Can activists and indexers get along?
On 9 May 2019, CFA Society Switzerland invited Andreas Weigelt and Samuel Meyer, CFA of Veraison Capital AG to hold a lunchtime presentation at Saxo Bank in Zürich on the topic of activist investing in Switzerland’s small- and mid-cap sectors. Veraison is a CHF 300M long-only activist fund that takes 6 to 12 positions in these sectors.
Activists: friends or foes of the broad market?
Spoiler alert: activist principles and passive or index investing make natural allies, according to the presenters. After all, these two investor groups have a very strong alignment of interests. Interests among all shareholders of a firm are generally more closely aligned than between any given shareholder and firm management, including the board of directors.
In fact, today’s much-trumpeted passive investing strategies only work at all because of faith that markets are efficient; that is, markets make best use of all information. Some market participants, like activist investors, play a key role in bringing new information to the market, for the benefit of all shareholders. Markets require high-information investors in order to remain efficient.
In general, activist investors today are minority investors. This means that in order to effect change in a given firm, they must convince the other shareholders of the validity of their views. Without a convincing idea, the activists will go nowhere. For this reason, it is also important for activist investors to build credibility in a given market over time, demonstrating a clear track record of clear ideas and added value.
Portrayal in the press
Despite the value they can provide to markets, activists have historically and even today been the recipients of bad press. The media often accuse this group of owners of taking a short-term perspective. This idea may stem from the era of corporate raiders in the 1980s, who gutted target companies for short-term profits. Contrast this with the idea of “engaged shareholders”, who must hold minority stakes over a medium or long term in order to profit. The presenters believe that the discussion should be rather focused around ideas: do these outside investors bring new ideas that can benefit a firm, and thereby all its owners?
The trend towards passivity
Globally, markets have become ever more dominated by passive investment strategies over at least the past decade. Between 2007 and 2018, about USD $1.5 trillion has been realigned out of active investment funds and products into passive vehicles. Black Rock, Vanguard, and State Street are the biggest managers of such vehicles and because of the growth in this space today they wield tremendous influence. Today 18% of the American S&P 500 is held by passive funds, with other big markets racing to catch up to this trend.
The passive malady
While passive holdings can be beneficial for each investor, making up the core of a well-designed portfolio, the trend towards more of this type of investing also carries with it some negative consequences for the market as a whole, among them:
- increasing herd behavior and with it market overreactions,
- increased risk of moral hazard,
- decreased efficient allocation of capital, and
- decreased operational efficiency.
For an individual firm, the negative consequences of having an increasingly passive investor base are:
- decreased fundamental analysis on the firm and with it less transparency,
- decreased direct feedback to the board and management,
- increased “checklist-approach” to annual general meetings,
- increased concentration of influence and power, and
- decreased insight into principal-agent risks.
A silver lining
These market inefficiencies do however provide opportunities for engaged shareholders to make good use of valuation gaps, to perform time-horizon arbitrage (taking a long-term view in a short-term market), and to make impact via engagement. Indeed there has been about 9% annual growth in activist engagement globally since 2013, with around 900 such investments in 2018. There is however still lots of opportunity in Europe, where engaged investing has not penetrated markets to the degree it has in North America.
How does Veraison Capital invest?
Veraison scours the market of small- and mid-cap Swiss companies for firms that are a good value, and then rather than the buy-and-wait strategy typically favored by value investors, tries to actively improve the target company to unlock the inherent value of the firm.
The fund typically takes stakes of between 5% and 20% in a target company, making them “big enough to get in the door” for meetings with management and the board of directors. Veraison favors a constructive (as opposed to hostile) investment strategy and prefer to create value through strategic and operational improvements (as opposed to financial engineering).
The fund enters investments that meet three criteria:
- the firm is undervalued by at least 30%,
- there are clear steps to take to realize value, and,
- they feel adequate support (from other shareholders, the board, and management) to act as a catalyst for change.
What to expect in an activist investment
Investing in this way is not for the faint of heart, or of wallet. Each engagement brings with it new challenges. Some management teams react with openness to new ownership and engage in constructive discussions, but other times the process becomes confrontational.
The engaged investor can expect staff to dedicate significant time to each position, including for face-to-face engagement with the company management, other investors, outside advisors, and media.
In the event of a public proxy contest, an engaged investor can expect lots of upfront cash costs for legal advice, proxy solicitors, and communication support. In addition, the activist can expect wide exposure, as ultimately the argument for change in a public firm needs to be made publicly. A website is both a valuable and necessary tool here, as information about the activist investor’s intentions must be openly available so as not to be considered inside information. The investor can also expect to be attacked in the media.
Finally, an engaged investor should not expect a level playing field in a game where the rules are made not by owners, but by management. Access to communicate with the other owners is often difficult, as many vote before the annual general meeting (AGM) via proxy. In Switzerland, the engaged investor must even guess even the names of his fellow shareholders to try to reach out to them in time, as there is no public access to the shareholder registry. Meanwhile, company management maintains long-established communication channels with all the shareholders, plus the media. Company management also maintains sovereignty of information: only it has access to all the operational data from inside the firm. On top of that, management alone sets the date, makes the agenda, and prepares the documents for the AGM. The media and the other owners generally at first give company management a “credibility advantage” as well: the burden of persuasion is placed on the shareholder wishing to effect a change.
With all of this said, it is possible to have a positive impact once other shareholders become convinced that a proposed change is in the best interests of the firm.
The nuts and bolts of the fund
Veraison Capital launched in 2015. It invests without leverage, and looks at companies in the range of CHF 150M — 3B in market capitalization. About 45% of the fund’s assets come from pension funds, 30% from family offices, and 25% from individuals, boutique asset managers, banks, and the management team. The fund has to date exited 7 investments, 6 of those successfully.