigns surged as investors sought to regain ground lost in the market collapse.
The number of companies targeted by activist campaigns topped 500 in 2013 and surpassed 750 last year, according to the research group Activist Insight. Through May of this year, 434 companies have been on the receiving end of activist demands, the group reports.
Widening the Playing Field
Who’s a target? “Effectively everybody and every sector,” says Daniel Kerstein, managing director and head of strategic finance at Barclays Investment Bank. “It’s really a function of where activists and investors think there are assets that are undervalued or underappreciated by the broader market, where they can make a reasonable return for their money.”
“No firm is safe,” says Duke University professor Jillian Popadak, part of a team of researchers who have done extensive research on activist investors. “It typically used to be that they went for underperforming funds in an industry. But recent evidence, post-crisis, shows they will go for large, popular firms that are successful, even relative to their industry peers.”
The turning point was in 2013, when, for the first time, one third of activist funds focused on companies with market capitalization greater than $2 billion, according to Columbia University professor John Coffee and Rutgers University professor Darius Palia, authors of The Wolf at the Door: The Impact of Hedge Fund Activism on Corporate Governance.
“Seemingly, if a credible scenario can be offered to the market that breaking up a company will yield shareholder gains,” they write, “activist funds will assemble to attack even those companies with a long record of profitability.”
So far this year, almost 28% of the companies targeted were large-cap ($10 billion and above) and close to 17% mid-cap ($2 billion and above), according to Activist Insight.
Popadak cites a couple of theories about why activists are eyeing large companies. One claims they’ve already picked the smaller, easier targets and are now expanding to those that will require a bit more work. The other is that they feel they can now count on institutional investors, who were initially leery of activists, to support their efforts.
Kerstein agrees that traditional investors are showing more interest in activism. “We’ve seen Neuberger Berman effectively initiate the campaign at Whole Foods,” he says. “They were out actively seeking an activist fund in what we jokingly refer to as an RFA, a Request for Activism.” The campaign succeeded, leading to Amazon’s $13.7 billion acquisition of the organic grocery store chain in June. Activist Barry Rosenstein’s Jana Partners was involved in the deal.
With the exception of a couple of high-profile cases, the insurance industry has largely been protected from activists, thanks in part to tight regulatory oversight. Kerstein says there’s greater risk of a deal falling apart in a regulated industry, so activists would need to see the potential for larger return than they’d get in other sectors before launching a campaign against a publicly traded insurance company or brokerage.
Yet those buffers may not last under the current administration. “I think the regulatory environment we’re moving into now, in all likelihood, is going to be a bit more of a laissez faire approach,” he says. “My guess is there’s probably less protection than there may have been in the past.”
Amrit David, a managing director at Barclays, points to another deterrent to activist investors that isn’t likely to change—the insurance industry’s complexity. “It’s very different to say a retailer or a company should spin off a division or sell some stores or revamp the product line,” he says. “When you start dealing in financial services, insurance and banks and others, it becomes increasingly difficult because of the complexity of the organizations, the way they’re linked in on multiple levels and a number of different ways the various business lines interact.”
Kerstein says he has expected activist interest in insurance to expand for a while now, but the industry is faring well in the stock market and the push for increasing share values isn’t as strong as in other sectors. “To my knowledge, it’s been pretty quiet,” he says.
David says a favorable rate environment and the potential for tax reform, as well as a strong market showing, play in the industry’s favor. “That’s not providing a lot of ammunition for folks to come in on,” he says.
But, as two iconic names in the insurance industry can attest, activist investors do come calling.
The Knock on the Door
The Ackmans and Icahns of the world generally get what they want. In 2015, close to 70% of activists in the U.S. achieved at least part of what they sought from a shareholder campaign, according to Activist Insight.
And even where they fail or bow out—as hedge fund operator John Paulson did a few years ago at the Hartford Financial Services Group, and as Carl Icahn has, for the moment, at AIG—they tend to have a lasting effect.
The Hartford, in some ways, seemed like an unlikely target for a shareholder intent on shaking up the institution. It began its storied history in 1810 as a fire insurance company, slowly building an empire over the next century as competitors succumbed to massive claims filed after major fires in New York, Chicago and San Francisco. The Hartford branched out into a wide variety of insurance and financial services, selling homeowners insurance to Abe Lincoln and Robert E. Lee and disability insurance to Babe Ruth, as well as helping to finance the Golden Gate Bridge, St. Lawrence Seaway and Hoover Dam, among other American landmarks.
But by November 2011, fresh from its 200th birthday celebration, The Hartford was wobbling badly, hurt by $2.8 billion in losses sustained in the market collapse. Company leaders had invested heavily in variable annuities in the runup to the crisis, and The Hartford’s stock was trading at less than half of book.
CEO Liam McGee, brought in to repair the damage, felt he and his team were making progress. But Paulson, who had amassed a fortune betting against the subprime mortgage market ahead of the collapse and had watched The Hartford’s annuity problems build up, wasn’t happy with the pace of the company’s recovery. He pushed for the company to spin off its life insurance business and focus on property and casualty.
McGee and the board held their ground, aware that regulators were leery of increasing risk for life insurance policyholders. The company forged ahead with its plans over Paulson’s objections, selling portions of its business to AIG, Prudential and MassMutual and backing out of annuities.
Share prices rallied in 2012 and again in 2013, and Paulson backed off his demands, content that the company was on the mend. He didn’t get exactly what he wanted when he started, but he did achieve smaller elements.
Paulson later praised McGee for leading “a generational transformation” of The Hartford and “positioning it to prosper by focusing on operations with industry-leading positions.”
In an interview with Chief Executive magazine shortly before his death in 2015, McGee said Paulson “indirectly did us a favor” when he set his sights on The Hartford. “We certainly didn’t want to be attacked. But it was serendipitous: it gave us cover to pursue what we were going to do anyway,” he said. “People weren’t happy about the new direction, so the attack helped us move to some painful changes in the organization.”
In 2015, as things began to settle down at The Hartford, the company that bought its broker-dealer arm, AIG, landed in Icahn’s sights. With a 4% stake in the company, Icahn began pushing for a breakup of AIG, which was still struggling from the 2008 financial crisis. AIG had recovered enough to pay back a $185 billion bailout from the federal government, but its shares still weren’t performing on pace with competitors.
Icahn also lobbied for the ouster of CEO Peter Hancock, who’d been brought in to lead a recovery from the crisis. The investor described Hancock as “someone who was trying to do brain surgery but was really a knee surgeon.”
Hancock resigned this spring and has been replaced by Icahn’s chosen successor, Brian Duperrealt, who is credited with rescuing Marsh & McLennan amid a shareholder revolt. Recent reports indicate Icahn has decided to back off his push to break up AIG, at least until the new CEO has a chance to try his hand at surgery.
Those encounters and others have had a far-reaching effect on all industries, according to CEOs and board members. Barbara Hackman Franklin, a former U.S. secretary of commerce who has served on more than a dozen corporate boards, recently told Harvard Business Review that activists influence strategic development and the allocation of resources even at companies they don’t target. “The idea that we should ‘think like an activist’ pops up from time to time in boardroom conversations,” she says.
What About Value Creation?
The founding father of activist investing was economist Milton Friedman, who penned a 1970 piece for The New York Times Magazine that sharply criticized calls for corporations to do more for the public good. He argued that a corporation’s primary mission is to boost shareholder value, or—as the title of the essay more bluntly declared—“the social responsibility of business is to increase its profits.”
Joseph Bower, then a young Harvard Business School professor, derided Friedman’s argument, calling it “pernicious nonsense.” Almost 50 years later, he hasn’t changed his mind. This summer, Harvard Business Review published an essay by Bower and Harvard colleague Lynne Paine that’s capturing attention in C-suites and the investment community. Citing Ackman’s involvement in the Allergan deal as a prominent example, the professors build a case that an overemphasis on shareholder value weakens companies by curtailing R&D and innovation and other long-term investments. They warn that activists could do broader damage to the economy and society if they don’t consider the corporation as an entity apart from its investors.
“No doubt, in some cases, activists have played a useful role in waking up a sleepy board or driving a long-overdue change in strategy or management,” they write. “However, it is important to note that much of what activists call value creation is more accurately described as value transfer. When cash is paid out to shareholders rather than used to fund research, launch new ventures or grow existing business, value has not been created. Nothing has been created.”
The idea of creating value could have both internal and external implications. “A lot of the unrest we’ve seen over the past year is rooted in the idea that wealthy, powerful people are disproportionately benefiting from the changes happening in society,” former Allergan CEO David Pyott told Harvard Business Review. “A lot of companies think that they need to make themselves look more friendly, not just to stockholders but to employees and to society. Having a broader purpose—something beyond simply making money—is how you do that and how you create strong corporate cultures.”
But Popadak and her colleagues at Duke found investors, when shaking up a company, often undervalue the importance of corporate culture, which is a mix of intangibles such as pledges to integrity and customer service.
In a piece for the Center for Effective Public Management at the Brookings Institute, Popadak reports that executives interviewed by researchers lamented the lack of attention to cultural values that sustain a business beyond a few quarterly earnings reports, such as avoiding morale-destroying mass layoffs in a downturn.
“As one interviewee put it, ‘We certainly do not get credit for culture-related investments particularly if you think of the short-term nature of some of our investors. Our long-term investors get it and understand it completely,’” Popadak writes.
The Long View
Company culture isn’t the only area in which the effects of a long-term versus short-term strategy can be seen. In an article accompanying this summer’s Harvard Business Review essay, researchers from McKinsey Global Institute and FCLT Global analyzed 615 non-financial U.S. companies and found that companies with an identifiable long-term orientation fared better from 2001 to 2014 than those with an identifiable focus on short-term gains.
“What if all U.S. companies had taken a similarly long-term approach?” they write. “[W]e estimate that public equity markets could have added more than $1 trillion in asset value, increasing total U.S. market cap by about 4%. And companies could have created 5 million more jobs in the United States—unlocking as much as $1 trillion in additional GDP.”
Other research has questioned the long-term effect of activist investors. A study by the Institute for Governance and Private and Public Organizations, a Canadian think tank, found that companies targeted by activist investors pushing for cost reductions in the United States and elsewhere saw a 4% drop in employment between 2008 and 2013, compared to a 9% increase among all companies.
In today’s ever-changing, tech-driven business environment, the lack of funds being reinvested in the business that is only after short-term shareholder gains can hinder a company’s ability to keep up. In a recent report for Bain and Capital, partners James Allen, James Root and Andrew Schwedel contend the shareholder primacy view is shifting under significant pressures on companies to adapt more quickly to market changes and customer wishes—two things that don’t always dovetail with activists’ focus on cost-cutting and short-term gains in stock value.
“In our conversations with CEOs,” they write, “we consistently hear how difficult it is to free up trapped resources to mobilize against important challenges and opportunities, despite the obvious and growing need for speed.”
While we may be more likely to hear about the quick-moving encounters, like Ackman’s involvement at Allergan, that singe the leather seats in the boardroom, there are activist investors out there who do take a longer look at the business. Kerstein, who frequently talks to hedge fund operators so he can advise clients at Barclays, says sometimes it’s just the most practical approach.
“We’re actually seeing them, in a way, forced to stay longer because they based their campaign on operational performance, which takes a longer time frame to actually implement and show results,” he says. “They don’t get the return until those things start to bear fruit.”
For example, the activist campaign by Jeffrey Ubben at Microsoft took a longer and more cooperative approach. Ubben’s San Francisco-based ValueAct Capital Management has distanced itself from its more aggressive colleagues in New York and cultivated a reputation for conducting activist campaigns through “gentle nudging rather than public shoving,” according to Financial Times editor Owen Walker in his book Barbarians in the Boardroom: Activist Investors and the Battle for Control of the World’s Most Powerful Companies (Financial Times Press).
In 2013, ValueAct contacted officials at Microsoft and asked for a meeting to discuss operations before obtaining a single share in the company. After acquiring a little less than 1%, Ubben and team began pushing for a realignment of priorities and strategies that eventually led to the departure of CEO Steve Ballmer. They secured a cooperative agreement with Microsoft management that gave ValueAct a seat on the board in exchange for concessions from the hedge fund.
“Publicly at least, you hear lots of wonderful things being said about ValueAct by management and by other board members,” Kerstein says, “and you hear lots of wonderful things being said about the board and management by ValueAct.”
Trian, led by Nelson Peltz, is another fund that tries to avoid quick-hit campaigns, Kerstein says. “They have been aggressive in places, they have pushed out some management teams, but I also think that they have done a pretty good job of focusing the operations in some places and finding ways to cut costs and really pushing management to a level of focus that was attainable—not unreasonable but difficult. They’ve been very upfront: look, this is what we do and this is how things are going to operate when we’re here.”
Preparing for That Knock
Michael Dell, head of the computer company that bears his name, figured out the most effective way to fend off activist investors like Carl Icahn: he took the company private in 2013.
The increased emphasis on shareholder value had produced “an affliction of short-term thinking” at Dell, he later wrote in The Wall Street Journal. Going private, he said, gave employees “freedom to focus first on innovating for customers in a way that was not always possible when striving to meet the quarterly demands of Wall Street.”
That’s not a practical solution for most companies, of course. To stay ahead, they need to develop a plan for how they’ll respond if an activist investor emerges among their shareholders.
As in many things, the best defense can be a good offense. “The best course of action that companies can take in terms of avoiding shareholder activism is clearly performance,” Kerstein says.
Stock prices are an obvious indicator of how well a company is performing, he says, but sometimes circumstances can overtake a company, or its industry may fall out of favor with investors, driving down value. In those instances in particular, Kerstein says, company leaders need to be ready to explain to shareholders how they’re managing risk, how they’re exploring new lines of business and how they’re keeping costs down.
“These are all things we all, to some extent, take for granted as being the hallmarks of good management,” he says. “I think it’s important to remember that’s really what it is that we’re being pushed to do by activist investors.”
Kerstein says activists look closely at the performance of corporate boards, too. Many investors perceive boards, especially in the United States, as caretakers. “They want to know that boards are actively pushing and engaging with management and, to some extent and not necessarily in a negative sense, holding management’s feet to the fire, pushing them to make sure the paths and strategies that are taken are the right ones,” he says.
That doesn’t mean boards need to fight with management every day, Kerstein says, but they do need to be able to show investors there is a healthy debate among board members and with management. “A board needs to make sure they’re asking the right questions and digging in on issues and ultimately, maybe, agreeing with exactly what management has recommended to them,” he says.
If they’re targeted, CEOs and boards need to become familiar with how that activist typically proceeds. “Each fund has its own style and approach that it takes to companies and situations,” Kerstein says. He says that Barclays engages regularly with fund managers to understand their approach and what they’re hoping to accomplish.
Some campaigns begin simply, with the investor acquiring a small stake and asking questions that any new investor might. Kerstein says it’s critical “to engage with the shareholder, whether they’re an activist or not, and not give them an excuse or something they can look to later as a reason for why they had to take more hostile action.”
Company leaders should make sure they have a team of advisors—including board members and others, preferably with experience dealing with activists—on standby, ready to develop a coordinated response. “Each situation has its own nuances,” Kerstein says. “We’re often asked, ‘Can you help us prepare a response in the event that we have an activist show up?’ I always say there’s a lot of different responses you need and sometimes the best response is actually none at all.”
Duke’s Popadak says companies should be ready to respond swiftly. “My sense is that, from the firms that we’ve interviewed and surveyed, they don’t really have a team in place to think about and deal with a hedge fund activist,” she says.
Telling the story about a strong corporate culture can help company leaders push back at activists asking for quick, major changes that may undermine a company’s long-term health, according to Popadak.
Corporate culture and other intangibles can be difficult to quantify, but numbers can be persuasive to hedge fund managers. Those metrics, she says, can include customer satisfaction surveys, churn rates for employees and any other leading indicators that show how company profits are reliant on product quality, customer service, and employee retention and innovation.
Convincing activists of the value of corporate culture is a challenge, Kerstein says. “Often where we see a positive culture, they see a culture that is rewarding management, rewarding employees, or rewarding other stakeholders at the expense of shareholders,” he says.
Boardroom veterans caution against returning fire with fire, yet sometimes a blunt response to activists is warranted. “You should listen to what they say and respond when you can. But remember: asking is free,” Allergan’s former CEO Pyott recently told Harvard Business Review. “If they say, ‘Hey, we want more,’ you have to be willing to come back with, ‘This is what we can commit to. If there are better places to invest your funds, then do what you need to.’”