As indexed and passive investment funds continue to grow assets under their management, they frequently appear among the largest investors on a public company’s roster of owners. These investment vehicles often own stocks only as a result of their inclusion in an index, and rarely apply any qualitative overlay. Buy and sell decisions are simply mechanical. These large investors thus are prone to take a hands-off approach when it comes to evaluating a company’s management and governance practices.
Corporate leadership is aware of the increasing numbers of these “silent owners” and the decrease in active institutional ownership. Consequently, there appears to be a growing lack of accountability by directors to active shareholders. Board directorships are very lucrative positions, offering both cash and stock compensation. Some in these positions may be tempted to act out of self-interest rather than in in the best interest of shareholders, resulting in needless underperformance of the company’s common stock.
As elected representatives of shareholders, corporate boards of directors have a legal fiduciary obligation to act in the best interests of their constituents. Their primary responsibility is to hire and provide oversight to executive management, ensuring strategic and financial objectives are achieved. Ideally, this oversight results in long-term shareholder value creation. What happens when boards fail in their primary duties?
Here is where operational activists come in. Operational activists are the guardians of shareholder rights. Operational activism fills a critical gap between passive shareholders and those charged with creating value for shareholders. They are becoming an increasingly important force, holding corporate officers and directors accountable to the rightful owners of the business, the common shareholders.
While traditional activists tend to demand or facilitate a company sale through go-private transactions or consolidation strategies designed to realize a quick profit, operational activists understand that a company’s share price is depressed because of the problems created by poor management and board oversight. Operational activists see opportunity in fixing the business, recognizing share gains through the stock market’s revaluation of the business as a result of its improved performance.
Operational activists bring vital leadership and expertise necessary to strengthen board and executive functions, which frequently requires the replacement of directors or management.
Leading indications that operational activism is warranted:
- Lack of board turnover
- Company CEO acts also as chairman
- Weak board governance practices
- Lack of open market stock purchase by officers and directors
- Incentive compensation misaligned with shareholder value creation
- Poor corporate capital allocation
- Ill-conceived acquisitions resulting in large write downs and impairment charges
- Lack of strategic plan by board and management
Insider share ownership and open market transactions are good indicators of alignment of the interests of management, directors, and shareholders. Far too often, large stock awards to executives are followed by the sale of that stock – hardly a reassuring signal to shareholders. Nothing speaks as loudly as management and directors digging into their own pockets to buy shares in open market transactions.
Through interaction with company management and examining public filings, investors can arm themselves with valuable details about the way a company is managed. Stock price underperformance can be an indicator that problems already exist.
Activism is a specialty and has high costs. Many proxy contests involve substantial commitments of time and money. Legal counsel is almost always required when approaching a company to demand change, and a vast array of other professional services (proxy solicitors, investment bankers, etc.) can be retained on a situational basis. The great irony in these situations is those who are being challenged have the company’s resources at their disposal – they can spend freely from the company’s cash and liquid assets to defend themselves from the very problems they’ve created and from the people they represent.
Operational activists seek to provide checks and balances at public companies, giving stockholders a united voice by demanding accountability from company boards and executives. It is rare for an operational activist to show up at a well-managed company that consistently creates shareholder value, but they are invaluable when poor governance and oversight begin to erode shareholder value.
Diligent investors and fund managers without the temperament to challenge companies or demand board representation should remain alert to the activities of operational activists, who may be willing to co-invest in a situation and intervene on behalf of all shareholders. Our market-based system allows for and rewards such constructive initiatives.