How Activist Investors Change the Game

More than ever before, company shareholders are making their voices heard. And what they lack in size, they make up for in profile.

Activist investors — or those who take a stake in firms to push management to boost returns through increased share buybacks, higher dividends or even a breakup of the company — have become a growing force in the U.S.

Formerly labeled corporate raiders, activists have undergone an image makeover during the past year, after instigating sweeping overhauls at companies such as The Jones Group Inc., R.G. Barry Corp. and Crocs Inc.

“In general, activist hedge funds are estimated to have more than $100 billion of total collective assets under management, with approximately $10 billion to $12 billion invested in activist hedge funds in 2013,” said Lois Herzeca, a partner at Gibson, Dunn & Crutcher LLP and co-chair of the firm’s fashion, retail and consumer products group.

In the fashion sector, the goal of recent campaigns can be divided into three broad categories.

The first is to implement management changes, such as Blackstone Group LP’s $200 million cash injection in Crocs in exchange for two board seats, or Engaged Capital LLC’s push to replace incumbent Abercrombie & Fitch Co. CEO Mike Jeffries. On a much smaller scale, a minority shareholder in Skechers USA Inc. recently urged the firm to overhaul its board.

The second involves spurring a going-private transaction, as Barington Capital Group LP did with Jones Group. That move resulted in the conglomerate splitting into four independent companies under Sycamore Partners LLC last month. More recently, Mill Road Capital, which previously held a 9.8 percent stake in R.G. Barry, acquired the rest of the company in a deal that values R.G. Barry at roughly $215 million and takes it private.

The third type is to steer management toward a merger or consolidation with another company in the same industry, such as Hirzel Capital Management LLC’s disclosure of its intent to actively influence the management of Aeropostale Inc., in which it owns a 6 percent stake, to put itself on the auction block.

According to FactSet, activists took action against 206 companies in 2013. Additionally, many more shareholder initiatives resulted in settlements and corporate transactions before a public campaign was even launched.

Why is the retail sector so ripe for this kind of activity? Investors often view footwear and apparel firms as relatively inexpensive targets with the potential for significant upside.

Additionally, the sectors are easy to monitor via obtainable metrics, such as same-store sales and other data that track performance and allow investors to pinpoint underperforming companies.

“The retail industry is much more visible than other sectors because it’s an easier industry to understand,” said Suraj Srinivasan, associate professor of business administration at Harvard Business School. “One reason activists take stakes in companies is due to generic underperformance because of the lack of good strategy or poor execution. The second is where there are assets that don’t belong in the firm.”

However, shareholders do not always create positive change. William Ackman of Pershing Square did embattled J.C. Penney Co. no favors when he pressured the company to adopt his ill-fated plan to revive the retail chain. Ackman’s actions fit into the activism categories that tend to be criticized the most — actions designed to increase a firm’s leverage, such as taking on more debt or using cash to buyback shares, or those that are particularly hostile to current management.

More broadly, instead of focusing on the firm’s financials, Ackman attempted to give J.C. Penney an extreme makeover. After stepping down from the board last year, reports emerged that he lost more than $700 million on the bet. “Shareholder activism has a spotty track record,” said Morningstar analyst Paul Swinand. “In the case of J.C. Penney, Ackman ran the thing into the ground. While he monetized some of the assets, he put those unlocked proceeds toward covering losses.”

Another criticism is that when aggressive shareholders take stakes in undervalued businesses — and use their power to unseat boards, sell assets or even file for bankruptcy — company share prices get an artificial boost.

Some argue this serves activists’ short-term motives and can be detrimental to the more passive, long-term investors. “Some activists have been less than successful because a business turnaround in retail can take many years to accomplish, which doesn’t match their time frame. If you want to make a turnaround in the branded apparel sector, it’s easier to be a private company outside the glare of Wall Street analysts,” said Herzeca, listing Kenneth Cole as a formerly listed company that has benefited from going private.

For public companies, the perception of and nature of their interactions with shareholders have changed over the years.

For decades, as portrayed in the 1980s film “Wall Street,” firms adopted poison-pill defenses, which were triggered when a shareholder’s stake reached 20 percent of outstanding shares. Once that happened, the firm could flood the market with shares, thereby diluting an aggressive shareholder’s stake and reducing their influence. After several very public failures, activists accepted a lower profile.

But in recent years, the level of activism has risen in a less hostile form. Now, shareholder engagement places a greater emphasis on collaboration with company boards and meaningful change.

“[The active investors] are almost considered unpaid consultants who are taking positions and advising on value-creating change,” Srinivasan said.

In addition, he noted, major funds such as Blackrock and Fidelity, which own shares in almost every public company in the U.S., can benefit. “The more passive investors now are much more interested and willing to support or engage with the activist shareholders,” Srinivasan said.

While activists can be an irritant to management, many have succeeded in bolstering share prices and making companies leaner and more efficient, argued Herzeca. “With the situation at Jones, it was a public company with a long, storied history, but it owned many brands and some industry observers said it lost its focus and was a ripe target,” she said.

Gregory Taxin, a managing director of the Clinton Group — which in 2012 attempted to remove and replace the board at apparel retailer Wet Seal Inc. — said the soft retail environment in the U.S. has exposed many weaknesses. “There are a number of retailers that are not performing terribly well, and it’s not surprising that activists have shown up at their door,” he said.

But by engaging with key stakeholders, firms are taking a more proactive approach to preparing for activist activity. Such measures include reviews of the company’s perception among analysts and the media, and dialogues with the largest shareholders.

The composition of corporate boards is evolving as well. Brent Magnuson, who leads executive search firm Egon Zehnder’s global retail, apparel and luxury goods practice, said, “The changing nature of the role of being a board member requires an increasing amount of industry expertise and experience. The role is completely different now than it was 10 years ago in terms of expectations.”

Just last week, for example, Target Corp.’s board removed Chairman and CEO Gregg Steinhafel in the wake of a data breach that hurt the U.S. retailer’s profits and rattled confidence. “Even if a campaign doesn’t hit, the threat of shareholder activism is something that keeps management in line,” said Swinand. “If your shares are undervalued, there is a reason for that.”