The following comes to us from Paul C. Hilal, a Partner at Pershing Square Capital Management, a New York City-based hedge fund founded in 2004.
Is shareholder activism good for the world?
A simple question, and yet it’s the subject of intense debate. Proponents say activists play a key role in the markets, shaking up entrenched interests and unlocking long-term value by acting as change agents. Critics claim activism pumps up short term stock prices for the benefit of the activists at the expense of long term interests of companies and their shareholders.
Who’s right and what does that suggest about the regulatory changes that some have been advocating?
The Myth of the “Quick Buck Artist”
Critics claim that activists are “quick buck artists” whose tactics increase share prices for just long enough for them to exit their positions at a profit, but serve over the longer-term to reduce the value of the underlying company. The critics’ false narrative provides that activists advocate for value-destroying gimmicks that create the illusion of value creation. Fear that the activist will successfully beguile shareholders into supporting the gimmick pressures wise boards to engage in value-destroying acts in order to avoid accountability from the beguiled shareholders. The beguiled shareholders then bid up the share price of the damaged company, providing the activist an opportunity to quickly liquidate its holdings for a profit, and laugh all the way to the bank leaving the rest of the shareholders “holding the bag”. This false narrative plays to the inherent deference reflexively paid to a company’s directors – typically accomplished executives or retired executives. Underpinning it is the presumption that shareholders are naïve and boards are wise, and the shareholders cannot be expected to correctly choose whether to support the incumbents or the activist.
Finance theoreticians and practitioners would argue that such tactics simply do not exist, and in most market conditions cannot exist. Indeed, the entrenched interests who advance this contrivance fail to support this claim theoretically or empirically and instead hope some less sophisticated audiences will find the myth to be intuitively attractive. And yet, this reasoning is neither intuitive nor true.
Do activists really have a short term horizon?
NYSE data from 2010 suggests that the average holding period for any given share is a mere 6 months, while other studies suggest an even shorter time frame. Investors today either lack the power or the incentive to play an active role in the companies they own and therefore often prefer to “vote with their feet” and get out when they believe management is not doing what it should be doing.
Activist investors, on the other hand, hold their positions for extended periods of time, with studies suggesting a median of 20 months (more than three times longer than the average holding period). Pershing Square typically holds its positions substantially longer than that.
Bottom line: activist investors generally stick around longer than the average investor and they reap the benefit or suffer the detriment of the long-term performance their actions influence (i.e. they “eat their own cooking”).
What about long term performance?
When an activist files a Schedule 13D, share prices generally increase materially, presumably because the market recognizes that activists have the ability and incentive to effectuate needed change. Studies consistently indicate that this increase in share price persists long-term.
For example, a comprehensive academic paper completed in July 2013 studied about 2,000 activist interventions and their impact during the first five years after the intervention and found no evidence for the claim that activists push companies to increase short-term earnings or share price at the expense of long-term operating performance or share price. In fact, the paper found the contrary, and further found that “the stock appreciation accompanying activists’ initial announcement reflects the market’s correct anticipation of the intervention’s effect, and the initial positive stock reaction is not reversed in the long term.”
The same paper also found that – contrary to the claims of activist critics – targeted companies were not more vulnerable to economic downturns, such as the 2007 collapse, than their peers.
Lucian Bebchuk (professor of law, economics and finance at Harvard Law School and director of its corporate governance program) is one of the most prolific researchers in this area. In discussing the July 2013 paper he co-authored (referred to above), he said:
“The claim that activist interventions by hedge funds are followed in the long term by declines in operating performance and shareholder wealth is, fundamentally, an empirical proposition that can be tested using data about companies’ financial performance. While opponents of activism have been making this claim with confidence and passion, they have failed to analyze the data and to back up their rhetoric with evidence.”
Side Benefits of Activism and Large Block Holdings
There are a multitude of studies which suggest that the mere presence of activists incentivizes good corporate practices. Studies show that when an activist or other block holder is represented on the board there is less likelihood that CEOs are compensated for luck rather than performance and a smaller incidence of option back dating. When there is a block holder on the compensation committee there is a stronger correlation between CEO performance and pay, stronger correlations between CEO turnover and performance, and lower CEO pay. Other studies show that when a block holder holds stock in a company there is an increase in shareholder opposition to management entrenchment proposals such as adoption of poison pills and classified boards.
In addition, the mere fear of an activist intervention causes board members to proactively adopt various beneficial practices, such as maintaining good relations with shareholders and effectuating fair compensation practices. One law firm that generally represents incumbent corporate management wrote several memos and articles advising its corporate clients to do precisely that. In one, it recommended “proactively addressing reasons for any shortfall versus peer company benchmarks” and “maintaining regular, close contact with major institutional investors” so as to put itself in the “best possible position to prevent or respond to hedge fund activism.”
Canadian Pacific: A Case Study
In 2011, Pershing Square began studying Canadian Pacific Railway Limited (“CP”) and concluded that it had substantially underperformed relative to its peers with no end in sight. CP’s key indicator of performance – its operating ratio – was the worst in the industry while CP’s closest comparable and competitor (Canadian National Railway Company) had the best. The difference enabled Canadian National to generate nearly twice the profit CP did for each dollar of revenue, and nearly triple the cash flow.
On September 22nd, 2011, Pershing Square began accumulating shares of Canadian Pacific. The market valued CP at approximately CAD $7.9bn at the time. Pershing bought so aggressively – sometimes 30% of the daily volume – that it drove CP’s share price up materially. On October 28th, 2011, Pershing Square publicly disclosed its substantial interest in CP through a 13d filing, and paused its purchase program. The next day, the share price jumped an additional 4%, to a level 44% higher than the closing price on the last trading day before Pershing Square’s unusually aggressive accumulation of CP shares lifted the price. The 44% delta represented the difference between what the shareholders thought the Company was worth before an activist was involved, and what it was worth with Pershing a large holder.
Pershing Square then met with the chairman of CP’s board to discuss how to improve CP’s sagging performance, and argued that with the right CEO and board, CP could close almost all of its performance deficit with respect to Canadian National in just four years. The board and CEO fiercely resisted any management change, and, citing a $5MM study it had commissioned of the railroad’s potential, argued that Pershing Square’s projections were “unachievable”, “unrealistic”, and evidence of “a clear lack of research or understanding or both.”
With no possibility of settlement with management, Pershing Square took its case to the shareholders, seeking to have seven of its nominees added to the board, and seeking to replace CP’s CEO with Hunter Harrison, a railroad legend. Pershing Square’s argument was delivered at a Town Hall Meeting in Toronto (the video of which can be found at www.cprising.com). In an historic landslide, at CP’s May 17th, 2012 Annual General Meeting, all seven of Pershing’s nominees were elected to the board with each receiving roughly 90% of the vote. After an accelerated search process, the restructured board promptly appointed Hunter Harrison as CEO, as three of the surviving legacy directors – whose seats had not been challenged by Pershing at the May AGM – resigned.
At the time of this writing – February of 2014, just a year and half into Mr. Harrison’s tenure – CP’s transformation is well underway. CP’s operating and financial performance and customer service levels are at all-time records, and the railroad has maintained an excellent safety record. In 2013, CP exceeded the performance levels that the former CEO and Chairman of the Company, and the Company’s outside consultant, had argued were impossible to achieve before 2016. CP management has guided that in 2014 it will exceed the 2016 target performance levels Pershing had articulated during the proxy contest – a full two years early.
It is clear that improvements like these would have been realizable in the absence of activist efforts. Indeed, CP’s fundamental problem was that its owners had been inactive.
As a result of the changes catalyzed by Pershing’s activism, from the last trading day before Pershing Square began to buy CP shares through February, 2014 CP’s stock price has risen 270%. CP was worth CAD $7.9bn when Pershing began accumulating stock, and is today, just two-and-a-half years later, and just a year-and-a-half into the transformation, CP is worth $29bn. Meanwhile, Pershing continues to be CP’s largest shareholder and continues to reap the benefits (alongside other shareholders) of continuing improvements.
What Does All this Say About Regulatory Proposals Impacting Activism?
In the US, activist investors are required to publicly report their investments by filing a Schedule 13D with the SEC within 10 calendar days of crossing the 5% threshold. There are some who have been calling for changes to this reporting regime, including shortening the ten-day filing window, imposing a hiatus on share purchases between the time the shareholder reaches 5% and the time it files its Schedule 13D (and thereafter for a cooling off period), and including derivatives such as cash-settled total return swaps into the calculation of beneficial ownership. In Canada, proposed changes are even more drastic.
An activist campaign is enormously expensive, both in terms of out-of-pocket costs (which often stretch into many millions or tens of millions of dollars) and – more significantly – a staggeringly high demand of time, energy, and resources at the highest levels of the activist firm. In addition, the illiquidity involved in activism creates enormous additional risk for the activist. These costs and risks, and the opportunity cost of the financial and human resources deployed in the activist engagement, mean that a firm can often justify going activist only if it can obtain enough shares at pre-disclosure prices to justify its risks, costs and time. Earlier disclosure would cause share value to jump to a price that includes the anticipated improvement in value, and that may preclude an activist from obtaining enough shares to justify the effort.
The predictable result, and in all truth the intended result of those arguing for these changes, is that activists will pass on some campaigns that would otherwise benefit target companies and their shareholders (both short and long term), thereby denying companies and shareholders respite from dysfunctional leadership.
Speaking from our own experience in the activist arena, we generally skip over companies in desperate need of shareholder engagement simply because they are in jurisdictions where the disclosure rules make accumulating an adequate position impractical.
Simply stated, the proposed disclosure changes would result in fewer dramatic turnarounds like the one we helped precipitate at Canadian Pacific. The disclosure changes are bad for the economy, bad for the country, and wholly inadvisable.
Proponents rely on two arguments to justify these proposals. First, they argue that the proposals will deter activists and deterrence is desirable because activists harm companies and their shareholders in the long term. The earlier part of this paper demonstrates that this argument is false.
Second, proponents argue that current regulations allow activists to keep their value creating intentions a secret for too long, thus exploiting the unaware shareholders who continue to sell their stock at prices unaffected by the knowledge that an activist will be surfacing. This objection is flawed for a number of reasons:
1) Adoption of the new proposals would decrease activism (and thus its benefits) in the first place, and thus would reduce the opportunity for shareholders to sell at advantageous prices due to the existence of an activist.
2) A selling shareholder will only be aided by the demand (and materially higher price) triggered by aggressive activist buying, and thus the selling shareholder has nothing to complain about.
3) The information that an activist will be surfacing is the activist’s own information, and there’s no more reason to insist that an activist prematurely disclose its interest than there is to insist that a potential acquirer disclose its desire to buy a target.
The beneficiaries of the activism are numerous and profoundly enriched, while the class of shareholders who sold to the activist are few and have not suffered any real economic harm. No shareholders want to reduce the likelihood that an activist can show up as a holder of one of their portfolio companies. None. And the proponents of these anti-activist regulatory changes plainly know this. Indeed, if a company’s shareholders wanted to limit the ability of activists to engage with the company, they could implement charter amendments that have that effect. Such amendments are not happening. In fact, the long-established trend of shareholders insisting that US companies de-stagger their boards proves that shareholders want just the opposite.
The empirical evidence is compelling: Activist investors do good for companies and shareholders alike. They increase the accountability of boards of directors to the shareholders they are supposed to serve – an extremely sophisticated collection of professional institutional investors that know a good idea when they see one. Activists’ direct involvement is statistically linked to higher total returns as well as improvements in operating performance while their mere shadow causes management to proactively implement various beneficial practices. Regulatory changes, such as shortening the Schedule 13D reporting window, that serve to reduce activist activity should be resisted with utmost vigor. The arguments supporting those changes are advanced by the agents of entrenched underperforming boards, and are utterly spurious.
 Sy Harding, Stock Market Becomes Short Attention Span Theater of Trading, Forbes, Jan. 2011.
 Alon Brav, Wei Jiang, Frank Partnoy & Randall Thomas, The Returns to Hedge Fund Activism, March 2008, available at http://ssrn.com/abstract=1111778.
 Bill Ackman held his position in MBIA for seven years, through Gotham Partners and later through Pershing Square. Pershing Square’s investments in General Growth Properties and Howard Hughes will reach their fifth anniversaries this Fall. Its average holding period for activist investments is four years.
 In The Returns to Hedge Fund Activism (cited above), the authors estimate an activist’s initial 13D filing results in a large positive average abnormal return in the range of 7 percent to 8 percent, Brav et al, supra note 1. Of course, that’s an average and the increase triggered by effective activists (short and long term) can be much higher.
 Brav et al., supra note 1. Lucian Bebchuk, Alon Brav & Wei Jiang, The Long Term Effects of Hedge Fund Activism, July 2013, available at http://www.columbia.edu/~wj2006/HF_LTEffects.pdf.
 Bebchuk et al., surpa note 5. Another study shows that plant productivity increases within three years after an activist intervention. Alon Brav, Wei Jiang & Hyunseob Kim, The Real Effects of Hedge Fund Activism: Productivity, Risk, and Product Market Competition, May 2013, available at http://www.columbia.edu/~wj2006/HF_RealEffects.pdf.
 Bebchuk et al., surpa note 5.
 Lucian Bebchuk, The Myth of Hedge Funds as ‘Myopic Activists’, The Wall Street Journal August 6, 2013.
 See Marianne Bertrand & Sendhil Mullainathan, Are CEOs Rewarded for Luck? The Ones Without Principals Are, 116 Q. J. Econ. 901 (2001).
 Lucian Bebchuk, Yaniv Grinstein & Urs Peyer, Lucky CEOs and Lucky Directors, 65 J. Fin. 2363 (2010).
 See Anup Agrawal & Tareque Nasser, Blockholders on Boards and CEO Compensation, Turnover and Firm Valuation, January 2011, available at http://bama.ua.edu/~aagrawal/IDB-CEO.pdf.
 See James A. Brickley et al., Ownership Structure and Voting on Antitakeover Amendments, 20 J. Fin. Econ. 267 (1988).
 Martin Lipton, Dealing with Activist Hedge Funds, August 2009, available at http://www.wlrk.com/webdocs/wlrknew/AttorneyPubs/WLRK.21952.12.pdf.
 Fred Green, Former CP CEO, CP Analyst Day, March 27th, 2012.
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