Telecom Italia Vote Shows How Activists and Passive Investors Can Work Together

It’s not every day that Italian capitalism can be heralded as a bastion of transparency. But the showdown on May 4 at Telecom Italia’s board meeting between U.S. activist fund Elliott Management and French conglomerate Groupe Bolloré proved to be one such opportunity.

That is because in Italy, unlike in the United States and other advanced economies, shareholder votes are part of the public record. As such, the vote in Milan was the perfect arena to observe some of the most important fault lines in shareholder capitalism today.

Ultimately, the case turned on the votes of large passive institutional investors, in particular the big three of Vanguard, BlackRock, and State Street.

Passive funds, which include low-cost exchange traded funds (ETFs), today manage an astonishing $8 trillion of assets, or 20 percent of all investment fund assets, according to Lipper data. For equities the figure is higher. In Europe, passives make up 30 percent of equity fund assets; in the U.S. the figure is 43 percent. For the foreseeable future, those numbers are only going to rise.

Passive funds have slashed investing costs for investors. Yet one outstanding question is what they mean for the allocation of capital. Two years ago, Bernstein Research described passive investing as “worse than Marxism” because of its indifferent approach to capital allocation.

The theory goes that passives, which mainly allocate funds to follow market capitalisation-weighted indexes, are typically backward looking. Therefore, the biggest company today will remain the biggest company tomorrow, and capital will therefore be allocated by size, not future productivity.

In response to growing concerns over governance, passive investors have argued that they are not necessarily passive stewards.

In his CEO letter earlier this year, BlackRock chief executive Larry Fink proposed “a new model of shareholder engagement,” noting that a “company’s ability to manage environmental, social and governance matters demonstrates the leadership and good governance that is so essential to sustainable growth.”

Similarly, Vanguard has promised to “continue to strengthen our commitment to investment stewardship.” In sum, passive funds are committed to being active when it comes to being good owners.

Which takes us to Milan. Vanguard, BlackRock, and State Street—which collectively own about 7 percent of Telecom Italia’s shares—had to choose between competing slates of 10 directors. One slate had been put forward by Vivendi—which is controlled by French billionaire Vincent Bolloré—and the other by U.S. fund Elliott. Vivendi had 24 percent of the voting rights and Elliott had up to 9 percent.

As expected, the vote was extremely close. Of attending shareholders, 49.8 percent voted for Elliott’s slate while 47.2 percent voted for Vivendi’s. It will not be clear for 30 days how the large passive investors voted, but given the strong result, it is most likely that they voted with Elliott. In fact, by one estimate, apart from Vivendi, just under 8 percent of the equity backed the French company’s nominees.

That is an extremely positive sign. First, because it shows passive investors were ready to tackle glaring corporate governance problems head on. Second, because it points to a broader model for a new partnership between activists and passive investors.

The fundamentals of this particular case are worth understanding. The fundamental issue at stake related to governance. Elliott argued that Vivendi was treating Telecom Italia as an extension of Vincent Bolloré’s business empire, and that value in Telecom Italia was thus being transferred upwards into its parent group, Vivendi, rather than to Telecom Italia shareholders.

Investors had signaled they liked Elliott’s message—since the fund declared its stake in early March, shares were up 12 percent. Elliott wants to keep chief executive Amos Genish but insisted on a new, and independent, set of directors.

One of the things that emerged in Elliott’s shareholder campaign was a systematic cataloguing of Vivendi’s efforts to channel value from Telecom Italia to itself.

For instance, in late 2016 Telecom Italia awarded a major advertising contract to Havas, majority owned by Bolloré at the time. Havas is run by Bolloré’s son Yannick, who last month took over from Bolloré as Vivendi chairman. The contract was worth 92 million euros, or around 7 percent of Telecom Italia’s net income last year, which is hardly small change. This is why Telecom Italia’s retail shareholder association, Asati, protested to the Italian market regulator Consob about the decision.

If that were the end of it, however, Telecom Italia minority shareholders might have let it go, perhaps chalking it up as a one-off cost of doing business with a man like Vincent Bolloré. But the leakage of value from Telecom Italia did not end there.

In October, Telecom Italia signed a joint-venture with Canal+, a Vivendi-owned TV company, in which Telecom Italia would commit to acquire Canal+ content, potentially worth hundreds of millions of euros. Given the stakes involved, that decision is also being scrutinized by Consob.

As if to underline the ethics problems involved with Vivendi’s governance, on April 25 French authorities announced that Vincent Bolloré is under formal investigation for paying bribes to the presidents of two African countries.

Bollore’s reason for running Telecom Italia in this manner may be surmised by looking at his incentive structure. Groupe Bolloré owns an economic stake of 20 percent of Vivendi shares, and Vivendi’s economic stake in Telecom Italia is 17 percent. Thus, Groupe Bolloré indirectly owns just under 3.5 percent of Telecom Italia shares.

It follows, as Elliott has argued, that 1 euro earned at Vivendi is nearly 6 times more valuable to Groupe Bolloré than 1 euro earned at Telecom Italia. In other words, Bolloré has a clear incentive for earnings to accrue at the Vivendi level rather than at Telecom Italia.

Therefore, for all the twists and turns of the case, the fundamental issues were relatively straightforward. Telecom Italia’s shareholders were better served by having an independent board of directors that would put its interest above all others’. The alternative was a parent company based in France with misaligned incentives and a track record of questionable governance. The vote showed investors recognized this.

Ultimately, the Telecom Italia vote may prove to be significant as a model for how activists and passive investors can work together. While index funds have teams of capable professionals to review opportunities to improve governance, many thousands of companies need to be evaluated. Yet corporate governance resources do not exceed three dozen people even at the largest index funds. To keep pace with demand, additional help is needed. Activists therefore can play an essential role. The vote in Milan is a sign that index funds and activists can successfully work together to improve companies in a scalable way.

This post comes to us from Sahil Mahtani, a vice president of research at Deutsche Bank. An earlier version was published in the Financial Times. All opinions expressed here are his own and do not necessarily reflect those of the bank.