Read Part 1 here.
Are Institutional Investors Biased in Favor of Activists and Against Boards?
There is at least one objective reason why investors might, in general, favor activist investor campaigns focusing on shorter-term initiatives. After all, the longer the duration of implementation of a business strategy, the greater the risk of miscalculation of its net present value creation. While projections are inherently uncertain, it is clear that the uncertainty factor increases over their duration. Moreover, execution risk also rises as the time frame of implementation lengthens. To this extent, being biased in favor of a shorter-term program instead of a longer-term one makes sense. Passage of time is not a friend to confidence in projected outcomes. But this consideration, standing alone, does not seem sufficient to explain the concerns of management and Boards with the impartiality of investors.
Why Institutional Investors Favor Activists
Over the past 30 years, institutional investors’ relationships with portfolio companies have changed drastically. Until the mid-1980s, the paradigm was simple: At actively managed funds, portfolio managers and buy-side analysts were the sole point of contact with management, and directors were simply not involved in the dialogue. And, of course, quantitative investors had no reason to, and did not, dialogue with management.
Beginning in the mid-1980s, this paradigm began to change as institutions increasingly felt compelled to vote, independently of management’s recommendations, on every ballot proposal for every shareholder meeting for every portfolio company. This represented a major change in policy from what many characterized as the “Wall Street Walk”—a policy of institutional investors of all stripes to vote with management on all matters and at least for all actively managed funds to sell a company’s stock when the institution lost faith in management. The demise of the Wall Street Walk resulted in a sea change in the way institutional investors dealt with the multitude of proxy votes they faced each year.
In response to the pressure to vote thousands of times each proxy season, institutional investors resorted to two or three complementary strategies.
- First, almost all institutions created an internal team (separate from the portfolio management function at actively managed funds) specifically to manage the portfolio company’s share-voting process. These teams, while initially small, have grown over the years as shareholder voting decisions and fund complexes have grown in number and complexity. This is particularly the case at quantitative firms, where the voting decisions cannot be informed, let alone made, by the portfolio management function (which simply does not exist).
- Second, many institutional investors outsourced voting recommendations, and quite often voting decisions, to proxy advisory firms, today principally ISS and Glass Lewis.
- Finally, the sheer number of voting decisions effectively demanded adoption of comprehensive voting policies by both investors and proxy advisory firms. The benefit of one-size-fits-all proxy voting policies, of course, is their ability to cope with thousands of voting decisions while requiring only a relatively small group of employees to administer. In contrast, a far larger staff would be needed for a proxy advisor or institutional investor to deal with each ballot proposal on a case-by-case basis in the context of the particular circumstances at each portfolio company. The financial incentive of a one-size-fits-all voting function is clear and becomes yet more compelling in the context of the reality that proxy season is at most five to six months long.
More important to the issue of bias against management and Boards, the dominant philosophy driving the creation and implementation of ISS’ and institutional investors’ voting policies has consistently been aligned with a populist/progressive skepticism about the motivations and behavior of corporations and their management. This was true in the late 1980s, when ISS and some pioneering public pension funds began to push back against the Wall Street Walk, and it remains true today, well after the Walk vanished into the pages of financial history as the prevailing voting paradigm.
The negative populist/progressive view of corporate management, moreover, has gained additional credibility from a number of events and the popular narrative surrounding them:
- First, the resistance of Boards and management to the takeover wave of the 1980s (in particular, the widespread adoption of Poison Pills throughout corporate America) was quickly labeled by proponents of a “free market” in corporate takeovers as systemic “entrenchment.” The opposition to takeover defense and management entrenchment further benefitted from the widespread support of academics, both Chicago School free market enthusiasts and shareholder empowerment advocates. Thought leaders at ISS and a number of investors (principally state and local pension funds and union pension funds) soon converted their philosophical distrust of corporate management into a campaign to critically examine and improve corporate governance at U.S. companies, often starting with redemption of Poison Pills. By the early 1990s, the die was cast. Corporate governance reform became the dominant policy not only of the proxy advisors but also of the managers of the proxy voting process at state, local and union pension funds and an ever-increasing number of for-profit institutional investors.
- The negative view of corporate management and Boards gained additional credence during the wave of corporate scandals in the early years of this century, which preceded and was responsible for the enactment of the Sarbanes-Oxley Act. Rightly or wrongly, the sins of the relatively few were attributed far more broadly to corporate America as a whole by a large swath of the public, the press and the political establishment, making it even more important in the eyes of the corporate governance community to rein in bad managerial behavior by major reforms in corporate governance.
- The suspicion – and too often distrust – of corporate management was yet again reinforced by the virtually universal attribution of the Financial Crisis of 2007-2009 to bad (if not venal) management and Boards. The fact that, at most, only a portion of the financial services industry (principally, money center banks and major investment banks) were connected to the events that gave rise to the Crisis seemed not to matter to most of America. The prevailing narrative quickly became that the Crisis was the fault of bad governance at public U.S. companies.
The end result, fairly or not, is that the corporate governance movement is not a natural friend of management and Boards. It was born and bred from a philosophy of distrust and opposition to them. Given its provenance and history, it is hardly surprising that the corporate governance community seems (and probably is) biased against management and in favor of activist investors, particularly when the activists embrace corporate governance reform as part of their campaigns against management.
Can the Bias of Corporate Governance Activists Be Overcome?
This, of course, is the question du jour for management and Boards today, whether or not their company is faced with an actual or imminent activist campaign. It is the ultimate rationale for the growing importance of the concept of “engagement” that is now offered as a universal component of every activist defense playbook. Engagement, quite simply, is the idea that senior management and, more importantly, directors must get to know the corporate governance staffs at their major investors in order to establish bonds of confidence and trust by the corporate governance staff in the strategy of the company and its senior leadership.
Whether a successful engagement campaign will prove sufficient to overcome the negative bias of the corporate governance community in the context of an activist campaign is the $64 question. But there do not seem to be any other remedies available to a company in today’s world.
A variety of defenders of corporate America against activist investing have campaigned against the activism and the institutional investor bias in favor of activists through a variety of media, utilizing a number of arguments—for example, asserting that activists don’t create lasting corporate value enhancements. However, this type of argumentation has not worked to date, and there is nothing on the horizon to suggest that it will be more successful in the future.
It is not plausible to think that the corporate governance community’s stranglehold on proxy voting at the vast majority of institutional investors will go away. While it is possible that some portfolio managers may gain a greater voice in voting decisions on activist campaigns, this will only be true for actively managed funds in a world where assets seem to be flowing toward quantitative investment strategies.
Nor is it any more realistic to think that the corporate governance world, the academic community or the press will soon alter their generally negative views of corporate management’s motives and behavior, which is a critical underlying component to the prevailing pro-activist bias on the part of the “owners” of the proxy machinery.
Another possible solution could be a relative implosion in the credibility of activist investor game plans brought about by a regression to the median as the growing size of the activist investor asset class overwhelms the number of available deserving corporate targets. Even if this were to occur, it will not happen quickly, and in any event some number of the more competent activists will probably continue to post outsized returns, even though more mundane members of the pack falter or even fail.
Another answer, in theory, could be some form of government intervention. For example, some advocate imposing fiduciary standards on the world of public pension fund administrators, as well as on the proxy advisory industry. This, however, is an unlikely antidote. After all, all the other participants in the institutional investor community have long been subject to strict fiduciary standards under both ERISA and the 1940 Investment Company and Investment Advisors Acts. Others have suggested deterring or foreclosing so-called short-termism through changes in capital gains taxation and/or capital gains treatment for carried interest. However, adoption of these proposals also seems unlikely to bring activism to a halt. Adoption might alter activist investor holding periods or the economics for the principals at activist investors, but such changes in the tax law are unlikely to end the appeal of activist investing so long as activists continue to produce above-market equity returns for their investors.
For better or for worse, engagement is management’s and directors’ best, and perhaps only, hope to obtain a relatively unbiased hearing from the proxy voting decision makers in the context of an activist campaign. At the very least, it is something all companies should be seriously examining today, if they have not already embraced the policy.
The difficulty, however, is that for all but the larger-cap companies, getting a hearing at their key institutional investors is easier said than done; institutional investors rarely have the bandwidth in their corporate governance group to meaningfully engage with all of their portfolio companies. Ironically, this problem is most apparent at the larger institutions, whose portfolios encompass thousands of companies. Smaller investors focusing on relatively concentrated portfolios may prove easier targets for productive engagement.
The bottom line, unfortunately, is that for the foreseeable future, corporate America will have to continue to live with an investor community that is inherently biased in favor of activism because of the domination of corporate governance advocates over the proxy voting machinery. At best, the larger companies and some of the more fortunate mid-cap and smaller companies may be able to ameliorate this bias by engaging productively with their key investors. The vast majority may just have to accept their potential victimhood.