Institutional investors are a vital and growing force in capital markets globally. Early evidence indicates that behind-the-scenes engagement by significant pension funds, such as CalPERS, and mutual funds, effectively improves governance structures but has a negligible effect on market values or earnings.
Activist investors have different goals, time horizons, and risk profiles than long-term shareholders and can unduly compress corporate time horizons to the detriment of long-term value creation.
Activist Investors and Corporate Governance
Activist investors use their voting rights to monitor management. Using this agency problem as an opportunity, they seek to improve governance by pressuring companies on issues such as board composition, executive compensation, and capital allocation. They must consider the costs of this activism and the benefits to their clients.
New SEC rules enable institutional investors to take on proxy issues without tremendous expense. However, they must also address the free rider issue. If an institution spends substantial sums on pressuring a company to change policies, the gains of this effort are reaped by all stockholders, not just the institutional investor’s clients.
While various forms of shareholder activism exist, the highest potential gains for an institution’s clients come from voting issues where the share price is at risk.
Early studies suggest that behind the scene engagement and voting are the most common tools of institutional activists. In particular, studies find that institutional investors with a long-term focus prefer to use these activist tools rather than filing 13Ds or waging proxy contests. However, these approaches have a limited impact on target firms’ governance structures.
The Role of Activist Investors in Corporate Governance
Institutional investors use a variety of tools to achieve their goals. They may engage in behind-the-scenes discussions, voting, shareholder resolutions and recommendations, and priority lists. They also sell their shares when dissatisfied with management or a company’s performance and governance practices. Nevertheless, their primary goal is to generate profits for their client’s funds. Other benefits, such as improving corporate governance, are secondary.
Investors generally perform cost-benefit analyses when deciding to become active shareholders. They are required by their fiduciary duties to try to increase financial returns for their clients without taking significant risks or sacrificing liquidity. Some studies have found that shareholder activism and corporate governance improve the financial performance of companies, while others find no evidence of a positive impact.
The most common form of activist activity involves seeking procedural reforms. For example, California Public Employees Retirement System has pressed Advanced Micro Devices to have its compensation committee composed entirely of independent directors. While this change is difficult to link directly to financial returns, it could benefit institutional investors by increasing the likelihood that AMD’s compensation committee will align executive compensation with shareholder returns through stock options and other devices. In addition, investors have pushed for separating the presiding officer from the CEO, which may lead to greater accountability. These changes are relatively cheap for activists, who only need to own 2000$ worth of company shares or 1% of the firm’s total capital to submit a proposal. They may even use the less expensive route of public protest to criticize their portfolio companies.
Activist Investors and Corporate Performance
Activist investors typically engage with firms to seek changes in corporate financial policies. For example, they might encourage a firm to boost dividend dispersal or promote a better capital structure. They may also appeal to the corporation to address social issues such as environmental reporting or discrimination.
Moreover, they can use cheap methods like proxy voting to exert their influence. For example, in the US, shareholders holding $2000 worth of stock or 1% of company shares can submit a resolution at shareholder meetings (SEC rules 14a-8).
However, some activist funds specialize in acquiring large ownership stakes in companies and engaging with them to push for changes. This strategy can reduce coordination costs and decrease the risk of being diluted by other investors.
Whether an activist investor targets a firm depends on the opportunities activists see for successful engagements. For instance, some research suggests that activists target small, high book-to-market firms with high-profit margins; while others suggest that they target firms with high takeover defenses or CEO pay. Similarly, the relationship between activism and firm performance is mediated by board demographic diversity and governance rating systems. As such, directors must understand which activist investors might engage with their firm and the issues they might raise.
Activist Investors and Corporate Value
Since the early 1990s, activist hedge funds have been crucial in interactions between corporate boards and markets. Their focus on changing governance procedures echoes efforts by public-employee pension funds and union-based investors. They seek to get companies to take on more debt, pay dividends, or buy back shares to enhance financial returns for their clients.
Whether these activities improve the long-term financial performance of targeted firms is a subject that warrants extensive study. Previous research has found that proxy activism positively affects stock returns. However, the benefits are only sometimes realized by the target firm.
Research also demonstrates that the costs of investor activism outweigh any potential benefit. These activities are usually covered by the money manager’s advisory fee, which is charged to its clients.
The question of how to balance the cost and benefits of investor activism is an important one. In light of this, most money managers are likely to engage in shareholder activism only when the expected benefits for their clients exceed the expenses associated with such activity.