What Is an Activist Investor?
An activist investor is a firm or can be an individual that buys a significant stake in a company, either without buying any shares and thereby controlling it directly or indirectly through a controlling position in the votes cast by a majority of the voting shares outstanding, but without having any concrete implementation plans.
The characteristics of an activist investor include a long-held belief in an idea, deep pockets, and a history of taking big risks. They are highly unconventional and tend to get involved in issues that most other investors shy away from.
Even then, they are willing to accept a low return on their investment because they believe in the company and its future performance.
Types of Activist Investors
Individual Activist Investors
An activist investor acts as an informal advisor to a target company. They may invest large sums of money, creating buzz about a new target or project in the industry.
When shares are offered on a trading platform, these investors seek out shares that are likely to go up—and sell them when the price falls. Investor advocates work to inform investors of their rights as shareholders and advocate on their behalf.
An activist investor’s objective is to change corporate policy in favor of socially responsible investment. Ideally, the goal of an Individual Activist Investor would be to increase the value of the business they are investing in while minimizing risk.
Advantages of Individual Activist Investors
- Individual activist investors can add value to a company’s stock price by influencing management decisions in favor of individual investors. Individual activists may also provide a “voice” for unexercised shareholders with similar interests.
Disadvantages of Individual Activist Investors
- While individual activist investors have become more influential in recent years, they may not share the same interests or goals as other shareholders resulting in destruction of shareholder value.
- An individual investor could influence a company’s management to take certain actions by purchasing stock when it is cheap and appealing to management by purchasing in pessimistic times. It could be argued that this type of buying is unethical since it could use insider knowledge to influence earnings.
Private Equity Firms
These are investors to achieve the goal of bringing about change in a company. They do this by arguing for changes in legislation, typically to improve shareholder value.
A key benefit of this investing is avoiding personal tax liability, as the proceeds from selling an asset are used to offset some or all of your income. Most private equity firms have limited partners who own a significant fund or general partners who assume unlimited liability.
Private equity firms are especially beneficial for investors with large estates and very high-income levels because they can pass along personal tax savings to their estate. Private equity funds may raise money from private investors or institutional investors who pledge preferred or debt capital.
Advantages of Private Equity Firms
- Private equity firms work with companies so that they help them grow by taking stakes in them and increasing their value.
- A private equity firm will also work with you throughout setting up your new business, including helping you prepare the initial business registration and financial statements with the applicable governments.
- A private equity investor can help you accelerate your growth by bringing valuable talent and additional capital to your company.
Disadvantages of Private Equity Firms
- The disadvantages include high average debt service and capital outflows since firms must invest in themselves. Usually, if a private equity firm invests in a company at its early stage, it may not have enough liquidity to service its debt when it needs to do so in the future, though this may not always be the case.
- Private equity funds may take on risky investments in addition to the stocks, properties, and debt of a company to which they already have a significant position. They may also use unconventional methods to gain additional shares of the company without selling additional assets.
They invest in public markets such as stocks, bonds, and real estate. This type of investment requires having access to vast amounts of capital to make changes in the market through systematic buying and selling of stocks and other securities.
The focus is on generating returns through short-term trading to achieve significant gains over time. Hedge funds, in short, are funds that invest in high-risk, high-reward investments. They specialize in companies with technical or fundamental weaknesses and later come into the investment business than traditional active managers.
Activist investors bring their management and economic expertise to bear on a company they believe has been mismanaged and isn’t doing what’s best for its stakeholders. They believe ownership of a company should follow the best interests of its current employees, customers, investors, and society at large rather than the bottom line.
So, in addition to buying out businesses, they may also try to promote changes on behalf of their shareholders through protests and demonstrations.
Advantages of Hedge Funds
- The primary advantage of a hedge fund is that it can generate alpha without following specific strategies. That means your money will be taxed at ordinary income rates when it is invested, but because the hedge fund doesn’t follow specific strategies, it doesn’t pay capital gains when it comes time to sell
- Hedge funds usually have more experience in making quick decisions than other funds, making them a good bet when you’re short on time. They also have the resources and skills to analyze a company’s industry relative to other funds and make investment-grade selections based on those factors. This saves hedge fund managers time and money.
Disadvantages of Hedge Funds
- However, the biggest drawback of hedge funds is that they are highly speculative; therefore, they are not appropriate for everyone.
- Hedge funds are not only controversial but have also been proven ineffective at achieving long-term results. The reason for this is only because a successful hedge fund usually takes years to build.
- Another biggest disadvantage of hedge funds is the high volatility of returns. The overall hedge fund industry has grown exponentially in the last ten years, yet the average hedge fund investor has lost money over this same period.
How does activist investing work?
Activist investors are generally experienced, business-savvy individuals who run hedge funds or private equity firms or are high-net-worth individuals. Typically, activist investors also have considerable analytical skills. They create an independent valuation, then share actionable investment advice to the companies’ management teams.
An activist investor is a stockholder who recognizes that a company may be underperforming and makes recommendations to strengthen it.
The key characteristics of activist investing include
- Identification of potentially risky investment opportunities.
- Directness towards those opportunities.
- Focus on maximizing the capital gains or return on investment (ROI) rather than renting out your stakes.
- Ability to move quickly between positions and change strategies when hit by adverse market conditions.
- Deep knowledge of corporate law and regulations.
This is how activist investors work
- Buy a large amount of shares of the target company- Investors who hold more than 5% of capital in a public company must file disclosure to the US Security and Exchange Commission (SEC). The disclosure informs the SEC that the investor aims to influence the company’s future.
- Publicly propose a specific set of changes for the company- An activist investor attempts to impact a company’s bottom line by advocating for major changes at the board level. The purpose of changing a company is to increase shareholder value.
- Negotiate with the board of directors- An activist investor holds a significant equity stake in a company and tries to influence management by influencing other shareholders.
- Pursue additional measures as necessary to effect the desired changes- When negotiations stall, the investor escalates to working with other shareholders, typically through a special resolution. With enough support from fellow shareholders, the investor can win control of the board. Once on the board, the activist has enough influence to ensure that changes are made to ensure improvement.
- Sell all shares once the specific objectives are achieved- Typically, activist investors who are also members of the company’s board of directors have restrictions on the number of shares they can sell over a while after their recommendations are implemented.
Activist investing strategies
Activism is a form of value investing that takes a more aggressive approach. Its basic principle is to flip companies from a passive position to an active one. It involves pressuring the management and the board of directors to implement a specific plan to increase its value. This change will most likely increase in stock price.
An activist investor has a contrarian view when they see key weaknesses or problems resulting in undervaluations that they also envision strategies that they believe will increase shareholder value.
The initiatives proposed by activist investors can be divided into four categories
Activist investors commonly propose operational cost reductions, along with strategies to increase revenue to improve a company’s long-term viability.
2. Strategic transactions
An activist investor may insist on splitting a company into separate divisions to increase value. This can include spinning off underperforming assets.
3. Capital allocation and structure
When a company doesn’t perform as well as shareholders had hoped, activist investors may use various methods to pressure management and try to improve the company’s direction.
Activist investors can improve company performance by suggesting that the company replace its board with directors who better understand shareholder interests.
Famous activist investors
1. Bill Ackman
Bill Ackman is a veteran investor with twenty-five years of experience. He is a billionaire and founder of the $20 billion hedge fund Pershing Square Capital Management. Bill Ackman’s hedge fund Pershing Square is listed on the New York Stock Exchange.
2. Daniel Loeb
Daniel Loeb is a business magnate, investor, and well-known philanthropist. In 2008 he formed Third Point Management LLC and currently serves as chairman and chief executive officer.
In 2007, Loeb founded the $14 billion hedge fund Third Point Partners LP with $500 million managed by him and about $7 billion managed by Loeb’s team. Forbes ranked Daniel Loeb 7th on its list of highest-earning 1% of Americans with an estimated income of $590 million.
3. Carl Icahn
Carl Icahn is a billionaire investor, CEO, and corporate raider famous for making bold bets. He’s never short a bet.
4. Barry Rosenstein
Rosenstein is a prominent activist investor and founder of the hedge fund Jana Partners. In 2017, Rosenstein took credit for being instrumental in convincing Whole Foods to be acquired by Amazon. Rosenstein’s fund realized a $300 million profit on the transaction.
5. Nelson Peltz
A famous investor named Nelson Peltz is known for his activist investing strategies. He began pressuring General Electric to appoint a new CEO two years before the company did this. One of his founding partners, Ed Garden, is now a board member of General Electric.