Whenever there’s any kind of shareholder activism, typically there’s one phrase thrown around: “unlocking value for shareholders.” The great debate about whether or not activists actually create value for their fellow shareholders continues with an interesting white paper about financial engineering.
Forms of activism
There are a few different ways of classifying shareholder activism. Proxy Mosaic Research Director Dave Whissel follows Activist Insight’s classification system closely. He gives these five categories and breaks them down into subcategories (All graphs/ charts in this article are courtesy Proxy Mosaic.):
Activism is big business
Interestingly, 15% of S&P 500 companies have been targeted by activism in the last four and a half years. Last year, activist investors were busier than ever, and this year is shaping up to be just as active. Investors have begun to sit up and notice too, as last year activist stock holdings rose to almost $250 billion.
Of course activism isn’t new. Decades ago, activist investors were often referred to as “corporate raiders.” But what has changed is the methods activists use to, as they say, “unlock value for shareholders.” In many cases, all it takes for activists to find value in a company is a little financial engineer.
What is financial engineering?
Whissel reports that over 25% of the 2,426 activist campaigns that have taken place in North America since 2010 have involved some form of financial engineering. One of the hallmarks of this type of activism is the claim that a company is undervalued. The activist them looks to unlock value through a spinoff, divesture or other transaction that somehow monetizes assets that weren’t previously monetized.
Another method of financial engineering involves calling for share repurchases. One example of this is Apple, which caught the eye of activist investor Carl Icahn because its huge pile of cash. He pushed the company to increase its share repurchases and ended up getting his way.
In general, Whissel defines financial engineering as “a cross between purely financial or balance sheet activism, business strategy or operational activism, and M&A activism.”
Does financial engineering actually work?
The analyst examined about 100 activism campaigns that have involved some type of financial engineering. He learned that about half of all the activism campaigns in North America involve financial engineering.
So why is this form of activism so popular? For one thing, he suggests that the strong M&A market in the wake of the financial crisis has laid a foundation for activist investors to build upon. Also he notes that more and more companies (most notably, tech companies) are starting to sit on huge piles of cash rather than putting their cash to work.
And third, he notes that activists have found so much success in spinoffs that more activists are coming forward to attempt spinoff strategies. In fact, Whissel reports that the average total shareholder return of parent companies a year after a spinoff is about 14%, which is better than that of the S&P 500 in a year. Looking out to two years after a spinoff, the percentage increases to almost 30%.
Another type of financial engineering is conversions into real estate investment trusts and sale-leasebacks. The analyst believes the popularity of these types of transactions is the result of the real estate market’s recovery.
Further, the analyst believes the strengthening of the U.S. dollar may be impacting financial engineering activism.
Financial engineering activism to continue
Whissel noted that FTI Consulting recently conducted a study which indicated that almost 90% of respondents expect activists to keep using financial engineering. A related study from Alliance Advisors indicates that activism involving share buybacks, dividends and restructuring have now become the prominent issues taken up by activist investors.
So if these trends are going to continue, it’s important to consider whether financial engineering really works when it comes to unlocking or creating value for shareholders. The analyst examined about 100 activism cases from Activist Insight’s database in which some type of financial engineering was the main goal of the activist.
He excluded cases in which the parent company in the case of takeover and private-equity buyouts and dividend-related cases. He also excluded calls for mergers because there weren’t enough “discrete instances to make the data meaningful.” That left activism involving acquisitions, share repurchases, divestures and spinoffs. Here’s a look at the breakdown of the popularity of each of these types of activism.
Financial engineering works
To determine whether financial engineering actually does unlock value for shareholders, Whissel looked at total shareholder returns and earning per share in four different windows. He also compared those numbers to returns in the S&P 500. In general, he determined that financial engineering does work. His study supports the findings of other broader studies on activism, which indicated that activism does work in the long run. As you can see, the longer shareholders stay in an activist stock, the higher the returns:
The results of Whissel’s study also demonstrate that the value unlocked by financial engineering is sustainable over time.
Which types of financial engineering work better?
The analyst also broke down total shareholder returns by the type of financial engineering that was being targeted and found that acquisitions actually result in a decline in shareholder value since the time of announcement, while spinoffs tend to be the most lucrative for investors.
In fact, he said approximately 50% of the acquisition-related activism campaigns resulted in value being destroyed in the shorter time frame since the initial announcement of the campaign.
Moving out 60 days
Interestingly, when looking at 60 days from the announcement of the campaign, the results were results. Whissel suggests that this is because it takes longer for a parent company and spin-co to create value.
Financial engineering can damage earnings growth
The analyst also found something else in the data that’s particularly interesting. In terms of earnings per share, he said financial engineering tends to dilute shareholder value. The only one that was not dilutive in this area was divestures:
He noted that it seems counterintuitive that share repurchases would not be helpful in growing earnings. He suggests that this might be because the earnings benefits are mostly short-lived if the company doesn’t change its operating efficiency “substantially.”
See full study below.