Shareholder Activism: A Survey of the Added Value of Activist Shareholders to the Company and its Stakeholders

Shareholder Activism:

A Survey of the Added Value of Activist Shareholders

to the Company and its Stakeholders

Abstract

The focus of this thesis is on shareholder activism and when and why activist shareholders create value for a company and its stakeholders with a special focus on the Netherlands. The essential issue in large, public companies is the agency problem which arises due to the separation of ownership and control. A possible solution for this conflict of interests between management and shareholders is actively monitoring the company’s management.

Many scientific articles argue that activism of shareholders can lead to more efficient monitoring, reduced agency costs and increased shareholder value. Others argue that activist shareholders only strive for their own short-term interests, neglecting long-term goals of the company and lacking interest for other stakeholders in the company.

Empirical evidence on the subject is mixed. It is therefore important to realize that different groups of activist investors have different liability structures, incentives, objectives, and strategies. Pension funds that pursue activism, for example, face certain constraints: their internal agency problems, strong regulation and political restraints. Hedge funds, on the other hand, face less regulatory and political constraints and have highly incentivized managers. Hedge funds are also more focussed on optimizing their activities. The unique organizational structure of hedge funds can be a reason to explain the high wealth effects of hedge funds activism. Private equity funds also have an advantageous organizational structure to pursue activism. Their public-to-private transactions are beneficial to shareholders.

These findings are supported by the empirical survey of chapter 5 on three Dutch companies and their activist shareholders. These companies have had a significantly high return on investment for shareholders after activism has occurred.

The main conclusion is that activism can be profitable to shareholders, if done correctly and with the required focus. It keeps management sharp and prevents them from destroying value, which is eventually in the best interests of all stakeholders of the company. The mechanism of activism is therefore an important element in the system of checks and balances in order to maintain or create company value.

JEL Classification: G20, G23, G24, G30.

Keywords: Agency Theory, Corporate Governance, Shareholder Activism, Institutional

Table of Contents

1 Introduction...5

2 Theoretical Background on Corporate Governance... 9

2.1 Ownership Structure...9

2.2 The Agency Theory ...10

2.3 Shareholder View versus stakeholder View... 10

2.4 Different Solutions to the Agency Problem... 12

2.4.1 Internal Monitoring...13

2.4.2 Compensation Structure... 14

2.5 Ideal Ownership... 15

2.6 Corporate Governance... 16

3 Shareholder Activism... 19

3.1 Motivation for Activism... 19

3.2 Monitoring Incentives... 19

3.3 Institutional Activism ... 21

3.3.1 Pension Funds...21

3.3.2 Hedge Funds... 22

3.3.3 Private Equity Funds... 24

4 Involvement of Activist Shareholders... 30

4.1 Types of Activities... 30

4.1.1 CEO Turnover... 30

4.1.2. Mergers and Acquisitions... 33

4.2 Blockholders... 35

4.2.1 Block Premiums... 35

4.2.2 Private Benefits...36

4.3 Disadvantages of Shareholder Activism... 37

5 Empirical Investigation... 40

5.1 Introduction... 40

5.2 VNU... 40

5.3 Stork N.V... 43

5.4 ABN AMRO Bank N.V... 45

5.5 Conclusions on Practical Evidence... 47

5.6 Recommendations of the Frijns Committee...51

6 Conclusions and Recommendations... 54

References... 59

1 Introduction

For many decades corporate governance has been an important element in the business world. The wave of corporate scandals that began in 2001 has, however, created increased international awareness on the importance of corporate governance and the need to prevent company failures (Solomon and Solomon, 2004). A well known example is the US company Enron which filed for bankruptcy in 2001. Due to failure of the corporate governance system, shareholder value was destroyed, thousands of employees lost their jobs and the confidence in the corporate system and in management’s integrity was harmed (Monks and Minow, 2004). According to Shleifer and Vishny (1997) corporate governance relates to “the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment”. This can be seen as a narrow view on the definition of the term ‘corporate governance’ and is framed in terms of shareholder value. The broader view on corporate governance also includes the relationships with other stakeholders. The essential problem in corporate governance is the agency problem which arises due to the separation of ownership and control in a company. The incentives of management and the incentives of stakeholders are not always aligned forming a conflict of interests (Berle and Means, 1932; Jensen and Meckling, 1976). This conflict of interests is especially relevant for shareholders of a company. Within this context, the major objective of management should be to maximize shareholders’ return. This can be achieved by ensuring a long-term vision of the company and by managing its relationships with stakeholders effectively (Monks and Minow, 2004). Management, however, often fails to act in the best interests of shareholders.

and the supervisory board1_{. The Frijns Committee was appointed to monitor the compliance} of companies with the Code and to assure the quality of corporate governance in the long run. In practice, the new regulations have facilitated the ability for shareholders to closely monitor management, influence the decision making process and speak out if they do not agree with management and/or its strategies. The passive, loyal shareholder is slowly disappearing and shareholders are now increasingly using the acquired control to get more actively involved in the company they have invested in. Recent examples of Dutch companies involved with activism are VNU, Stork and ABN Amro. These companies have been under pressure of activist shareholders wanting to split up the companies in order to create more shareholder value. These new activist developments led to much commotion about the influence of shareholders and to discussions on whether this involvement has gone too far. The question is whether shareholder activism is in the best interest of the company and all its stakeholders. Some authors argue that activism of shareholders can lead to more efficient monitoring, reduced agency costs and increased shareholders’ return (Demsetz, 1983; Shleifer and Vishny, 1986; Akhigbe et al., 1997). The fear of activism on the other hand, is that activist shareholders only strive for their own short-term interests, neglecting long-term goals of the company and lacking interest for other stakeholders in the company (Lipton and Rosenblum, 1991; Shleifer and Vishny, 1997; Kahan and Rock, 2006).

This upcoming shareholder activism has worried the public as well as the Dutch government and was the reason for the government to ask the Frijns Committee for advice. In May 2007 the Committee reported several specific recommendations to restrict the power of activist shareholders2_{. Almost all recommendations of the Committee were adopted by the Dutch} government. These recommendations provide an interesting element to the discussion. Initially, shareholders were given more power by the Code Tabaksblat but now, after a couple of public incidents of activism, the government wants to limit the power of activist shareholders again. An important question we should ask is whether we actually do have to fear these investors and need to control their powers or can we consider activist shareholders to have a positive effect on a company’s performance and developments? What is the true value of activist shareholder involvement and when is it valuable to a company and its stakeholders?

1 _{The Dutch Corporate Governance Code} 2

1.1 Research Objective

The objective of this thesis is to develop a survey of theoretical and empirical literature regarding the important elements surrounding shareholder activism. The aim is to provide a better insight into the reasoning of activist shareholders, the benefits and the risks, and the possible value to the company.

1.2 Research Question

The research question of this thesis follows:

‘When and why is an activist shareholder valuable for a company and its stakeholders?’

1.3 Sub Questions

The following sub questions will be answered in order to answer the main research question. ~ What is the relationship between ownership structure, stakeholder theory, ideal ownership and corporate governance?

~ In practice, what is the motivation for shareholders to become active in a company? ~ How do activist shareholders and other shareholders benefit from activists’ actions and what type of actions do they undertake?

~ What are the disadvantages of shareholder activism for a company?

~ What are the effects of activists’ actions on the share value and trading volume of the company?

1.4 Thesis Outline

2 Theoretical Background on Corporate Governance

“Laws alone can not secure freedom of expression; in order that every man presents his views without penalty there must be a spirit of tolerance in the entire population”

~ Albert Einstein

2.1 Ownership Structure

2.2 Agency Theory

The separation of ownership and control in a company brings about the agency relationship. An agency relationship can be best defined as “a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent” (Jensen and Meckling, 1976). A typical case of this agency relationship in a company is the one between shareholders and management. Managers are placed in control of resources belonging to shareholders and have a contractual obligation to use and invest these resources in the best interest of shareholders. Using the contractual view, Fama and Jensen (1983) describe the company as “a nexus of contracts” consisting of written and unwritten contracts that specify the rights and duties, and the behaviour of management. The problem is the difficulty to perfectly contract every action of management in the best interest of shareholders (Brennan, 1995). Usually, contracts do not cover all the decisions made by management, giving them most of the residual control rights. However, management’s incentives are not always aligned with those of shareholders causing agency problems to arise. If both are utility maximizers (Jensen and Meckling, 1976), it is very likely that management’s behaviour diverges from profit maximization and which is in the best interests of shareholders. Incomplete and asymmetrical information between shareholders and management is the main issue, causing an imbalance of the powers, which can also lead to problems like adverse selection and moral hazard. Another important element in the agency theory is the different attitude towards risk of shareholders and management (Eisenhardt, 1989). In theory, principals modelled as shareholders usually are risk neutral. They can easily diversify their portfolio by buying shares of different companies and thereby reduce their risk. Management, on the other hand, has a natural aversion for risk because their job is linked to the company’s performance and cannot be diversified. Different risk preferences have effect on the decisions made in the company and cause the interests of shareholders and management to diverge. The agency problem that arises can be best identified as the conflict of interests between shareholders and management and the difficulty to exactly monitor management’s actions (Eisenhardt, 1989).

2.3 Shareholder View versus stakeholder View

on shareholder value and “based on a traditional but now discredited conception of the corporation” (Perrow, 1986; Barney, 1990; Newton, 1992). Not only shareholders and management play an important role in the company, other stakeholders, for example employees, customers and suppliers, society and environment, are also affected by the way the company is managed. The ‘stakeholder view’ uses a broader perspective on the company as a whole and includes the interests of all stakeholders of the company. Berle and Means (1930) were early to state that the community “must demand that the modern corporation serve not alone the owners or the control but all society”. Companies’ responsibilities can be seen in a wider context than merely financial. Freeman (1984) was one of the first to explore stakeholder theory and states the definition of a stakeholder in an organization as “any group or individual who can affect or is affected by the achievement of the organization's objective”. Another definition of a stakeholder is given by Clarkson (1995): “those groups or individuals who assume some degree of risk bearing activity with the corporation”. This two-way relationship between stakeholders and the company (Carroll, 1989) shows the important element of this theory: to take the interests of all stakeholders into account. According to Jensen (2001) a company cannot maximize value without recognizing its stakeholders. Carefully balancing the interests of all stakeholders by management is therefore essential for company survival (Caroll, 1989).

Nevertheless, the discussion among authors whether the agency framework and stakeholder framework can be integrated is still going on. Cornell and Shapiro (1987) describe it as “an ongoing struggle between economic views of the firm which are decidedly silent on the moral implications of the modern corporation, and ethicists who place the need for understanding ethical implications as a central role in the field of business ethics”. Solomon and Solomon (2004) argue that a well managed company should most likely have “a good environmental management system and high levels of stakeholder dialogue and engagement”. Shankman (1999) concludes that stakeholder theory is the necessary outcome of the agency theory and therefore a more appropriate way to conceptualize theories of the firm. It is therefore beneficial for company performance to integrate both frameworks and to manage “strategically and morally” simultaneously.

2.4 Different Solutions to the Agency Problem

In an agency relationship, it is of great importance to select the appropriate governance mechanisms to induce management to act in the best interest of shareholders. Positive changes in management behaviour and higher managerial incentives can lead, on average, to higher corporate performance and shareholders’ wealth increases (Manne, 1965; Jensen and Meckling, 1976; Shleifer and Vishny, 1989; Morck et al., 1990). The appropriate disciplinary mechanisms can be divided into external methods and internal methods. External methods are monitoring activities by external sources, e.g. the capital market (usually shareholders) and legislators. Internal methods consist amongst others of internal monitoring, compensation contracts and bonding.

managerial discretion is high and when monitoring is expensive (Pratt and Zeckhauser, 1985). The next subparagraphs will go more into detail about internal monitoring and compensation structures.

2.4.1 Internal Monitoring

The need for monitoring depends on the performance of management. If the company is performing well, shareholders will be satisfied and there is no need for intensive monitoring. If, on the other hand, there is room for improvement or the company is underperforming, shareholders would want to increase monitoring. Monitoring of management reduces the information asymmetry between shareholders and management and can thereby decrease the agency problem. The more information is obtained about management and its decision making, the less likely management is able to diverge from shareholders’ interests (Eisenhardt, 1989).

Internal monitoring is primarily done by the supervisory board. Its main responsibility is to hire, fire, compensate, and monitor management in the best interests of shareholders (Gillan and Starks, 1998) and to take into account the interests of other stakeholders. In theory, especially in large corporations with diffuse ownership, the supervisory board should play an important role in minimizing agency problems. Hermalin and Weisbach (2003) explain the function of the board “as part of the equilibrium solution to the contracting problem between diffuse shareholders and management”. By monitoring management closely, information problems and managerial power abuse can be diminished.

al., 1988; Huddart, 1993). This way, the incentive to monitor management is influenced by the ownership structure of a company. Jensen (1989) was one of the first to suggest that concentrated ownership contains more value than a diffusely held company. Large shareholders have better incentives and are therefore more capable to create a hold on management misbehaviour. This makes monitoring by large shareholders more effective and thereby contributes to corporate performance (Shleifer and Vishny, 1986; 1997). Mehran (1992) concludes that the presence of major shareholders may even be an effective substitute for monitoring done by the supervisory board. However, intensive monitoring and concentrated ownership is not necessarily favourable to a company. According to Burkart et al. (1997) ownership concentration involves a trade-off between control and initiatives. If initiatives of management lead to an increase of company value, intensive monitoring and control is not the optimal strategy for the company (Burkart et al., 1997). With intensive monitoring of shareholders, management will not show initiatives because shareholders are likely to interfere. Monitoring will lead to less initiatives of management, which eventually leads to a decrease in company value. For this reason, monitoring should always be considered carefully. The optimal levels of monitoring should be determined on the specific features and structures of the company being monitored.

2.4.2 Compensation Structure

idea that, due to managerial opportunism and the board’s inability to be independent towards management’s wishes (Crystal, 1991; Bebchuk et al., 2002), management has the ability to influence the level and structure of their payments at the expense of shareholders (Core et al., 1999; Bebchuk and Fried, 2004). However, management’s bargaining power has its limits. Management compensation can not be exceptionally high; otherwise the public will react to this ‘outrage’ (Bebchuk, et al., 2002). Nevertheless, the aforementioned problems and high managerial power can lead to inappropriate levels of compensation. Rather then only diminishing the agency problems, compensation structures can be part of the agency problem (Bebchuk and Friek, 2003). An efficient board, active monitoring by shareholders and concentrated ownership can improve the optimal level of compensation (Bebchuk and Friek, 2003; Khan et al., 2004; Almazan et al., 2005).

The two main forms of incentive compensation are cash compensation, e.g. bonuses, and equity-based compensation, e.g. restricted stock grants. The tendency nowadays is much more towards performance-based compensation (Hall and Liebman, 1998). With equity-based compensation, management’s payment is directly tied to the company’s performance giving management a greater incentive to make value maximizing decisions (Benston, 1985; Jensen and Murphy, 1990). According to some research, companies tend to perform better when management compensation is equity-based (Leonard, 1990; Mehran, 1995; Frye, 2001). Depken et al. (2005) found results consistent with the agency theory; cash compensation tends to increase the agency conflict while equity compensation tends to lower it. This would suggest that the form of compensation is an important motivation for management to increase company value rather than the level of compensation (Mehran, 1995). Either way, an efficient compensation structure is an important element in the corporate governance system and can be crucial in the way management behaves. The level and the form should therefore be set with consideration by an efficiently operating board or closely monitored by shareholders.

2.5 Ideal Ownership

show that an ‘ideal owner’ should have the incentives and the knowledge to govern a company. In the case of a owner/shareholders, a sufficiently large stake provides a shareholder with power and resources to efficiently monitor management. The ideal owner should also have a long-term interest with the commitment to maintain ownership for a long period. In addition, the ‘ideal owner’ should feel responsible not only for his own investment in the company, but also for the company as a whole including other shareholders, management, employees and other stakeholders and should try to preserve full integrity. In the context of the subject of activism, the next chapter will discuss whether an activist shareholder fits the characteristics of an ideal owner.

2.6 Corporate Governance

The problems associated with the separation of ownership and control, as described above, have been present as long as public companies exist. However, recent corporate scandals including fraud and excessive CEO compensation have shown that the power of management in large, public companies needs to be controlled (Cools 2005). In order to have management act in the best interests of stakeholders, a broad range of legislation was made in the Netherlands known as the Code Tabaksblat. The Code is implemented amongst other things with the aim to minimize and maintain the possible conflicts between shareholders and management and to enhance the quality, transparency, integrity and accountability of management (Gillan and Starks, 1998; Grant, 2003; Akkermans et al., 2006). In the Netherlands, the Code Tabaksblat has also made shareholders an essential part of the regulated corporate governance system. The ‘comply or explain’ rule gives shareholders the position to ask for an explanation if management does not follow the best practice provisions of the Code.

shareholders will not be an effective mechanism. In this case, legal protection in combination with an active board is more effective. In countries with concentrated ownership, monitoring plays an important role and will possibly be exercised by large shareholders. It is then rather important to protect the interests of minority shareholders against the power of large shareholders. This problem will be further discussed in the next chapter.

Furthermore, the relationship between shareholders, other stakeholders and management of a company is an essential element of a corporate governance system. In the Netherlands, the so-called ‘Rijnlands model’ is used. This model can be best described as a stakeholder model. According to the Dutch Corporate Governance Code, management and the supervisory board have the responsibility to create long-term shareholder value but also have the responsibility to take into account the interests of all stakeholders3_{. This model uses a ‘two tier’ board} system which means that most Dutch public companies have two separate boards: management board and the supervisory board. Management board manages the company. The head of this board is the chief executive officer of the company. The supervisory board consists of non-executive directors who supervise management board. The head of this board is the chairman. The separation between management board and the supervisory board provides a formal division of power and should make the supervisory board an independent and objective body4_{. The disadvantage of this system is that the members of the supervisory} board have a part-time function, usually do not possess enough specific knowledge on the company and its industry and have little incentives.

Most other countries in the world use an Anglo-Saxon model. Their aim is to maximize shareholder value and to look only after shareholder interests; also known as shareholder model. In these countries, a ‘one tier’ board system is used. There is only one board consisting of executive directors who manage the company and non-executive directors who supervise. In the United States, the CEO and the chairman of the board used to be the same person. This person had a great deal of power which was not in the best interests of stakeholders. Recently, there has come a division between chairman and CEO. An important advantage of a one-tier board is the equal level of information to all directors because they are on the same board5_. Lack of independence of the non-executives is, however, a disadvantage.

The Anglo-Saxon model nowadays prevails in the world and is supported by the majority of international investors. The Anglo-Saxon atmosphere has created a main focus on shareholder

3 _{The Dutch Corporate Governance Code} 4 _{Het Financieele Dagblad, 18 maart 2008} 5

value and is emerging in the Netherlands as well. Foreign investors in Dutch public companies, their ownership being approximately 76%6_{, do not always know or understand the} dual corporate governance system used in the Netherlands. Some Dutch multinationals (e.g. Shell, Unilever) have therefore changed their structure into a one-tier board to be able to attract more foreign investors. Important in both models, however, is for the supervisory role to have knowledgeable people with commitment, responsibility and accountability. Proper supervision is essential for the system of checks and balances to work efficiently.

The development of new, stricter regulation on corporate governance has had a positive impact on the agency problem between management and shareholders that arises from the separation of ownership and control. It is, however, not the solution for everything. Honest corporate culture, ethical behaviour of management towards all stakeholders and an efficient, independent supervisory board will also contribute to minimize this problem. However, the agency framework works best if there are shareholders to monitor and act as principals, especially large shareholders (Bentrand and Mullainathan, 2001). They will take the responsibility of monitoring management and thereby reduce agency costs and diminish the conflict of interests between shareholders and management.

In practice, the emerging Anglo-Saxon approach with its main focus on shareholder value, the often inefficiently functioning supervisory board, the open shareholder structure in the Netherlands and the large ownership by foreign investors, in combination with the dismantlement of legal defense mechanism, have made the Netherlands an attractive target for shareholder activism (Boot and Cools, 2007). This will be further discussed in the next chapter.

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3 Shareholder Activism

Various factors like globalization, liberalization of capital markets, more availability of information and new regulations are giving shareholders an increasing amount of power. Shareholders are more conscious of their investments and want to use their rights to optimize these investments. As a result, shareholder activism has become extremely popular in the corporate environment, especially after the collapse of the stock markets and corporate scandals.

3.1 Motivation for Activism

If a shareholder believes that the performance of a company is not to his satisfaction, the return on investment is not high enough, management is not doing a good job, and/or the supervisory board fails its duty to safeguard shareholders’ best interests, there are three things a shareholder can do: exit, loyalty or voice (Hirschman, 1970). Exit or ‘voting with your feet’ is synonym for selling the owned shares and leaving the company. If stock markets are liquid and monitoring is costly this can be an attractive solution. Second, instead of selling its shares a shareholder can also hold on to the shares, be loyal to the company and not act in any way. The third option for a shareholder is to show the dissatisfaction by using his voice. Shareholders can speak out and use their ownership rights in the company to put pressure on management to change decisions and/or strategies. This is known as shareholder activism. A common used definition of an activist shareholder is a shareholder “who tries to change the status quo through ‘voice’, without a change in control of the firm” (Gillan and Starks, 1998). Activism can vary from financial goals to social and environmental goals. This thesis focuses on financial activism and how a shareholder can exercise his rights as owner to attempt to protect and enhance the value of his investment. The need to correct the agency problem and thereby collecting potential gains is the main reason for activist shareholders to intervene in management’s behaviour (Gillan and Starks, 1998).

3.2 Monitoring Incentives

Without adequete monitoring by the supervisory board, management has the freedom to give themselves excessive compensation, has the ability to make decisions in favour of themselves and many other perks. Activism of shareholders can provide additional monitoring to correct this agency problem.

Minow, 2004). Primarily, an ideal owner should have a large enough stake. Theoretically, activist shareholders also need to have a large enough stake to overcome the free-rider problem (Grossman and Hart, 1980). Activist shareholders incur all the costs of their actions and only receive a fraction of the benefits. The received benefits do have to outweigh all the costs in order to make the actions profitable (Grossman and Hart, 1980; Shleifer and Vishny, 1986; Huddart, 1993). In addition, a shareholder with a large stake in a company is quite illiquid, which makes it not always possible to ‘vote with his feet’ and sell off all shares at once. Instead, when dissatisfied, it will be more convenient for shareholder to exercise control. The strong descending stock prices of the last years have also made it difficult and unprofitable to quickly leave the company. Furthermore, illiquid stock markets can also reduce the ability for shareholders to easily trade shares and ‘vote with their feet’, encouraging them to monitor (Bhide, 1993). These factors suggest that a large shareholder is more or less forced to act through voice. Or as Monks (2001) states: “If you can’t sell, you have to care”.

The second criterion of ideal ownership is to have a long-term perspective. As Michael Porter (1992) argues: “the long-term interests of companies would be better served by having a smaller number of long-term or near permanent owners, whose goals are better aligned with those of the corporation”. Taking this criterion into account, activist shareholders can be broadly distinguished into two groups. The first group consists of the opportunistic shareholders; they are looking for an investment opportunity. Their strategy is to invest in underperforming companies with the aim to actively change the company and maximize profits with the result of short-term value creation. Usually, these activist shareholders only focus on getting the highest possible return on investment as quickly as possible. They lack commitment on the long-term prospects of the company. The second category consists of shareholders using activism to improve management’s behaviour in a broader perspective. Their strategies contain long-term visions of the company and their main goal is to keep continuity among shareholders and other stakeholders. This last group would be a more appropriate fit to the long-term perspective criterion of an ideal owner.

The above description of an ideal owner contains characteristics of shareholders. However, no activist shareholder is the same. Each shareholder differs in the type of investment, his incentives and objectives to monitor the company and to get actively involved. To specify every type of activist shareholder goes beyond the extent of this thesis. Institutional investors, however, come close to the ideal owner concept (Agrawal and Knoeber, 1996) and will be the focus of the next sections.

3.3 Institutional Activism

The most common group investing large amounts of money in the financial markets are the institutional investors. Institutional investors, e.g. banks, insurance companies, pension funds, hedge funds and private equity groups hold an increasing amount of listed stocks in the global capital market. For the Netherlands in specific, the total investments of institutional investors amounted about 1200 billion euros in 2006; of which 47% is invested in equity7_{. As a result,} institutional investors hold a significant portion of the Dutch equity market and, when exercising their power, can have an important impact on certain companies in specific and on the economy as a whole. In the next sections three types of institutional investors, namely pension funds, hedge funds and private equity, will be discussed on their active approach on investments.

3.3.1 Pension Funds

In the Netherlands, all pension funds together had a total amount of around 700 billion euros invested in assets in 2006; of which more than 52% was invested in equity securities8_{. Pension} funds aim to meet their long-term liabilities by attempting to maximize their long-term return on investments and minimize the potential risks. Pension funds do have similarities but are definitely not “a homogeneous set of investors” (Del Guercio and Hawkins, 1999). They all have different investment strategies, objectives and incentives. Pension funds can range from passive management strategies, where fund managers use a diversified market portfolio to track a certain index, to active management strategies where fund managers try to outperform the market by selective stock picking.

As activism emerged, this group of institutional investors also used their influence on companies in order to ensure a long-term return on their investments. An important reason for

7 _{Centraal Bureau voor de Statistiek} 8

pension funds to engage in activism is their large, long-term investments in companies making it not always profitable to sell off their shares.

Although in literature often regarded as ideal owner, in theory, pension funds face several constraints. This makes pension funds less effective monitors and less likely to engage in certain kinds of shareholder activism (Kahan and Rock, 2006). First of all, pension funds face regulatory and political constraints (Romano, 1993; Kahan and Rock, 2006). This is necessary because pension funds are of major importance for the economy as a whole and for the labor market in particular. Besides, funds can be politically pressured to invest in local and social preferable companies (Romano, 1993) which can harm the performance and actions of the funds. This also includes the risk to harm the reputation of the fund by becoming too active and the risk of litigation. As a result, the funds are subject to strong regulations. Second, pension funds are subject to internal agency problems. Pension funds are run by fund managers who manage and invest the money of their investors. This adds another layer in the ownership structure and can lead to a conflict of interests between the fund manager and its clients (Admati et al., 1994). Fund managers receive typically management fees which are independent of their performance. As a consequence managers lack proper incentives (Murphy and Van Nuys, 1994) which gives fund managers the opportunity to pursue their personal agendas and motivations instead of effective monitoring for their clients (Barber, 2006). The agency problems inside pension funds make them less effective monitors (Romano, 1994). Some authors even argue that fund managers lack skills and experience to pursue activism and to argue with and contradict management’s decisions (Lipton and Rosenblum, 1991). Third, pension funds usually follow a passive, diversified strategy, investing in many different companies. Large stakes in a company represent only a small portion of the total assets of the fund. This makes active monitoring not worthwhile because it is too costly and time-consuming (Admati et al., 1994). To summarize, theoretical evidence shows that pension funds have numerous constraints to take into account. Using empirical evidence, the effectiveness of pension funds’ activism on corporate performance will be discussed in the last section of this chapter.

3.3.2 Hedge Funds

assets of 1,87 trillion dollars. Rival Hedge Fund Intelligence9 _{reported an amount of 2,5} trillion dollar invested in the assets of hedge funds. In the Netherlands the amount of hedge funds is still relatively unknown.

In 1949 Alfred W. Jones was the first to introduce the strategy which has been used ever since by hedge funds (Loomis, 1966). He wanted to ‘hedge’ the market movement risks of his long-term stock position and did this by short selling other stocks. Using leverage for his ‘going long’ stocks he optimized his potential return. By hedging market movements he could focus on stock selection instead of market performance making it possible to get a positive return in either a bull- or a bear market. This is the foundation of hedge fund strategies.

Nowadays the term ‘hedge fund’ does not have one definition but is used as a broad term to describe investment funds that use a variety of different investment strategies. The funds are actively managed by fund managers whose main objective is to obtain the highest possible

absolute return on investments, with low market correlation and a high degree of leverage.

Hedge funds have some other common characteristics. A specific characteristic of hedge funds are the highly incentivized fund managers. First of all, fund managers are usually required to invest a part of their own money in the fund they manage which gives them a good incentive to perform. Besides, fund managers receive a performance fee above the usual management fee. This fee depends on the positive performance of managers and helps to align the interests of managers and investors and also gives the manager a good incentive to maximize return. This performance-based fee can, however, give the managers the incentive to pursue aggressive, high return, short-term investments instead of long-term investments (Partnoy and Thomas, 2006). Pursuing short-term gains can lead to additional risks and the short-term investment horizon can also be at the expense of long-term profitability of the company (Kahan and Rock, 2006). Although hedge funds are often characterized as short-term investors, empirical evidence shows that this is not always the case (Brav et al., 2006) (also see section 3.4). Another characteristic of hedge funds is that they require a lock-up period of the investment made by clients. Shares can not be traded on a daily basis making the investment less liquid in comparison to traditional investment funds. In many countries (e.g. United States and offshore) hedge funds are also not subject to any regulatory constraints. To escape regulation duties hedge funds often run their companies offshore. Therefore, hedge funds are able to follow strategies, including leverage and short selling, which other institutions cannot. This gives them an advantage on today’s market (Partnoy and Thomas,

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2006). Hedge funds are also more likely to hold concentrated stakes of equity because they focus on absolute returns rather than performance relative to an index (Partnoy and Thomas, 2006).

Recently, hedge funds have received increasing amounts of negative media attention in the Netherlands, due to their so called aggressive forms of activism, e.g. The Children Investment Fund (TCI) at ABN Amro, Centaurus Capital and Paulson Capital at Stork. However, as described before, hedge funds all have different strategies and incentives and are therefore not all activists by nature. Only 2% to 5% of approximately 10.000 hedge funds in the world will become an activist shareholder10_{. Íf, however, their main strategy is activism, hedge funds} usually are more successful than traditional institutions (Kahan and Rock, 2006).

These activist hedge funds are not aiming for a controlling stake in the company (Brav et al., 2006). With relatively small stakes and the support of other shareholders they try to influence management to change specific things. Healthy, profitable but undervalued companies are the most likely target of activist hedge funds (Klein and Zur, 2006; Brav et al., 2006). By getting actively involved in the company and getting rid of the bottleneck causing the underperformance, activist hedge funds try to obtain the highest possible return on their investment. Due to ‘learning by doing’ and the willingness to invest in costs and efforts, these hedge funds can be effective monitors. Traditional institutions, like pension funds, follow a different profit strategy; the strategy of diversification. They are therefore not prepared to fully invest in activism simply because it is not their core business. The several advantages of hedge funds, e.g. high incentivized managers, fewer internal conflicts, less regulatory and political constraints, and a focus on activism, suggests that activist hedge funds are attractive shareholders to actively monitor a company (Kahan and Rock, 2006; Partnoy and Thomas, 2006). Section 3.4 will describe the empirical evidence of the effects on hedge fund activism on company performance.

3.3.3 Private Equity Funds

Private equity is a financial sector which is growing tremendously. In 2006 they invested over 2.4 billion euros in Dutch companies and total assets of private equity funds in the Netherlands increased from 13,5 billion euros to 20,4 billion euros in 200611

.

The main objective of private equity funds is to invest in the equity of (private) companies with the intention to obtain a majority interest in the company. This gives the fund the ability

10 _{‘Feitenonderzoek naar hedgefondsen en private equity’, Ministerie van Financiën} 11

to get complete control and to be able to alter strategies, the composition of management board and/or to reorganize the company. After a couple of years the fund sells the company again with a profit12_{. A common characteristic of private equity funds is that they are very} much interested in the strategic direction of a company and willing to carry out previous research into the possible target (Thomas and Young, 2006). Furthermore, a private equity fund usually has a limited partnership as a legal structure. The general partner (the fund manager) makes investments on behalf of the limited partners who are the external investors and who have limited liability. In addition, the investments of private equity funds are usually illiquid, e.g. the acquisition of a company. Therefore, the investments have a long lock-up period which gives private equity the characteristic of its medium- to long-term investment horizon. Illiquidity of the investment and the high usage of leverage make private equity investments risky but also increase the potential return on investment.

At the moment, the discussion on shareholder activism also includes private equity funds. They are actively purchasing (parts of) public companies after which they delist the company in a public-to-private transaction. This is a specific type of a leveraged buyout and can be very profitable for shareholders. The funds use their stake to restructure the company with the aim to optimize company performance and then sell off the company with a profit through specific exit strategies. Recent targets of private equity funds have been public companies who are struggling with other activist shareholders, e.g. VNU and Stork. There are several advantages for a company to go private. Primarily, going private eliminates the agency problems between management and shareholders which arise in public companies and thus also eliminates the monitoring activities done by shareholders. In addition, management no longer has to deal with activist shareholders. This gives them the ability to focus solely on corporate business. Managerial incentives realignment lowers the agency costs (Renneboog et al., 2007) which creates company value. Furthermore, private ownership gives management the ability of autonomy (Boot and Thakor, 2003) and contractibility of corporate governance arrangements (Pagano, 1993) which can also lead to a more efficient company. For these reasons, private equity investments provide a combination of capital and knowledge of experienced fund managers.

Private equity funds and hedge funds are often mentioned together as alternative investments vehicles. They have similar characteristics: no regulation constraints, a lack of transparency, the usage of high levels of leverage and the usage of performance fees for fund managers.

12 _{The two main types of investments done by private equity funds are venture capital, which focus on small,}

However, there are also significant differences. The main difference between the two investment vehicles is that private equity funds aim to acquire a controlling stake of a company while hedge funds are usually minority investors (Thomas and Young, 2006). They only need a large enough stake to have a voice in the company and to be able to persuade other shareholders of their ideas. Another difference is that hedge funds have a shorter investment horizon in comparison to private equity funds. Most of the recent activism is performed by hedge funds rather than by private equity.

3.4 Value Effect on the Company

The main argument for activist shareholders to get actively involved in a company is to improve performance and company value. Activist shareholders only speak up if the company is experiencing difficulties and if they believe that their actions can improve performance. This makes it difficult to measure the real value effect of activism on the company performance and the causal relationship between activist shareholders and market reactions (Gillan and Starks, 2007). Without active involvement the performance might have been boosted in another way. Furthermore, the company is almost always exposed to many other factors that affect performance which makes it possible that results are “buried in the noise” of these factors (Black, 1998). Taking these limitations as given, in theory, activism can be seen as a possible solution for the agency problem (Shleifer and Vishny, 1986). Activism increases monitoring in a company and thereby reduces agency costs and raises share value (Black, 1992). Activist shareholders target undervalued companies with specific deficiencies. However, activism can be (ab)used by large shareholders for their personal gain at the expense of other stakeholders (including minority shareholders). Furthermore, all activist shareholders have their own incentives and their own limitations which presumable makes some activist shareholders superior in their actions in comparison to others. However, using the hypothesis that shareholder activism is a form of additional monitoring, it should increase efficiency, lower agency costs and have a positive value effect on company performance.

evidence indicates that shareholder activism can prompt small changes in target firms’ governance structures, but has negligible impact on share values and earnings”. He also argues that the mixed empirical finding of other authors is not due to different results but rather due to differences in the metrics emphasized. Black (1997) claims that “the general absence of convincing evidence of a relationship between activism and company performance suggests that activism has, at most, a minor impact on firm performance”. Gillan and Starks (1998) conclude that “while papers have found some short-term market reaction to the announcement of certain types of activism, there is little evidence of improvement in long-term stock market performance or operating performance after the activism”.

To look whether the market perceives activist actions as a positive impulse and thereby alters the expectations about the company, authors have studied price reactions after an announcement of activism. Akhigbe et al. (1997) found strong positive valuation effects over a period of three years for US companies after the announcement of activism. They found even more apparent effects when activism was initiated by individual shareholders. The wealth effects clearly submerge the costs made by the activist shareholder (Akhigbe et al., 1997). In contrast, Gillan and Starks (2000) only found small but statistically insignificant abnormal returns to proxy proposals sponsored by active, individual shareholders. Proposals sponsored by institutional investors, like pension funds, result in small but measurable negative abnormal returns over the period from 1987 to 1994. In addition, Karpoff et al. (1995) found the average effect of shareholder proposals had an insignificant effect on share value.

the three years following an initial form of activism. They did, however, find positive value effects in the short-term but these results are unelaborated.

Monks and Minow (2004) conclude in their work that the most important contribution of public pension funds was perhaps “to make the world an uncomfortable place for a director of an underperforming company”. In general, the above mentioned evidence supports the lack of announcement effects of pension fund activism. Reasons suggested by Black (1997) for this ineffective monitoring ability of pension funds is a lack of activity efforts due to legal rules, internal agency costs, information costs, collective action problems and limited institutional competence.

More recent studies have empirically tested the results of activist hedge funds on company performance. Klein and Zur (2006) found that companies in the United States targeted by hedge funds activism had an abnormal result of 10.3%, while companies experiencing non-hedge fund activism had an abnormal return of 5.2%. This was compared to companies without activism who only had an abnormal return of only 2.9%. Clifford (2007) also found positive wealth effects accompanying hedge fund activism. In addition, Greenwood and Schor (2006) found that US companies targeted by activists had a higher abnormal return both at the announcement date and in the long run; but only if these activists succeeded to persuade the company into merging or getting acquired. If not, average abnormal returns were not statistically positive. They also found that activist hedge funds usually target undervalued companies. This finding is supported by Brav et al. (2006). Their recent research includes US companies targeted by activism over the period 2001 through 2006 and shows an abnormal return of 5% to 7% on corporate performance after the announcement of activism, with no reversal of returns after one year.

Unfortunately almost no research is conducted into this topic for Dutch companies. Stokman (2007) used a sample of companies from North America and Europe and found a short-term significant positive abnormal return after the announcement of activism. However, this effect was partly offset on the medium term. Overall, activist hedge funds create shareholder value, although he concluded that activist hedge funds in North America were more successful in creating value than in European hedge funds (Stokman, 2007).

like highly incentivized managers, the ability to lock-up investor capital, ability to ultimately acquire the target, a lack of regulation and few internal conflicts of interests are of great importance making hedge funds more suitable as informed monitors (Brav et al., 2006). An empirical survey of Gillan and Starks (2007) concludes that the “relatively recent entrance of hedge funds into shareholder activism has provided more evidence on gains from activism”. The question is whether activist hedge funds can hold on to these aggressive strategies and the excessive returns they made over the past years. Brav et al. (2006) find that during the period of 2001 to 2006 abnormal returns of activist hedge funds were steadily declining from 9 percent to 3.1 percent. Gillan and Starks (2007) also argue that the long-term effects are unknown. Since hedge fund activism is a rather new phenomenon, there is a lack of evidence showing these long-term effects of activism by hedge funds.

As other activist shareholders, private equity vehicles have also helped to keep management of public companies alert. Their most prominent form of activism is a public-to-private transaction. Several scientific studies have examined the wealth effects for shareholders of US companies dealing with these transactions. On average, there are significant positive share prices reactions after the announcement of a public-to-private transactions (DeAngelo et al, 1984; Kaplan, 1989; Renneboog et al., 2007; Sudarsanam et al., 2007) and shareholders receive a high premium on their investment (Kaplan, 1989; Weir et al., 2005; Renneboog et al., 2007) when the shares are sold to the fund or to management. These results suggest that activism by private equity funds enhances shareholder value.

4 Involvement of Activist Shareholders

4.1 Types of Activities

One attractive aspect of activism is the possibility for relatively small shareholders to successfully launch actions against management. This can be done by selling their ideas to other shareholders and persuading them to vote for these ideas. There are many different types of activities shareholders can undertake when they are dissatisfied with the way things are going in their company. These activities include speaking out on private and public meetings with management, calling an extraordinary shareholders’ meeting, using the media for publicity campaigns to publicly show the problems in the company, direct negotiations with management, proxy proposals,lawsuits, etc. The next subsections will focus on two activities often pursued by activist shareholders, namely the replacement of one or more top managers and merger and acquisition activities. Section 4.2 explains the incentives for shareholders to buy blocks of shares and the last section discusses the potential disadvantages of activism.

4.1.1 CEO Turnover

composition. Since activist shareholders decide to monitor companies based on their prior performance, there is nowadays a stronger relationship between poor performance and CEO turnover (Huson et al., 2001). Denis et al. (1997) also suggest that ownership structure is an important factor determining internal monitoring efforts. They find that when outside blockholders (see section 4.2 for more information on blockholders) are present in a company, CEO turnover is more sensitive to poor performance and the probability of CEO turnover increases. However, these results are only weak significant.

Activist shareholders pursue strategies to replace top managers, when the supervisory board is ineffective in making these kinds of decisions. It is, however, in the first place the job of the supervisory board. In public companies, the (dispersed) shareholders delegate the job of firing CEOs to the supervisory board. The annual survey of Booz Allen Hamilton (2006) found that nowadays corporate boards were quicker than ever to replace underperforming CEOs. They found that the board was less tolerant to poor performance and was more independent of management. According to Steven Wheeler, Senior Vice President at Booz Allen Hamilton, “it is clearly time to say goodbye to the age of the imperial CEO. Welcome to the era of the inclusive CEO, who embraces and reflects the concerns of board members, investors and other constituencies”.

supervisory board of Dutch listed companies provides evidence to support this finding (van Ees et al., 2003). In companies with smaller boards there is also a stronger relationship between company performance and CEO turnover (Yermack, 1996; Wu, 2000). Finally, the advice according to Boot and Cools (2007) to help the effectiveness of the supervisory board is a larger diversity of people, younger of age, higher rewards and better availability of information to the board.

Performance-related forced resignation of a CEO can boost performance. In theory, if management is performing poorly, increased monitoring and the intended CEO turnover should improve corporate performance. However, empirical research conducted into this issue is however still inconclusive. Denis and Denis (1995) argue that operating performance generally improves after top management changes and especially with a forced turnover. Furtado and Rozeff (1987), Worrell et al., (1993), Kang and Shivadasani (1996) and Dherement-Ferere and Renneboog (2000) also found announcements containing information about CEO replacements to be associated with positive market reactions. Cools and van Praag (2003) investigate the stock price reaction as well as changes in trading volumes regarding a forced management departure. Their results show that turnover announcements are value relevant and that internal monitoring is effective.In contrast with these findings, there are also empirical results that are inconsistent with the theoretical basis of effective monitoring. Warner et al. (1988) also found an average effect of zero on stock price reactions after the announcement of a top management change. Significant negative market reactions to announcements of CEO departures were reported by Mahajan and Lummer (1993) and Dedman and Lin (2002). Hermalin and Weisbach (1998) try to explain this inconsistency of results by using the perspective of investors. A change in management can reveal information on both the board and the CEO. If a CEO replacement is based on public information, no new information is revealed and investors view the firing as good news because the board is apparently independent enough to replace a poorly performing manager. This has a positive effect on the stock price. If, on the other hand, a CEO replacement is based on private information only known by the board, the value expectations of investors lower and stock prices fall due to the negative information revealed.

made by activist shareholders to replace a CEO are viewed as a positive action and can result in a positive share price reaction. Since poor performance is an incentive for CEO turnover, management can feel pressured to obtain high short-term returns in order to satisfy shareholders and to remain in their position. The challenge for management is trying to hold on to their long-run strategies and at the same time realizing short-term profits to satisfy the shareholders.

4.1.2. Mergers and Acquisitions

For many decades merger and acquisition activities have been a major part of business strategies. Mergers and acquisitions tend to occur in waves. The late 1980s, for example, can be characterized by the wave of hostile takeovers and leveraged buyouts (Holmstrom and Kaplan, 2001). In the 1990s, there was a wave of large-size, mostly friendly, mergers and acquisitions influenced by factors like globalization and liberalization. The wave following in the mid 2000s was, amongst others characterized by its involvement of activist hedge funds and other activist shareholders (Lipton, 2006). The high growth levels of institutional investors, like private equity funds, resulted in an increase of buyouts (Lipton, 2006). Shareholders aiming at a continuous increase of shareholder return can focus on M&A activities, including mergers, restructuring, divestments and sell offs, in order to maximize shareholder return.

Others, on the other hand, found no evidence of underperformance for the acquiring company (Bradley and Jarrell, 1988; Franks et al., 1991). Cools et al. (2004) of the Boston Consulting Group analyzed the long-term performance effects of more than 700 US companies and even found that acquisitive growth strategies can create superior shareholder return. They concluded that under the right circumstances, M&A activities can be the best way to achieve value-creating growth.

A reason for these mixed results on corporate performance is that M&A decisions can be motivated by the incentives of management. Roll (1986) argues that hubris and overconfidence of management can lead to overpayment of the target company. There is also a possibility that management pursues personal benefits instead of following the interests of stakeholders. If mergers and acquisitions contain high private benefits for management, they are willing to overpay for the target (Morck et al., 1990), which could possibly reduce shareholder value. A theory presented by Jensen (1986) explains how the strong incentives of management for growth can result in value destroying M&A decisions. Growth gives management the ability to control more resources which increases the power of management (Jensen, 1986). This phenomenon is also knows as ‘empire building’. The danger, however, is that management has the tendency to grow beyond the optimal size of the company and can thereby destroy value. This is especially the case if a company has high free cash flows. Management prefers to reinvest the money instead of paying it out to shareholders. The excess cash is often used by management to invest in negative net present value projects (Jensen, 1989). Another theory to explain why management makes value-destroying M&A decisions is presented by Shleifer and Vishny (1989). This theory is based on management entrenchment in which management is willing to make certain decisions in order to increase their value to shareholders and reduce the probability of being replaced (Shleifer and Vishny, 1989). One of these decisions contains the incentive to diversify in businesses in which the manager has a comparative management advantage, while mergers used for diversification purposes can destroy value (Bruner, 2001; Berger and Ofek, 1995).

and then try to pursue merger and acquisition strategies (Greenwood and Schor (2006). Undervalued companies would probably also be acquired by other companies without the intervention of activist shareholders but activist shareholders can speed up the process. They will contact potential acquirers and can persuade other shareholders to agree with the decisions. In the end, M&A activities can help shareholders to quickly boost the return on their investment. Short-term investment horizons and the often large positions of activist shareholders in target companies makes M&A an attractive exit option for them (Greenwood and Schor, 2006).

To conclude, activist shareholders often get involved with companies who pursue M&A activities. Either to stop value destroying mergers led by managerial incentives or to pressure management into value enhancing M&A strategies. M&A strategies give shareholder the ability to quickly get a high return on investment and to exit easily.

4.2 Blockholders

As discussed in earlier chapters, large shareholders have strong incentives to monitor management. Holding a large block of shares in one company is, however, inconsistent with the modern portfolio theory of Harry Markowitz (1952). This theory states that an investor’s portfolio can be optimized through diversification. Large shareholders do not follow this theory and find other ways to maximize their investment.

4.2.1 Block Premium

Purchasing a block of shares gives shareholders the ability to become actively involved in the company and thereby obtain certain benefits. For this reason, blocks of shares are often sold for a higher price than the market value, a so-called premium (Barclay and Holderness, 1989). Investors are willing to pay a premium for a block of shares if with that transaction they gain the ability to exercise control and thereby receive extra benefits. Barclay and Holderness (1989), Mikkelson and Regassa (1991), Chang and Mayers (1995) and Shome and Singh (1995) found significant premiums on the pricing of block trades to the post-announcement exchange price.

performance is good and will not pay for the additional control. The probability to effectively change the company also affects the value of the premium (Damodaran, 2005). If the probability to change the company is small, the expected value of control is also small resulting in a lower premium. Finally, if there are no extra benefits at all for holding a block of shares, no premium will be paid (Barclay and Holderness, 1989).

4.2.2 Private Benefits

As mentioned in the previous section, private benefits from control are the motivation for block ownership. Private benefits to shareholders can be divided into private benefits due to ownership and private benefits due to control (Hwang, 2005). Private benefits due to ownership are the dividend rights, the voting rights and the received cash flows attached to these rights. These benefits are shared among all shareholders, both minority shareholders and large shareholders. The market value of these benefits is reflected in the share price (Barclay and Holderness, 1989). The benefits due to control are benefits that only accrue to the blockholder and are attained by using the power of control (see section 4.3 on expropriation). Private benefits of control are described by Coffee (2001) as “all of the ways in which those in control of a corporation can siphon off benefits to themselves that are not shared with other shareholders”. The potential private benefits of control are reflected in the block premium. Hwang (2005) argues that private benefits increase slowly in case of more ownership in the company. In case of more control of the company, he found that private benefits increased rapidly. The ability to exercise control of the company was measured by the probability of top executive turnover following a block trade. This study indicates that having ownership is less beneficial for shareholders, while having control of a company can increase shareholder’s benefits greatly.