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Why Companies Have to Listen to Carl Icahn

WALL STREET, Michael Douglas (standing), Saul Rubinek (head, right) 1987.
No raiders here. Today, Gordon Gekko would call himself an "activist." 20th Century Fox—Courtesy Everett Collection

Apple's noisiest shareholder is often called an "activist investor." What does that actually mean?

Updated: October 9

Investors have been pushing for—and often winning—big changes at companies. Billionaire investor Carl Icahn has fired off a letter to Apple APPLE INC. AAPL 1.1905% , of which he owns 53 million shares, urging the company to move forward on a plan to buy back its own shares. Last week, Ebay EBAY INC. EBAY 0.3125% split off its PayPal division, a plan Icahn pushed. Meanwhile, the hedge fund Starboard Value has been calling for another big tech deal: a merger of Yahoo YAHOO! INC. YHOO 0.406% and AOL AOL INC AOL -1.0904% .

Icahn and Starboard are usually described as activist investors, a fresh bit of Wall Street jargon that may leave you scratching your head. Here’s what you need to know about this not-really-new breed of financial power players. They may be shaking up a company you invest in—or work for—next.

What is an “activist investor”?

Ownership of a company’s shares usually comes with voting rights of one vote per share. Whereas most investors simply hold a stock and seek no direct role in management decisions, activists use their voting rights—and those of other investors they can rally to their side—to push for changes in how companies are run.

Activist shareholders can include big pension funds and mutual funds. But the most prominent activists these days are hedge funds, including Bill Ackman’s Pershing Square, Starboard Value, and funds run by Icahn.

The label “activist” itself is a bit of a public relations coup. Back in the 1980s, investors like Icahn used to be better known as “corporate raiders.” Gordon Gekko, the charismatic villain in Oliver Stone’s film Wall Street, is someone who today might be described as an activist. (He was also an illegal insider trader, but that’s different from being an activist or raider.) In his iconic “greed is good” speech, Gekko is at a shareholder meeting berating “Teldar Paper” managers for their fat salaries and poor performance. He wants control of the company. If there’s a distinction between then and now—that is, between corporate raiders and activist investors—it’s that activists today seem less inclined to mount a full-fledged hostile takeover and instead use their stakes and public pronouncements to exert pressure on the existing management and boards.

“Activism” calls to mind the image of idealistic political activists, but only a tiny slice of activist investors have political or social goals, like trying to get companies to reduce their carbon footprint. Most activists just want a higher share price, and tend to cash out once the price pops up.

What do activists want companies to do?

Sometimes activist investors are interested in changing day-to-day operations. In one notorious example, Ackman pushed JC Penney J.C. PENNEY JCP -1.3995% to appoint Ron Johnson of Apple as its CEO. Johnson tried to transform Penney’s into something more Apple-like, remodeling the stores and promising always-fair prices instead of constant discount sales. Bargain-hunting customers hated it. Revenues tanked, and Ackman later admitted he made a mistake.

More recently, Starboard Value drew a lot of (amused) attention with a 294-slide presentation on Darden DARDEN RESTAURANTS INC. DRI 1.5821% , owner of the Olive Garden restaurant chain, criticizing, among other things, the generous breadstick servings and a decision not to salt the pasta-cooking water.

But activists are often focused on one-time financial restructuring moves. As David Dayen at Salon pointed out, most people missed another thing Starboard wants Darden to do: sell or spin off the real estate its restaurants sit on. That generates cash for shareholders now, or creates a new real-estate stock that might be worth more outside of Darden. It may not be so great for Darden, though, if the restaurant side of the business later hits a slump.

Some other things activist investors like companies to do: get acquired by another firm for a higher price. Buy up other companies the activist happens to also own. Take on debt, which can amp up near-term profits. Or pull cash out of the company and give it to shareholders via dividends or stock buybacks. Apple’s already been doing that, thanks in part to pressure from Icahn and the fund Greenlight Capital. Icahn’s latest letter may speed that up.

Why are activist investors getting so much attention these days?

This may be an echo effect of the 2008 crisis. Activists looking for opportunities will often look for stocks that are cheap, so they can scoop up lots of shares and (they hope) engineer a large price gain. The crash created lots of opportunities. And as companies recovered, Time‘s Rana Foroohar says, many were still nervous about the economy, so they built up big reserves of cash. That cash is a fat target for activists.

The recent rise of hedge funds has something to do with it, too. Mutual funds and pensions have to be highly diversified, so they have limited ability to build up big share blocks, and less incentive to get involved in specific fights. But in a recent paper UCLA law professors Iman Anabtawi and Lynn Stout observe that lightly regulated hedge funds, which are only available to institutions and wealthy investors, can focus their assets on just a handful of stocks.

So what’s the verdict: Are activists good guys or bad guys?

Economics blogger James Kwak puts it this way: “In finance, there are rarely battles between good and evil. Instead, you have battles of, say, greedy and corrupt versus greedy and ruthless.” CEOs in these battles want to keep their jobs and control, and shareholders want a better return for themselves.

Critics of activists say they are too focused on short-term goals. The cash a company pays out as special dividend today can’t be plowed into R&D; the debt that finances a restructuring could later drive the firm into bankruptcy. Some companies, like Google GOOGLE INC. GOOG -0.1312% , have set up multiple share classes, some without voting rights, to insulate management from investor demands. The wild success of Google both as a stock and as a business shows that a company can do just fine without nagging from hedgies.

One influential study looks at what happened to 2,000 companies targeted by activists over a number of years. It concluded that activism worked out fine for investors, even over a period as long as five years. And “operating performance relative to peers improves consistently,” writes co-author Lucian Bebchuk, an economist at Harvard. This was true even for companies that took on debt or cut capital spending. But another recent study is less upbeat, finding little impact on growth and profit margins.

Even if share prices do rise, this doesn’t mean activists are good for the flesh-and-blood people who work for the corporation, or for that company’s customers, or for society or the economy as a whole, UCLA’s Stout has argued. By forcing top managers to be relentlessly focused on share price, activists make it even less likely that companies will take into account, say, their impact on the environment, or the interests of their workers. Think companies based in America shouldn’t move headquarters abroad just to save money on U.S. taxes? Talk to the hand, say the activists.

In the 1980s, the early heyday of corporate raiding, after Icahn’s takeover of TWA led to significant pay cuts and layoffs, economists Adrei Shleifer and (future Treasury secretary) Lawrence Summers described the gains from Icahn’s activism this way: “essentially a transfer of wealth from existing flight attendants… to Icahn.”

One thing a real-life Gordon Gekko probably wouldn’t have done: cut the salary of the next CEO of Teldar Paper. Although activists are supposed to be tough disciplinarians for managers, their focus on “shareholder value” helped push more companies to pay the C-suite largely in stock incentives instead of fixed salaries. CEO pay exploded.

TIME activist investors

Shareholder ‘Activists’—Are They Good or Bad?

“Activist” investors are all over the news once again. From Carl Icahn nabbing seats on the board of Herbalife, to Daniel Loeb suing Sotheby’s auction house over its use of a “poison pill” to defend against Loeb, who wants to buy up more stock and put his own people on the board, investor activism is at record highs. According to FactSet Research, activist investors have targeted more than 20% of industrial companies in the S&P 500 over the last five years. There are plenty of reasons for this, as I explained in my cover story about the granddaddy of all activists, Carl Icahn, last year. But the main reason is the most obvious one: Companies are holding more cash than ever on their balance sheets, and activists want them to give it back to shareholders.

The question is and has always been whether this is a good thing. People like Icahn would argue yes — according to him, most corporate boards are made up of lackeys to the CEO, people who typically don’t make great investment decisions and shouldn’t be entrusted with spare cash. Others simply argue that if a company has run out of productive places to put investment capital, then, hey, why not give it back to shareholders?

But I think that there are a fair number of companies out there for which neither point holds true. There’s no question that the share buybacks and dividend payments pushed for by activists boost stock prices in the short term. But as many economists have been arguing for the last several years, there’s never been a better time for companies to do big capital investment projects — from building new factories to buying new technology, expanding overseas, or developing new business offshoots — than there has been since the Fed lowered interest rates to record levels after the financial crisis. We’re now coming to the end of that cheap money era. As Fed chair Janet Yellen indicated in her press conference last week, rates may go up as early as mid 2015. The cost of borrowing will rise, and companies may need their spare cash to pay down debt. No wonder a BofA Merrill Lynch survey of fund mangers shows record support for capital spending, and decreasing support for giving back cash to shareholders.

If activists want to succeed in this new era, they’ll have to argue for more than just big money payouts, and come up with real strategic plans to help the companies they are targeting. Otherwise, they are likely to face increasing push back from investors and experts. For more on that, check out this article arguing against shareholder activism, by well known judge Leo Strine, in this month’s Columbia Law review.

 

 

 

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