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Shareholder Activism

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Shareholder Activism. Shareholder Activism. Certain hedge funds focus on shareholder activism as a core investment strategy - PowerPoint PPT Presentation
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Page 1: Shareholder Activism

Shareholder Activism

Page 2: Shareholder Activism

Shareholder Activism Certain hedge funds focus on shareholder activism as a core

investment strategy An activist shareholder acquires a minority equity position in a public

corporation and then applies pressure on management in order to increase shareholder value through changes in corporate policy

Some of the common changes advocated by activist shareholders include reducing corporate costs, repurchasing common shares, increasing corporate leverage, increasing dividends, reducing CEO compensation, reducing cash balances, and divesting certain businesses

In addition, activist shareholders will sometimes campaign against proposed acquisitions or allocation of cash for purposes that are not perceived to create shareholder value

Activists sometimes also pursue a sale of a target company or a breakup of the company through a piecemeal sale or spin-off of significant operations

Page 3: Shareholder Activism

Shareholder ActivismShareholder Activism

• Some corporations are vulnerable to hostile initiatives by activist shareholders• Hedge funds can be vocal investors who demand change in the corporate governance landscape in a

number of ways:o Publicly criticizing/challenging Boards and managementso Nominating Board candidates and pursuing their agenda through proxy contestso Supporting other activists

• Hedge funds’ activist strategy has been successful by taking advantage of:o Like-minded hedge funds’ herd mentalityo Ability to overcome reputation for short-term focuso Ability to skillfully use a deep arsenal of securities and financial instrumentso Familiarity with M&A and legal regulations and rightso Readiness to go to battle and devote significant resources to full-blown public relations battles

Source: Morgan Stanley

Page 4: Shareholder Activism

Shareholder Activism Activist shareholders usually acquire between 1% and 10% of a

target company’s shares, or create an equity exposure by entering into equity derivative transactions, such as purchasing call options on the company’s stock, simultaneously purchasing call options and selling put options on the company’s stock, entering into forward transactions to purchase the company’s stock, or entering into equity swaps in relation to the company’s stock

A relatively small share holding or equity derivative position established by an activist shareholder may enable the investor to launch a campaign to make significant changes in the company, without the added cost and time required by a complete acquisition

To be effective, however, the activist shareholder generally must obtain the support of other large shareholders through large-scale publicity campaigns, shareholder resolutions or, in the extreme, proxy battles for control over the board of directors

Page 5: Shareholder Activism

Shareholder-Centric vs Director-Centric Corporate Governance A key issue in corporate governance is whether the

corporate board of directors will survive as the governing organization of the public corporation, or if shareholder activism will ultimately invalidate the role of the board

In other words, will corporations become more shareholder-centric and less director-centric in their governance?

Some critics of shareholder-centric governance indicate that this movement is causing a shift in the board’s role from guiding strategy and advising management to ensuring compliance and performing due diligence

This shift can create a wall between the board and the CEO, removing the “trusted advisor” role of board members, as CEOs become increasingly wary of sharing concerns with investigative and defensive boards

Page 6: Shareholder Activism

Shareholder-Centric vs Director-Centric Corporate Governance Based on concern about litigation, directors sometimes

become so focused on their individual committee responsibility that they are less able to focus on the broad objectives of maximizing shareholder value and they become “Balkanized” into powerful committees of independent directors, unable to broadly coordinate the focus of the entire board

Even when the board is able to focus on the business of the corporation in cooperation with the CEO, activist investors create pressure on boards to manage for short-term share price performance rather than long-term value creation.

This may result in short-changing the company’s relationships with its employees, customers, suppliers and communities, as well as reducing investment in R&D and capital projects that are critical to a company’s long-term success

Page 7: Shareholder Activism

Shareholder-Centric vs Director-Centric Corporate GovernanceAnother criticism of shareholder-centric governance is

that shareholder activists could ultimately wrest substantial control from boards, causing companies to bring almost every important decision to a shareholder vote

This would largely shut down the normal operating procedures of the company, slowing down decisions and creating competitive disadvantages, as previously confidential decisions that were made by the board are put in the public domain

There is also concern that activist shareholders can create inappropriate pressure on boards through non-documented alignments between different activists to achieve their objectives

Page 8: Shareholder Activism

Activist Shareholder ReturnsComparison of All Hedge Fund Returns vs. Activist Hedge Fund Returns, 2005 – 2008Annualized total return, %

Source: Hedge Fund Research, Inc.

2.7%

9.3%4.2%

-23.3%

26.3%

17.8%

5.0%

-30.8%

2005 2006 2007 2008

All hedge funds (HFRX Global Hedge Fund Index)

Activist hedge funds (HFRX Activist Index)

Page 9: Shareholder Activism

Activist Shareholder TacticsPotential Activist Tactical Approaches

Activist quietly accumulates stake –no contact with company

Activist required to file for HSR clearance if intention is to accumulate a stake >$63MM or >50%

Activist required to file Form 13D after accumulating stake of at least 5%

a) Calls Chairman/CEO to arrange meeting

b) Sends letter outlining “Plan” to Board only

c) Announces “Plan” directly in a press release / 13D filing

d) Submits shareholder proposal regarding “Plan”

e) Submits shareholder proposal nominating Board candidates

Private Discussion Public Assault

Within 18 months of an initial activist 13D filing, more than 50% of targets are involved in an asset-sale and/or change in capital structure/corporate governance related outcome

Primary Campaign Type: 2008 Proxy Fights

Source: Morgan Stanley

Activist approaches Board and/or shareholders

• Activists aggressively use the public domain to communicate and play out their intentions• There is also a “herd” phenomenon in which funds will collaborate informally to increase influence• This phenomenon means that a situation can destabilize quickly amid a churn in the investor base,

despite small individual investments

Board representation 63%

Board control 31%

Withhold vote for director(s) 2%

Vote for a stockholder proposal 2%

Vote/activism against a merger 2%

Maximize shareholder value 1%

Vote against a management proposal 1%

Page 10: Shareholder Activism

Activist Hedge Fund StrategiesFor an activist investor, timing is everything Their objective is to accumulate enough

ownership in a targeted company to influence change, but they want to accumulate shares without drawing attention from the target and without attracting tag-along investors, whose purchases can drive up the stock price, making it too expensive to accumulate additional stock

Some activist investors have utilized derivatives to help them create a large exposure to a company, without alerting either the target or other potential investors

Page 11: Shareholder Activism

Accumulating Shares Through An Equity Swap: CSXThe SEC requires investors that own 5% or more of a

company’s equity to disclose their ownership through a 13D filing within 10 days of acquisition

To avoid tipping their hand, however, some activist investors have used cash-settled equity swaps (which do not require 13D disclosure) to create an equity exposure to the target

An equity swap is typically entered into with an investment bank counterparty, which causes the bank to buy shares as a hedge against their obligation to pay the returns of the stock ownership (appreciation or depreciation, plus dividends) to the activist hedge fund in exchange for payments that are based on a floating rate of interest (typically LIBOR) plus an appropriate credit spread

Page 12: Shareholder Activism

More on Equity Swap Example: take a simple index swap where Party A swaps £5,000,000

at LIBOR + 0.03% (also called LIBOR + 3 basis points) against £5,000,000 (FTSE to the £5,000,000 notional). In this case Party A will pay (to Party B) a floating interest rate (LIBOR +0.03%) on the £5,000,000 notional and would receive from Party B any percentage increase in the FTSE equity index applied to the £5,000,000 notional.

In this example, assuming a LIBOR rate of 5.97% p.a. and a swap tenor of precisely 180 days, the floating leg payer/equity receiver (Party A) would owe (5.97%+0.03%)*£5,000,000*180/360 = £150,000 to the equity payer/floating leg receiver (Party B).

At the same date (after 180 days) if the FTSE had appreciated by 10% from its level at trade commencement, Party B would owe 10%*£5,000,000 = £500,000 to Party A. If, on the other hand, the FTSE at the six-month mark had fallen by 10% from its level at trade commencement, Party A would owe an additional 10%*£5,000,000 = £500,000 to Party B, since the flow is negative.

Page 13: Shareholder Activism

Accumulating Shares Through An Equity Swap: CSXIn some equity swaps, the hedge fund has the right to

purchase the underlying shares from the counterparty under certain circumstances, at which point the hedge fund would disclose ownership of the shares (but not before the shares are delivered)

The key question under this arrangement is who controls votes attached to the shares that are the subject of the equity swap?

Since the activist does not own the shares, they technically do not own the voting rights, and therefore may not be required by the SEC to disclose ownership under 13D rules

However, since the hedge fund might be able to receive these shares before a future vote on the election of directors, the activist can theoretically own the shares when it matters most

Page 14: Shareholder Activism

Accumulating Shares Through An Equity Swap: CSX

Equity Swaps on CSX Shares

Assume CSX share price of $40 when equity swaps were executed on 62.5 million shares (a notional amount of $2.5 billion)

Interest payments @ Libor + 50 b.p. on $2.5 billion

62.5 mm CSX shares

$2.5 billion

Interest payments @ Libor + 25 b.p. on $2.5 billion

$2.5 billion loanInvestment Banks LendersTCI and 3G

Total returns paid on Equity Swap involving 62.5mm CSX shares

The outcome of this transaction is:• TCI and 3G receive economic exposure to 62.5 million CSX shares since they receive/pay total returns from/to

investment bank counterparties (quarterly appreciation/depreciation of CSX share price + dividends) • Since TCI and 3G don’t own shares (investment banks purchased 62.5 million CSX shares to hedge their equity

swap position) the hedge funds may not need to report beneficial ownership of these shares to the SEC• The investment banks receive a spread of 25 basis points between their cost of borrowing $2.5 billion and the

payments received from TCI and 3G under the equity swap• The hedge fund may have the right to unwind the equity swap in the future before a proxy vote by paying $2.5

billion to the investment banks in exchange for 62.5 million CSX shares

CSX Shareholders

Page 15: Shareholder Activism

Accumulating Shares Through Equity Collars: YahooDuring February 2008, Microsoft offered to buy Yahoo at $31

per share, but Yahoo’s CEO and founder rejected the offerFollowing this rejection, Carl Icahn started accumulating a

position in Yahoo stock, attempting to benefit from an eventual sale to Microsoft

During May 2008, Icahn initiated a proxy fight against Yahoo after acquiring an equity equivalent position of 59 million Yahoo shares. This position was comprised of 9.9 million common shares and equity collars on 49 million Yahoo shares

The equity collars were created through the purchase of call options on Yahoo (American style calls with an unknown strike price and maturity) and the simultaneous sale of put options on Yahoo (European style puts with a strike price of $19.50, maturing in November 2010)

Page 16: Shareholder Activism

Accumulating Shares Through Equity Collars: Yahoo

The equity collars provided the following potential benefits for Icahn The estimated cost for the equity collars could be zero,

compared to the over $1.23 billion cost that Icahn would have paid to purchase 49 million Yahoo shares at the $25.15 opening share price on the date the collars were entered into

Entering into a collar transaction was less visible than purchasing 49 million shares, enabling Icahn to secure his position without competing directly in the market for shares

The options can be settled physically, by delivery of shares, or if Icahn does not want to buy Yahoo shares if options are exercised, he can “cash settle” the options

Cash settlement means that, if an option is exercised, the economic equivalent of a physical settlement will be paid in cash (payment to Icahn if Yahoo’s share price exceeds $32.85 or from Icahn if the share price falls below $19.15)

Page 17: Shareholder Activism

Accumulating Shares Through Equity Collars: Yahoo

Equity Collars on Yahoo Stock

• Assume Yahoo share price of $25.15 when the equity collar is executed• Put options on 49 million Yahoo shares at a strike price of $19.15 and an 18 month maturity can be sold for

proceeds of:

(i) $2.14/option

• Call options on 49 million Yahoo shares at a strike price of $32.85 and an 18 month maturity can be purchased for a cost of:

(ii) $2.14/option

• Total cost for a “Cashless Equity Collar” = (i) - (ii) = $2.14/option - $2.14/option = $0

$19.15 $25.15 $32.85

-$2.14

$2.14

$2.14

$0

$25.15 $32.85

-$2.14

Economic Value

Economic Value

Economic Value

Economic Value

$19.15 $25.15

$25.15

$0

$0$0

Sell Put Options Buy Call Options+

= Costless Equity Collar vs. Purchase Yahoo @ $25.15

Page 18: Shareholder Activism

Activism Summarized There is disagreement on whether hedge fund shareholder activism

makes companies stronger or merely generates short-term gains that principally benefit the activist at the expense of long-term shareholders

During 2008, there were more than 75 U.S. hedge funds dedicated to event-driven, activist-style investing and these funds managed more than $50 billion in assets

Some institutional investors have lined up with these hedge funds to push boards to be more responsive to shareholders

In a number of cases, it appears that improvements have been made in companies that, in the absence of shareholder activism, may not have occurred

In other cases, large share repurchases pushed by activists and created large opportunity costs when the repurchases occurred before subsequent steep share price drops

In addition, some acquisitions pushed by activist shareholders have seen significant share price drops since closing


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