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Barbarians at the gate

Finance

Low cost, high impact: the new ‘Barbarians at the Gate’

Published 14 May 2021 in Finance

In 1988, the leadership of private equity firm KKR believed that food and tobacco giant RJR Nabisco was badly run and bid for the company’s shares. KKR went on to execute one of the most notorious leveraged buyouts (LBO) in history, depicted in the book and film Barbarians at the Gate: The Fall of RJR Nabisco.  

The playbook for that era’s wave of corporate control transactions went as follows: identify an underperforming company, mount a bid to acquire it with borrowed money, replace management and overhaul governance, restructure the company to help it flourish again, and eventually sell it on for a hefty return.  

If you think through the chain of events required for that playbook, you soon realize that you need a significant range of capabilities to come out on top. 

First, you need the analytical skills to determine the extent of the undervaluation of the company and the right levers needed to improve performance. Second, you need access to enough capital to put into the deal and, additionally, the power and infrastructure to raise additional money, be that equity and/or debt.

After all, you need the financial firepower to acquire 51% of the outstanding target shares (or the minimum that would allow you to actually exert control), including, of course, the ability to convince your stakeholders. And last, but not least, you need to have the execution power to implement all those changes that you envision could improve the performance of the company – and its stock price.  

Each of these stages requires different skills: financial analysis and business acumen in the first stage, the ability to raise and deploy capital in the second stage, and managerial, operational and execution capabilities in the last one. It goes without saying that not many organizations have what it takes to line up all of these.

The corporate control value chain The corporate control value chain 

Low-cost alternative

Over 30 years later, the classic corporate control approach has been revamped by activist shareholder campaigns, but the overarching objective remains broadly the same: foment value-enhancing changes in companies and benefit from the resulting improvement in stock price. There is evidence that shareholder activism – where investors take stock positions to bring about change in a company – is associated with positive stock price reaction. That is, the model works even if there have been notable exceptions and even if the jury is still out on the short and long-term price implications.

While the objectives may be similar, shareholder activism represents an interesting twist in the corporate control game. We argue that shareholder activism is, in fact, a “low- cost” version of the corporate control business model that makes it easier to execute in today’s uncertain environment. Here are three key factors fueling the surge of the new “Barbarians at the Gate”:

First, small(er) stakes will do

One important difference between an acquisition and an activist campaign is the stake acquired. While you need a large amount of capital to complete an acquisition, active shareholders only need a small fraction of that money to achieve their objectives.

Third Point LLC, one of the main players in this market, bought 0.3% of The Walt Disney Company in 2020 to push the company to buy more content rather than paying a dividend. It bought 0.5% at Intel when urging it to explore strategic alternatives and deal options. Elliott Investment Management L.P. bought 4% of Twitter when asking to remove its CEO, and 3% of Softbank when seeking a share buyback and improved corporate governance. This lower threshold for impact makes it easier to raise and deploy the capital to launch a shareholder campaign.

There is evidence that  shareholder activism is associated with positive stock price reaction
- Salvatore Cantale and Luigi Rizzo

Second, greatly reduced risk

Furthermore, while the required stake may be smaller, an activist transaction can be made even cheaper if executed using derivative positions such as “collars”. In 2019, when Elliott acquired a stake in the Italian incumbent telecom operator TIM, it established a collar agreement with JP Morgan. According to the Financial Times, a similar funded equity collar was put in place by Edward Bramson with Bank of America, on a substantial portion of his stake, again in 2019, when he took his 5.5% position in  Barclays, the British bank.

Collars are created by taking a position in a stock plus a combination of long (buy) put options and short (sell) call options. The long put option helps to limit the downside risk associated with a concentrated equity position and the short call option, while capping the upside potential of the equity position, helps to defray the cost of the put options.

Because collars reduce the risk of a stock position, banks are willing to increase the amount of money offered to their clients from 50% to around 85% of the entire transaction. As such, the amount of own funds necessary to build a successful campaign is further reduced. 

Third, no execution needed

While active shareholders need to have first-rate board level skills and capabilities, they rely on the target company for execution responsibility. The breadth of required skills needed to execute the necessary sweeping changes in a corporate acquisition are less relevant in the case of an activist campaign.

This also implies that the time needed to obtain the desired positive price reaction could be much lower. Indeed, this kind of short-term intervention has been highlighted by those concerned about the potential misalignment of some activist shareholder campaigns with long-term value creation for a company. It is very possible that the time between an activist shareholder entering and exiting a transaction could be a matter of months, rather than the years associated with a corporate acquisition.

In the case of KKR and its buyout of RJR Nabisco, for example, the private equity firm took some 17 years to complete its exit. During that time, KKR needed the capabilities to tackle strategic questions such as where to invest or what assets to sell as well as execution decisions such as where to save money and who to appoint as CEO. By contrast, activist shareholders have a time horizon for their interventions that rarely stretches beyond 36 months, and is often much shorter.

These “easier” conditions created by poor stock price performance – often represented by lower potential growth prospects – higher levels of uncertainty and even poor ESG records offer a Trojan horse opportunity for activist shareholders. In this market landscape transformed by COVID-19 with shorter value chains, lower initial capital requirements and a fraction of the skills needed in a corporate control takeover, the stage is set for more low-cost, high-impact transactions.

Authors

Salvatore Cantale - IMD Professor

Salvatore Cantale

Professor of Finance at IMD

Salvatore Cantale is Professor of Finance at IMD. His major research and consulting interests are in value creation, valuation, and the way in which corporations structure liabilities and choose financing options. Additionally, he is interested in the relation between finance and leadership, and in the leadership role of the finance function. He is the Program Director of the Business Finance program.

Luigi Rizzo banker

Luigi Rizzo

Retired Managing Director for Bank of America

Luigi Rizzo served as Managing Director for Bank of America. He was Head of Investment Banking for Europe, Middle East and Africa (EMEA) for Bank of America Merrill Lynch. He was previously head of Mergers and Acquisitions in the region after joining the bank in 2013 from Goldman Sachs.

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