By Tony Cole, Business Leader for Mercer’s investment consulting business in the Asia Pacific

This article was first published in the June edition of Company Secretary.

When I joined the investment consulting industry a little over a decade ago, socially responsible investing (SRI) was a minority activity. It was frequently described as ethical investing and was largely confined to religious groups and foundations established to pursue good causes. SRI was typically implemented by means of negative screens which excluded investments in firms engaged in, for example, gambling, alcohol, tobacco or perhaps armaments or uranium mining. The mainstream investment industry was dismissive, arguing that by constraining investment opportunities, such investors must face lower risk-weighted returns. Various studies were undertaken which proved this form of SRI involved a cost in terms of higher risk and lower returns over time.¹

To a degree these criticisms missed the point. The organisations using negative screens were behaving consistently with their underlying purposes. For example, a cancer research foundation may not wish to invest in tobacco companies on the basis that to do so would be inconsistent with its purpose. Similarly, a charity assisting homeless people may screen out investments in gambling, alcohol and tobacco. For these investors the resulting small loss in risk-weighted returns could be regarded as a small cost to pay to remain true to their principles and, importantly, to retain the support of their membership and donor support base.

The rationale for activism

A common response of investors with a company in their portfolio which repeatedly disappoints is to quit the stock and swallow the loss. Some people describe this as voting with your feet. Warren Buffet has described it as “gin-rummy” behaviour (discard your least promising business at each turn)‘.² For an investment manager holding five per cent or more of the stock of a company, voting with its feet in this way can be a big swallow.

The company is a dud. The manager wants out but nobody else wants to buy in. It takes time to quit the stock and each sale takes place at a lower price. This can be very galling, particularly when the manager believes they know what needs to be done to make the stock the winner they believed it would be when the shares were first purchased. The only alternatives seem to be to sit and hope for a takeover, which will at least provide a control premium, or to persuade current management to change strategies so as to unlock value.

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The beginnings

Institutional investor activism on a meaningful scale appears to have originated in the mid- to late 1980s with mega pension funds in the USA, including CalPERS and TIAA-CREF.³  These funds had found it just too hard to invest their very large equities portfolios with active managers who could add value. This has led them instead to save costs by adopting index tracking for their equities investments. As index trackers, even the “gin-rummy” behaviour of selling off the duds was not available. They simply had to sit and wait for someone to acquire the underperformers in their portfolios. The funds observed that an increasing number of companies which saw themselves as possible acquisition targets began to introduce “poison pill” takeover defences.

There was also a rash of state government interventions in markets to prevent local corporate icons from falling to raiders from other states, and action by one or two states (particularly Delaware) to provide management friendly jurisdictions to attract company headquarters. ⁴

With this weakening of the takeover discipline, some form of activism seemed the only option left. In the early days activism was limited to private meetings and letters urging the removal of poison-pill provisions, removal of staggered board terms and abolition of classes of shares, so that all ordinary shares had the same voting rights. Suggestions were made that, in the event of inaction, motions would be moved at AGMs. The funds were trying to re-establish takeover discipline on poorly performing companies.

In 1992 CalPERS began publishing its annual focus list of funds that it would target on governance issues.⁵

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Impact of activism

The impact of activism is fundamental to the fiduciary responsibilities of most institutional investors. If the evidence and history of activism does not allow trustees to believe that activism adds value or reduces risk then they cannot be activists.

Advice to the United Nations from the legal firm Freshfields Bruckhaus concludes that ‘the links between ESG [environmental, social and governance] factors and financial performance are increasingly being recognised. On that basis, integrating ESG considerations into an investment analysis is clearly permissible and is arguably required in all jurisdictions’.⁶ Whether it is permissible or required still rests on the issue of whether it can be expected to add value/reduce risk.

For that reason the impact of activism has been thoroughly addressed in the literature and will be a focus of the remainder of this article. There are two quotes which are frequently referenced on this topic. The first is from an article by Bernard Black in 1998 and reads, ‘A small number of American institutional investors, mostly public pension plans, spend a trivial amount of money on overt activism efforts. They don’t conduct proxy fights, and rarely try to elect their own candidates to the board of directors … the institutions achieve the effects on firm performance that one might expect from this level of effort – namely not much’. ⁷

The second is from Jonathan Karpoff’s 2001 survey of 20 empirical studies of the impact of activism on target companies: ‘Most evidence indicates that shareholder activism can prompt small changes in target firms’ governance structures, but has negligible impact on share values and earnings’. ⁸

Black’s article considers shareholder activism to be a substitute for the threat of hostile takeover activity and as a prod for change in poorly performing companies, and finds that it is not effective on this front. He notes, however, that activism has probably been useful in stopping some pro-manager governance changes being made. For example, while activism aimed at the repeal of staggered board provisions was seldom successful, the increasing frequency of such actions was followed by a dramatic decline in new staggered board proposals. ⁹

While the quote from Karpoff is representative of his overall findings, a later paragraph expresses a qualification which is worth noting. From 1986 through 1990 shareholder proposals were associated with negligible or slightly negative share value changes. Some proposals in the early 1990’s, in contrast, are associated with share value increases. One conjecture is that shareholder activists have learned over time to target their efforts better to increase share values. If so, then current activist efforts could have relatively large impacts on target firm values and operations. (emphasis added)¹⁰

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The CalPERS effect

CalPERS is the largest pension fund in the USA and is widely regarded as the leader in activism. The impact it has had has been closely observed and hotly debated. A measure of the short-term effect of CalPERS focus list is to compare the share price movement of the focus list companies with the overall market movement on the day of announcement. Brad Barber of UC Davis updated this exercise to include 2005 data in an article published in March 2006. ¹¹

The analysis begins in 1992, the year CalPERS began publishing its annual focus list, as it is not possible to measure announcement effects prior to that date.

He found that each year targeted firms experience a reliably positive market-adjusted reaction which has averaged 35 basis points. The cumulative effect of this relative outperformance over the 14 years was to lift the market cap of the firms by a total of $3.1 billion, or an average enhancement of $224 million for each annual focus list. This is a worthwhile aggregate benefit but it flows to all the shareholders in the companies. The benefit to CalPERS has been only around $1.12 million a year but, of course, the full costs of achieving it have been met by CalPERS . Nevertheless, the costs are relatively low (the salaries and other costs for three full-time staff members) so it is reasonable to conclude from this analysis alone that the fund does benefit from the activity.

Measurement of long-run effects is much more contentious. The methodology used by CalPERS supporters measures the relative share performance of target firms over the five years before they appear on the focus list and the five years after. Wilshire updates this data annually. ¹²   As it is attempting to measure the impact of the activism it covers the whole period of engagement from 1987. Companies on the focus lists up to 2004 are included in the analysis (later lists are too recent for meaningful analysis to be conducted). Wilshire finds that in the five years before being targeted, the relative share performance of the companies was a decline of 13.9 per cent a year or a cumulative relative decline of 92 per cent. For the five years after they appear on the focus list, the targeted companies produced above benchmark returns of 16.4 per cent. In US dollar terms Wilshire ascribes a benefit of $89.5 billion to activism and puts the share of that benefit flowing to CalPERS at $420 million, or $32.3 million a year. Wilshire notes that these aggregate results reflect very different outcomes at the individual company level. For 60 per cent of companies covered by the study relative performance in the five years after the event was still negative. The aggregate result reflects some sharp turnarounds and a significant slowing in the rate of decline for the majority of companies.

The major criticisms of this analysis are that it compares the performance of targeted companies with the broad index and that it ascribes the improvement in relative performance to the impact of activism. Critics suggest that at the very least a value index should be used for the comparisons as all the companies are underperforming and would have value characteristics.¹³ Over time, value indexes tend to outperform total market indexes. They also argue that corporate performance tends to mean revert – poorly performing companies not targeted by CalPERS often manage to achieve stronger performance — but the methodology ascribes all the gains to activism. Brad Barber points to all the weaknesses of studies that have tried to establish the long-run effects of CalPERS’ activity. He attempts his own longer-term analysis and concludes that ‘While the alphas that we estimate are uniformly positive and economically large, we cannot conclude that they are unusual based on the available evidence’. He concludes that his short-term analysis does demonstrate useful benefits and that ‘This is surely an underestimate of the total value of CalPERS activism’.¹⁴

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Shareholder engagement funds

These early efforts at activism focused heavily on broad governance issues and were aimed at making the market for corporate control work. CalPERS and the other funds involved did not consider they had the expertise to intervene in strategic decision making or replacements of CEOs . By the late 1990s some funds were beginning to question whether what they were doing was enough. They were watching companies with substantial franchises sustaining very disappointing relative performance and loss of economic value over several years before facing any discipline from the market through a takeover. On the other hand, the cost and complexity of acquiring and applying expertise at this level was seen as not justified for an index tracking fund.¹⁵ This dilemma was resolved through the establishment of specialist engagement funds.

These investment management funds typically invest in a small number of poorly performing companies where they believe governance or strategic changes can reverse declining relative performance and value loss. CalPERS was a cornerstone investor in one of the earliest of these funds, Relational Investors, in 1996 and remains an investor in the fund. Through their investment with the investment managers, the funds increase their exposure to the companies engaged with beyond index weight, thus increasing their share of any positive impact of activism. This structure also enables the investment managers to pay what they need to attract and retain the necessary expertise and separates the funds from the activist actions which are undertaken on behalf of all investors.

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Hermes UK Focus Fund

The engagement fund which has been most analysed is probably the Hermes UK Focus Fund (HUKFF). The HUKFF was established as a joint venture between Hermes (the British Telecom Pension Fund, which invested 15 per cent of its equity allocation in the fund) and veteran US activist, Bob Monks’ LENS fund. Other investors included some UK local authority pension funds, a Canadian fund and a Japanese Life Insurance company. In 2006 HUKFF made its records available to a group of researchers from the European Corporate Governance Institute.¹⁶

HUKFF takes meaningful positions (1–13.5%, mean of 4.8%) in a small number (4–8 new investments a year) of underperforming companies which it believes it can successfully engage with and expects to be able to achieve at least 20 per cent more value than the current share price. At the time of the study HUKFF had engaged with 30 companies. The median term of investment was 517 trading days.

Engagement was characterised by numerous meetings with CEOs, chairmen and CFOs, including site visits to headquarters and operations sites of target companies. In 60 per cent of cases there was also contact with non-executive directors. In more than 80 per cent of cases HUKFF contacted other institutional shareholders to communicate its objectives and solicit support. Engagement was private rather than public.

In most cases the objectives of HUKFF’s engagement included the sale of non-core divisions of diversified firms, the sale of non-core assets or stopping diversifying acquisitions. In more than half, the objectives included replacement of the CEO and/or the chairman. A frequent objective was to change financial policies to increase payouts to shareholders.

HUKFF’s success rate in achieving its objectives ranges from 60 per cent to 90 per cent. The size of assets and number of employees are substantially lower after intervention (assets decline a little more than employment, suggesting jobs may go with the assets to new owners) and an improved return on assets. The disciplines and outcomes achieved through engagement are similar to those expected to result from takeover activity (whether by hedge funds or otherwise) with the difference being that the benefits achieved stay with existing shareholders rather than their receiving a takeover premium. Figure 1 shows the performance of the HUKFF fund relative to benchmark since its establishment.¹⁷

It also shows performance of some related funds. The outperformance recorded by the HUKFF would be welcome to trustees of pension funds at any time, but must have been especially so in the relatively subdued return period covered.

Figure 1: Hermes results

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Other engagement funds

CalPERS became an investor in HUKFF in November 1999. Its website shows that by the end of 2006 this was one of eleven engagement funds it invested in. The funds operate in various major equity markets around the world. A report shows the returns earned by CalPERS on its various investments.¹⁸ Returns are quite variable, with some funds underperforming their benchmarks. Overall, however, the results indicate that funds can reasonably conclude that this form of activism adds value.

Recently CalPERS has commenced a program of co-investment with its established governance investment managers to further leverage the benefits of high-intensity activism.¹⁹  Initial benefits of this program have led the fund to expand the program. In addition to funds in developed capital markets, specialist activist funds are spreading to the developing world.²⁰   Lazard recently established a joint venture governance fund in Korea. Officials in Malaysia have asked the Korean fund to assist in establishing a fund in Malaysia. The International Finance Corporation (part of the World Bank) is supporting the establishment of a Brazilian fund.

Activism in Australia

Perhaps because Australia is a smaller market with a smaller group of really significant companies (so that the gin-rummy option is less attractive) Australian investment managers have been outspoken on governance issues for most of the past two decades. Their activities have contributed to changes in CEOs and in board structures and memberships. In the early days some found this uncomfortable as their parent businesses had broader business relationships with the firms they were seeking to force to change. A continuing trend of the establishment of specialist funds management businesses (without insurance, banking or other business lines which are trying to market services to plans or their corporate sponsors), together with corporate super outsourcing, have reduced the potential for such conflicts and we can expect investment managers to continue their activism. Recent years have seen the emergence of specialist socially responsible investment strategies in the product line-ups of some institutional investment management groups. The investment teams running these strategies engage with companies on ESG issues.

At the super fund level, interest in activism has been relatively recent. Among the more notable events, proxy voting advisory services were introduced around 2000 and have gradually extended their client base. This was followed by the establishment of the Australian Council of Superannuation Investors (2001), which uses the research of the proxy voting advisory services and the decision by the Commonwealth Superannuation Scheme and the Public Sector Superannuation Scheme (also in 2001) to engage BT Financial Group to pursue governance issues on its behalf (a service now subscribed to by several other public and private sector funds). At this point activism by superannuation funds in Australia is similar to what occurred in the USA a decade ago in that it addresses broad governance issues such as takeover protection measures. Another popular issue has been board and management compensation. The superannuation funds have refrained from intervention in business strategy issues and decisions about board memberships or appointments of senior executives. Investment managers have from time to time pressed for changes to company chairmen and/or senior management and for strategy changes. This division of labour is probably appropriate as the investment managers have far more knowledge about companies, their competitors and the markets they operate in than trustees of superannuation funds can be expected to have.

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Conclusion

The evidence that activism can and does add value is convincing. This means activism is here to stay. Fiduciaries will increasingly feel that they are not fulfilling their duties if they do not take activism seriously. For all but the mega funds it is appropriate that activism be delegated to third parties.

Globally, specialist activist funds with very concentrated portfolios and intense engagement have demonstrated that they can add considerable value to previously underperforming companies. The outcomes are similar to what we expect from takeovers but the action probably comes earlier and incumbent investors share in the gains rather than receiving only a takeover premium. 

Notes

1. Mercer Investment Consulting, The impact of excluding tobacco and armaments from a UK equity portfolio, 2005
2. '‘Lots of laughs but no funny business’, Coultan M, Sydney Morning Herald, 2 May 2005
3. Clark GL and Hebb T, ‘Understanding Pension Fund
   Corporate Engagement in a Global Arena’, October 2002, Paper for seminar sponsored by Rockfeller Foundation at School of Geography, University of Oxford
4. Black BS, ‘Shareholder Activism and Corporate Governance in the United States’, in The New Palgrave Dictionary of Economics and the Law, 1998, Peter Newman, ed.
5. Barber BM, ‘Monitoring the Monitor: Evaluating CalPERS’ Shareholder Activism’, March 2006 Available at Social Science Research Network website, www.ssrn.com
6. A legal framework for the integration of environmental, social and governance issues in institutional investment, United Nations Environment Program, available at www.unep.org
7. Black BS, op cit
8. Karpoff JM, ‘The Impact of Shareholder Activism on Target Companies: A Survey of Empirical Findings’, September 2001, Mimeo, University of Washington
9. Black BS, op cit
10. Karpoff JM, op cit
11. Barber BM, op cit
12. Junkin A and Toth T, ‘The ‘CalPERS Effect’ on Targeted Company Share Prices’, July 2006 , Wilshire Associates, available on Wilshire website, www.wilshire.com
13. McQuillan LJ, ‘CalPERS’s Corporate Activism Does Not Help Shareholders or Pensioners’, February 2005 Pacific Research Institute Briefing. Also see Engelen E, ‘The Fairy Tale of Pension Fund Engagement’ in E. Engelen & M Sie Dhain Ho (eds) De staat van de democratie. Also available in English at www.fmg.uva.nl
14. Barber BM, op cit
15. Becht M, Franks JR, Mayer C and Rossi S, Returns to Shareholder Activism, Evidence from a Clinical Study of the Hermes UK Focus Fund, European Corporate Governance Institute, December 2006, Working Paper No 138/2006. Available at Social Science Research Network website, www.ssrn.com
16. ibid; also see Melville C and Hirt H, ‘Corporate Governance and Performance’, October 2005, published by Hermes, available at www.hermes.co.uk
17. Hermes presentation to clients
18. CalPERS Hybrid Investments Monitoring Report, Fourth Quarter 2006, available at www.calpers.ca.gov
19. CalPERS Statement of Investment Policy for Corporate Governance Investments, November 2006, available at www.calpers.ca.gov
20. Corporate Governance in Asia, Seminar by Prof Hasun Jang, Asian Institute of Corporate Governance, March 2007

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