This is the second instalment in the Corporate Activism series. The first article discussed strategies and tactics shareholder activists employ in controlled or blockholder-influenced companies in Hong Kong and Germany. This instalment will drill down to assess further similarities and differences between the hedge fund activist experiences in both markets. The third instalment, which will be featured exclusively online, will argue that the dominant theme in Hong Kong and simultaneously the pragmatic common ground of shareholder and hedge fund activism between Hong Kong/China and Germany/Continental Europe is the notion of shareholder engagement.
Activist Hedge Fund Monitoring Effectiveness
The principal-agent conflict is ascertainable in those 40 percent of German public companies that are widely held. In distinction, in Hong Kong, an agency conflict exists between controller and minority shareholders, as most listcos are controlled or blockholder-dominated.
In the view of many, the separation of ownership and control (Berle-Means) and the principal-agent problem (Jensen-Meckling) has recently led to sharp market cap drops and share price value-losses at the expense of shareholders in large DAX 30 German corporations and corporate groups, say, such as the utilities RWE and E.on, but also TUI, Commerzbank, Volkswagen and Deutsche Bank. It is no secret that concerned institutional investors have initiated discussions with activist hedge funds on these matters as to how to restore value (see Appendix A in Part I, featured in Hong Kong Lawyer (June 2017)).
Observers believe that leading activist hedge funds who acquire usually a minority position in the 1–10 percent range (seldom more than 15 percent total) could exert such a monitoring function on behalf of all shareholders without necessarily destabilising the balance of powers between AGM (shareholders), the supervisory board and the management board. First, they are not imposing their views on anybody, lest on the management or the supervisory board; rather they seek to engage and present well-thought out alternative courses of action. Second, they have to persuade and win the votes and confidence of a majority of fellow shareholders and institutional investors in order to have any strategic impact.
Knowledgeable market participants in Europe have started to acknowledge that it is neither theoretically trivial nor to be discounted that higher agency costs/waste stemming from the separation of ownership and executive management powers can be lowered by activist interventions. Thus, higher efficiency takes hold, when activists are enabled to start a conversation with management about the future strategic course of their companies. This statement is not quite accurate in Hong Kong, where the predominance of controlling shareholders creates a manifest agency problem between controllers and minority shareholders rather than a principal-agent conflict. In such a setting, active or activist investors can be successful in eradicating corporate waste by making proposals to the management/controller to enhance company value, improve operative efficiency and deepen investor relations ascertainable in a stock price rise. It is the controller who profits the most from such constructive suggestions on the part of active or activist investors.
By analysing 50 different activist campaigns lodged between 2003–2015 by international and local Hong Kong activists, Frank Wong has established that it is largely inaccurate to describe activist goals to be short-sighted or largely oriented towards short-term payouts. Rather, activist interventions and campaigns have created significant and quantifiable long-term value in Hong Kong over this time period. His research has helped us advance our understanding of the direct (and indirect) processes through which activist hedge funds are exerting an ascertainable, considerable disciplining effect on management and the controllers of the Hong Kong public company universe.
Until recently, the principal corrective for managerial slack and shareholder value destruction due to performance failure in these markets was deemed to be the threat of a hostile takeover. Today, active monitoring by engaged value minority investors is the dominant corrective force, which occurs when minority investors generate enough support among fellow shareholders and institutional investors to form the requisite statutory AGM majorities, if necessary. With foreign institutional Investors owning 60–70 percent of the voting stock of leading German corporates, this train of thought is to be taken seriously. Similar trends of strong global institutional and passive investor interest currently inform the Hong Kong equity markets.
Challenging the Legitimacy of Equity Hedge Fund Activism in Germany
As a common observation for both Hong Kong and Germany, at first blush, the role of activist hedge funds as “Corporate Governance Monitor” seems to be almost self-explanatory due to their flexibility, independence and core competency in financial and capital markets expertise. However, in Germany it is strongly argued that the corporate structure conditions due to the two-tiered board set-up trump, if not vitiate such intuition. It is held that the supervisory board is not only the organ whose monitoring role and indirect participation in the management function via approval of certain defined business decisions requiring such consent stands out; but that it is simultaneously charged with insuring Good Corporate Governance practice on a firm-wide level.
To highlight this notion, traditional German scholarship contrasts the German Corporate Governance Code (“DCGK”) with the UK Stewardship Code (2012). The UK Stewardship Code provides: “For investors, stewardship is more than just voting. Activities may include monitoring and engaging with companies on matters such as strategy, performance, risk, capital structure, and corporate governance, including culture and remuneration. Engagement is purposeful dialogue with companies on these matters as well as on issues that are the immediate subject of votes at general meetings” (No. 4, 1st Sentence). While the DCGK provides: “It is the task of the supervisory board to advise the management board in the course of leading the enterprise and to monitor its actions” (No 5.1.1). “The management board regularly and instantly informs the supervisory board about all relevant questions of planning, development of the business and risks, including risk management and Compliance” (No 3.4). “Management and supervisory board closely cooperate to further the well-being of the enterprise” (No 3.1). The almost identical wording of the description of the activity spectrum and tasks of active shareholders in a UK setting and the role of the German supervisory board suggests – so the traditionalists argue – little room left for creating additional shareholder value through the offices of yet another monitoring instance in the German context.
The role of “non-executive”, independent directors in the UK (and Hong Kong, as opposed to supervisory board members in Germany), they say, has a different gravamen which implies a perceived need for an additional corporate monitor in the UK. In other words, neither are there similar objections to a monitoring role of activism in Hong Kong; nor are the conservative German doctrinal objections against activists as an additional layer of monitoring compelling.
Increased Influence of Activist Hedge Funds in Public Company Universe
Activist campaigns in Europe generally, and in Germany in particular, range from moderate engagements in governance demands (eg, separation of CEO and Board Chairman, already built into the German dual system) to more intrusive interventions in strategy such as stock buybacks/dividend payments, divesting non-core divisions, replacing CEO/board members, or selling the company. In Europe, hedge fund activism is a less combative or confrontational, behind-the-scenes, pro-active form of intervention in underperforming or even performing targets, with more nuanced, at times even patient value investors seeking incremental changes. This is also true for Hong Kong.
There are ascertainable converging interests between activists and institutional investors who are supportive of insurgents if they present credible and thoughtful proposals, backed by convincing evidence of operational improvements and strategic logic in a constructive manner, detailing facts and the competitive landscape. This extends to the serious media if choices are being suggested with analytical and stylistic integrity rather than stereotype accusations, aggressive letter-writing or unfair name-calling typical of extremist activism.
Their success has emboldened activists in recent years to engage larger market cap companies in a crescendo of involvement such as seeking dialogue, negotiations with management, shareholder resolutions, publicity campaigns, proxy fights and litigation. With proxy advisory firms wielding significant influence, no public company today seems immune from activist pressure, regardless of its market capitalisation, as support for activists by traditional long-term passive and index investors has lost any stigma that it once had.
Different Classes of Value and Activist Investors in Hong Kong
In Germany, over 100 different, mostly foreign, activist hedge funds have initiated about 400 campaigns against approximately 200 public companies in the past 15 years – most of them informal and secretive; only recently have local funds begun to play a more visible role (the August 2016 Stada campaign being the first successful proxy fight by a local German fund). The German regulatory and tax regime is quite unfavourable to setting up hedge funds and investment partnerships.
By contrast, there are four classes of different value- and investor relations-driven actors that make up the shareholder engagement and activism spectrum/movement in Hong Kong.
(1) When a portfolio company underperforms, globally operating institutional investors such as BlackRock, T. Rowe Price and Vanguard now seek informal and private discussions with the board on an annual basis (see the typical list of demands made by such investors in Appendix B in Part I, featured in Hong Kong Lawyer (June 2017)), a collaborative and secret approach that has been described as “engagement” which has to be contrasted with traditional voting behaviour on part of such passive institutional or index investors in AGMs/Special Meetings. BlackRock alone is invested in 900 Hong Kong listcos and in close performance discussions with 100 of them on an annual basis – this signifies hundreds overall such exchanges and meetings between global institutional investors and underperforming public Hong Kong companies.
There are two different manifestations of local active Hong Kong investors investing in Hong Kong listcos:
(2) The first group (Value Partners) approaches management/the controller of underperforming Hong Kong companies in a spirit of informal politeness and constructive dialogue in order to persuade them to adopt some of the value enhancing demands and measures (see Appendix B) put forth by the investors – if the controller or management refuses to entertain such discussion with their investor, they immediately after the failure of establishing dialogue between investor and target company sell their position;
(3) The second group of local active Hong Kong investors (Argyle Street) identify purposefully widely held targets (of which there are only about 100 in the Hong Kong public market, instead of controlled companies) for their investment strategy: in the event of reluctance of the target board to engage in a dialogue about value and investor relations improvement (see the catalogue of investor demand in Appendix B), they do not exit their position (unlike the first group under (2), but proceed in the opposite direction by increasing their stock position and attempt a contested takeover strategy of such reluctant target company instead.
(4) The fourth, and most visible, class of activist investors that are the subject of Frank Wong’s study of Hong Kong activism (TCI, Elliott, SAM, Webb), some local Hong Kong and several international activist investors, just like the other already mentioned three classes of Hong Kong active or activist investors, also at first attempt to engage in constructive dialogue with the listcos in which they are invested in the hope that target management would adopt their proposals (see for such typical demands, Appendix B). They go public/hostile reluctantly as a last resort, only after a break-down of negotiations.
The most intriguing example for such informal and constructive activist approach was established by several local Hong Kong funds with hundreds of campaigns that have followed the pathway as described above under (2). They deliberately do not crave the name recognition of some of the well-known local Hong Kong and international activist investors (as outlined under (4)); they rather seek to convince with a broad investment base and successful dialogue as outcome determinative, even if virtually hidden from the public view. Just one of those Hong Kong funds alone (Value Partners) is invested in minority positions in the 5–10 percent range in a little under 200 Hong Kong listcos and has been engaged in value improvement and investor relations enhancement discussions with half of their targets over time.
In the fund’s self-understanding, it pursues a philosophy that is constructive rather than confrontational to the invested firms. Regarding the local peculiarity that family-controlled firms make up the vast majority of the public market, this fund recognises the chairman-centricity of many potential target firms so much so that all corporate decisions are de facto centralised. Hence, after having made their investment in the 5–10 percent range, this fund typically commences its communicative engagement with the target company chairman, and attempts to come across as friendly with its often very detailed list of suggestions for improvement (see Appendix B). Much like BlackRock, they appeal to the self-interest of the controller that stands to profit the most from better valuation and higher share price.
We describe the paradigmatic active local fund activist approach in Hong Kong merely as “giving advice”. We are told that such fund’s constructive approach has worked in two-thirds of their engagements. If the approach does not work, they prefer to sell their position and exit rather than becoming confrontational. Typically, the local fund’s advice will include an improvement of dividend pay-outs, other capital structure optimisation, and an enhancement of investor relations. In terms of target firms, their engagements focus on small to mid-cap firms as historic targets since its establishment.
It is important to distinguish between the above-referenced four different types of active global institutional and active local Hong Kong investors, as opposed to local Hong Kong and international activist investors and hedge funds that differ markedly in their investment thesis and execution of their strategic plans, but have one tactical outlook in common: They resort to a publicity campaign in the press, a proxy fight or litigation for minority shareholder protection only reluctantly, once all attempts at reasoning with target management/the controller about specific value propositions designed to increase the stock price and shareholder value have broken down. The most remarkable phenomenon is that, as Frank Wong has demonstrated, (i) so many more instances of local or international active and activist investments have taken place in the Hong Kong market missed by the press and professional circles; (ii) how large passive investors such as BlackRock have been quite active in this segment, with about 100 annual monitoring meetings out of their 900 Hong Kong portfolio companies on their part alone; and (iii) how local Hong Kong funds (such as Value Partners) have refined their pragmatic, “giving advice” approach in hundreds of precedent cases that is both so effective and at the same time purposefully hidden from public view.