By Elizabeth Kopple
Small cap and micro cap activist investing plays an important role in maximizing shareholder value for this sector. In many ways, activism is more valuable at small public companies than at large caps. A small cap company may not get the same press when it makes a bad business decision. Operating activities can be less transparent to investors. Board members are more likely to be friends of management who were placed on the board to be agreeable. Finally, smaller companies often have shareholders with less buying power. The smaller funds and investors may not have the resources or the expertise for a proxy fight. Without an activist partner, these investors cannot gain the publicity and the public pressure needed to convince management to agree to improve things.
Investors should consider activism when all other efforts have failed. When they have reached a wall. Typically, fund managers have watched their investment drop in value for years. Management has promised earnings figures and failed to deliver quarter after quarter. Perhaps compensation is not tied to company performance. Or management should return surplus cash to shareholders in the form of a dividend. A CEO may be investing valuable resources in a pet project that has no chance of success. A division is worth more if it is sold off. If a majority of investors believe in a critical change, management needs to listen to their suggestion and carefully consider its implementation.
Some activist targets have taken advantage of investors to a degree that is almost comical. In one of my contests, a CEO built a swimming pool at company headquarters for the exclusive use of his family. In another case, a key executive did not come into the office for three full years. In yet another company, a board voted to award bonus payments based upon estimated revenue numbers. After the bonuses had been paid, they announced that they had missed sales forecasts.
What makes a stock a good candidate for activists? Here are some of the patterns for successful activist targets:
- Wide shareholder support for changes to the board and management team
- Insiders own less than 10% of the company
- Cash is being spent on frivolous acquisitions
- Quality employees are leaving due to poor management
- Management has lost its focus and is not driving growth
- Management is misstating financial results
- Valuable patent portfolio value is being squandered
- The company is trading for less than the sum of its parts
Proxy contests can be expensive for those without expertise. Investors can reduce their costs by working in partnership with an experienced activist investor. Experienced activists can often reduce this cost substantially. They are high volume clients who have formed special relationships with expert legal advisors and proxy solicitors.
Certain shareholder demands are more likely to generate a positive investment return. Hedge funds are usually better at implementing plans that can be crafted with publicly available information. This includes selling an asset or paying a dividend. Funds have not been as successful, on the whole, when they create new business plans that require confidential, inside information (1).
Once an activist investor team has decided to move forward with a proxy contest, they must work through a specific process. First, shareholders must be contacted and convinced to support the activists. You will need to have detailed presentations demonstrating the changes you suggest and your credibility to implement these changes. Next, investors must reach out to proxy advisory firms such as ISS and Glass, Lewis and explain the key issues. These proxy advisory firms can choose to recommend that shareholders vote in support of your proxy. It is critical to have support from ISS and/or Glass, Lewis. It sends a powerful signal to incumbent management, board members as well as investors. Next, activists usually nominate representatives to join the Company board. These nominees must be experienced, capable executives with industry experience. Finally, a form DEF 14A must be filed with the SEC and a proxy letter must be written to shareholders and the incumbent board.
It can be challenging to gain a majority of shareholder approval. First, it is helpful if the management team owns less than 10% of the stock. This usually means that management is more worried about their salary and perks than the stock price. It is important to find the connectors within the shareholder base. The connector could be a small individual investor who knows the largest shareholders and keeps them all connected. He may post regularly on the message board and send specific alerts to shareholders when something is amiss. Again it is sometimes the smaller shareholders that wield the most power.
Activists need a focused plan for improving the company that they can sell to investors. It is not enough to point out the weaknesses of the current Board or management team. Demonstrate what you can improve. For example, an activist may present the following outline and then provide details on how they will execute:
§ Focus on free cash flow
§ Reduce corporate overhead
§ Attract and retain talent
§ Exit unsuccessful businesses
§ Pay for performance
Throughout the entire process, investors should be open to negotiating with management and agreeing to reasonable terms for a settlement. It is much better when management agrees to terms before the proxy contest is completed. Sometimes the credible threat of a proxy contest is enough to settle the dispute with management. And that credible threat is the reason small cap activism is critical to ensuring investment returns and maintaining efficient markets.
(1) Bratton, William W., Hedge Funds and Governance Targets: Long-Term Results (September 8, 2010). University of Pennsylvania Institute for Law & Economics Research Paper No. 10-17
Elizabeth Kopple is a Director with IDWR Multi-Family Office, an organization that invests its own capital in small cap proxy contests. She can be reached at firstname.lastname@example.org. Ms. Kopple is also a member of The Activists Association: www.activistsassociation.com
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