Just as different value and growth investors focus on different fundamental components of a company’s investment thesis, activist investors display a variety of distinctive preferences as well. It is misleading to generalize any given active investment strategy according to an ambiguous style rather than a behavioral tendency. There exists a variety of subcategories not only with growth, value and GARP strategies, but also with activism. In particular, corporates must acknowledge the importance of not generalizing the multiple facets of activism. Perhaps one of the most critical lessons that 2016 taught corporates is that activist strategies also exhibit an overwhelming fondness for the small cap profile. According to FactSet’s 2016 Shareholder Activism Review, the percentage of campaigns against targeted firms with a market cap under $1 billion was 75%. And under this umbrella, there has emerged three distinct segments of activism which have displayed completely separate agendas.
Uniting the perceived disparity between performance and supposed potential continues on as a viable strategy within the activist continuum. There has also emerged a recent wave of activism whose cornerstone relies less on economic opportunity and more on aggressive grandstanding. Lastly, the third segment of activism is predominantly grounded on the relative proficiency of corporate governance policies and the overall commitment to SRI/ESG standards. This clear divergence in behavior and approach, particularly within the small-cap eco-system, is a critical distinction both boards and executives must prepare for.
An activist’s penchant for the small-cap market isn’t coincidental and it isn’t necessarily because they are simply priced cheaper than their larger counterparts. Instead, relative to mid- and large-cap companies, senior management teams and board members running small-cap companies can often be less experienced. This is especially true with respect to capital raises and matters of corporate governance. That is primarily due to the fact that mid- and large-cap teams have already experienced the typical growing pains that go along with any corporate evolution and maturity. As a result, the relative inexperience of small caps provides a variety of vulnerabilities for activists to prey on.
Further, the volatility and respective market inefficiencies associated with the small cap universe tends to skew the magnitude of opportunity. In other words, there exists a greater degree of information, transparency and overall understanding among mid and large caps. For any active investment strategy, this usually results in a misassumption, misunderstanding or just incorrect ideas on how to optimize the value of the small-cap firm. This specific aspect is a critical notion to consider, particularly in matters associated with how the activist accumulates their position.
Ultimately, an activist’s end game is to accrue a position large enough that allows them to influence corporate strategy. However, the volatility and relative illiquidity of the small-cap universe normally exceeds any reasonable threshold of risk the activist is willing to take on. Effective risk management within the portfolio demands some type of hedge that can alleviate a significant portion of the activist’s gamble. Accordingly, we recommend corporates adopt the following maxim – in the realm of activism, derivatives follow the stock, and not the other way around.
If a corporate is solely surveying the path of derivatives, they are essentially listening to blind noise, especially considering the fact the vast majority of activist derivatives trade OTC. All corporates, and specifically small caps, must consistently monitor the various vulnerabilities management presents to the market. Additionally, “vulnerability” extends far beyond economic profile. It must also include the relative strength of corporate governance policies, along with the relevant components of SRI/ESG. The world of activism has evolved into a complex series of independent strategies, all aimed at ultimately enforcing some degree of change. In terms of ownership accumulation, however, the motivating catalyst is not necessarily that important. The activist does not always construct their ownership with the intention of being guileful through the usage of derivatives. Instead, during the course of accumulation, they methodically build their position within the shareholder base while at the same time emphasizing their preferred adjustments to management and the board. Oftentimes derivatives are utilized to lower the cost of capital.
Those requested adjustments are broad, but the manner in which the position is built is not really that noisy. In fact, it is pretty clear cut. Recent history has taught us that an activist’s intentions are geared more towards negotiation. Sometimes the negotiation is hostile and sometimes it has been benign. Regardless, it is hard to make any request as an active investor when bluffing a position. The activist’s modus operandi typically centers on accumulating stock with a corresponding request to come to the negotiating table. Management’s best defense should not revolve around monitoring derivative activity. Any risk management policy within the small cap world would deem derivatives a suitable tool and because small-caps are so volatile, derivatives are constantly utilized in a benign fashion. Instead, the best defense is proactively assessing the various investment theses their firm offers the market. This means evaluating the economic feasibility of potential alternative strategies on an ongoing basis. In short, scenario analysis from a variety of investment angles is critical. More importantly, as the company’s market cap evolves, management should not delay the coinciding evolution of their corporate governance policies, capital deployment strategies and SRI/ESG profile.
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