Are activist investors having a profound effect on American board rooms? McKinsey Director Larry Kanarek says, “I think the answer is absolutely yes.” How should executives respond?
ACTIVIST investors are having a profound impact on American board rooms. Faced with this new situation, Larry Kanarek argues that executives should work with activists, rather than against them, in order to improve performance.
Kanarek may be right, but before we consider how executives should respond to activists, let’s first be clear on what we mean by “an activist”.
Basically, activists are individuals or groups that provide an alternative investment vehicle, like private equity or hedge funds, that seeks to achieve above average returns for investors by doing three things:
- Firstly, they identify companies that are under performing; this may be due to any number of reasons including mismanagement, a high cost structure, or poor corporate strategy;
- Once they have a company in their crosshairs, they buy a large number of shares in the target and seek to take control or gain influence by forming a voting bloc or obtaining a seat on the company’s board; and
- Finally, the activist attempts to use their influence to effect an organisational change (usually a major one) with the aim of increasing performance, raising the share price and selling its shares for a profit.
So, in essence, activists make a living by improving organisational performance. This sounds pretty reasonable, right?
Well, not so fast.
While it may be true that executives of public companies can be complacent in pursuing growth, and that this can attract activist investors in search of profit, we disagree with Kanarek’s broad and sweeping argument that executives should necessarily and happily work with activists in order to improve performance.
We suggest instead that executives take a more considered approach. Boards should deal with activists on case by case basis, and keep in mind that the long term best interests of the company and the interests of the activist will often not be aligned.
This view is based on two observations:
1. Short term profit versus long term growth: As Kanarek tells us himself, activists are seeking to achieve above average returns for investors. Given the time value of money (that is, a dollar today is worth more than a dollar tomorrow), activists by their nature are interested in short term profits. The problem for executives is that there are lots of ways to increase short term performance that can undermine the long term stability and growth of a company. For example, increasing the use of debt, divesting low growth (yet countercyclical) businesses, firing loyal long term (and hence expensive) employees, or paying dividends instead of holding cash.
Richard Branson, who recently spoke at the Skoll World Forum, outlined the predicament that executives of public companies find themselves in when he stated:
“The approach to running … private companies is fundamentally different to that of running public companies. Short-term taxable profits with good dividends are a prerequisite of public life. Avoiding short-term taxable profits and seeking long-term capital growth is the best approach to growing private companies.”
2. Stakeholder versus shareholder: Kanarek tells us that activists are all about driving shareholder value:
“[In a] few situations, they have gotten management in boardrooms, at least across America, on edge, talking about them, worrying about them. And by the way, I’m not so sure that’s a bad thing, because it means they’re asking themselves hard questions about whether they’re doing the kinds of things that drive shareholder value, which is what activists are all about anyhow.”
Or, to state Kanarek’s position another way, “Activists are all about driving shareholder value. That is, they are in it for themselves. They are not interested in driving value for customers, employees or the community.”
Executives should be cautious about favouring one set of stakeholders over another, and should certainly be skeptical about the argument that companies exist solely to drive shareholder value. For activists, this is a convenient story. However, in the long term it doesn’t ring true.
If executives are serious about the long term interests of shareholders then they need to focus on serving their customers. A company that loses the desire to serve its customers will soon be denied the privilege of doing so. Such a company is like a ship without a sail, it loses the ability to propel itself and will soon need to be fixed (restructured), salvaged (acquired) or scuttled (liquidated).
Activists are not necessarily illegitimate, nor should their activity be banned. But, we believe that Kanarek’s argument provides only one side of the story, the activist’s side.
Executives need to take a balanced and long term view, especially when dealing with people who, by their very nature, have short term interests at heart.