The question that CFOs should consider asking themselves: “How would I describe the company’s performance to shareholders if I were an activist, and what actions would I propose to potentially increase shareholder value?”
For CFOs of publicly traded companies, it’s never been more important to pay attention to shareholder activists. When the COVID-19 pandemic took hold during the heart of the 2020 proxy season, many activists abandoned campaigns or quickly settled. Activists and issuers shifted their focus to company survival in the long-term rather than near-term increases in shareholder value. As U.S. equity markets have more than recovered their early pandemic losses, shareholder activists have resumed efforts to identify underperformers and catalyze actions to increase share prices.
Almost three-quarters (74%) of activists surveyed as part of the EY Global Corporate Divestment Study said that the pandemic has affected how they look at targets. The biggest areas of focus — the flexibility of a company’s cost base (80%) and the ability to adapt to different routes to market (70%) — reflect the challenges companies face adjusting to changes in markets and customer behavior during and after the pandemic.
Five Ways to Think Like an Activist
CFOs should question all areas under their purview as potential fodder for an activist campaign and address issues that shareholder activists would likely focus on.
- Capital structure. Do we have the right capital structure to support the company’s strategy? Underleverage is a common criticism of shareholder activists. Outside of a few sectors, primarily financial services, activists argue that maintaining an investment-grade credit rating is unnecessary and increases the company’s cost of capital. Activists, and many traditional institutional investors alike, view leverage as providing management with discipline and excess equity capital as resulting in less management accountability.
- Capital allocation. Suboptimal allocation of growth capital was named by 63% of activists in the survey as one of the most important factors in identifying new investment opportunities. CFOs can ask the following: How does the company deploy capital? Is there a defined methodology to evaluate opportunities? Does the company stick to that framework? What would induce the company to repurchase shares rather than deploy available capital elsewhere? Is the framework communicated clearly to shareholders?
- Measurement. How is the company measuring its return on capital, as a whole and for individual investments? What metrics are used (return on investment capital (ROIC), total shareholder return (TSR), etc.)? Who receives this information internally? What actions are taken based on that information?
- Environmental, social, and governance (ESG). Institutional and index investors expect increasing levels of disclosure around ESG and are starting to base their voting decisions on these issues. How does the company track and quantify ESG-related metrics and initiatives? Does the company incorporate ESG into its capital allocation framework?
- Shareholder engagement and disclosure. Shareholders are demanding more granular information. How does the company engage with its shareholders and how often? Is there a dedicated outreach program aimed at proxy voting teams at the large passive and actively managed funds? Does the company actively solicit shareholder perspectives? How does the company act on shareholder concerns, and how is that action communicated back to shareholders?
Tackling Activism Risk
After this review, CFOs can take several steps to prepare for potential activist interest.
First, do not underestimate your company’s vulnerability to shareholder activism. Every publicly traded (or soon to be publicly traded) company is at risk.
In recent years, activists have targeted companies that have delivered outsized positive total shareholder returns in the year before the activist campaign. Honeymoon periods for newly installed management teams have evaporated as activists try to push their strategy ideas before a new CEO can implement his or her strategy. A company being the target of a recent or even current activist campaign has not dissuaded other activists with a different perspective. Activism is not chickenpox; it can target you more than once.
Second, be expansive in your evaluation of potential activist vulnerabilities. Do not focus on just the obvious issues. Put yourself in the shoes of an average shareholder possessing much less information. What messages might resonate? It is often helpful for an independent third party to help with this exercise since it is easy to lose sight of the forest when you spend every day among the trees. Recognize that shareholder support for an activist does not rest entirely on the feasibility of the activist’s ideas. Often, in the case of a contested director election, shareholders use their votes to protest the status quo and signal their desire for change in general.
Third, be proactive. Do not wait for an activist to take an interest in the company before you take action to address potential vulnerabilities. Waiting makes the company look reactive and defensive. CFOs can examine the company’s corporate governance structure and compare it to the evolving expectation of the company’s shareholders. Consider changing any “shareholder-unfriendly” provisions. Rationalize orphan assets and business units.
Fourth, update the shareholder engagement and communications strategy. Provide better information, more frequently, and in a way that shareholders can understand. Engage regularly with investment decision-makers, as well as the proxy voting and governance teams at the top 20 shareholders. Include senior management and select directors in these discussions.
Be Ready When an Activist Approaches
Despite this preparation, an activist may still approach the company. Have a plan in place. Know which company leaders will engage with a shareholder activist and which will remain focused solely on the business.
Know who your outside advisers will be and have a plan in place to activate them in short notice.
Proactively identifying and addressing potential areas of activist attention is an important strategy to reduce the chances of becoming the target of a campaign. And if it does happen, the leading strategy for dealing with an activist approach is to engage with the activist while keeping the management team’s focus on executing its strategy to deliver long-term sustainable value.
David Hunker is principal, Ernst & Young; EY Americas shareholder activism defense leader.
The views reflected in this article are those of the author and do not necessarily reflect the views of Ernst & Young LLP or other member firms of the global EY organization.