When the Minority Shareholder Is Calling the Shots

THINGS CHANGE WHEN HEDGE FUNDS DRIVE SHAREHOLDER ACTIVISM THROUGH THE PURCHASE OF 10% OF THE CAPITAL WITH VOTING RIGHTS, AND GAIN CONTROL WHEN OTHER SHAREHOLDERS JOIN THEM

by Gaia Balp
Translated by Alex Foti


The phenomenon of shareholder activism by hedge funds is growing strongly on both sides of the Atlantic. These are campaign drives, where, by purchasing a significant stake in a target company (close to 10% of equity capital with voting rights) hedge funds start more or less aggressive initiatives, often leveraging the seats obtained in the company’s board of administration. They push through significant changes to governance, strategy and financial structure, so as to increase stock value and then divest from the company when the desired capital gain is attained.

Increasingly often, the campaigns are successful, in the sense of the corporate issuer implementing activist proposals. Among the reasons for the success of hedge fund activism there is certainly the considerable level of support that the proposals put forward are able to obtain from co-shareholders, in particular from non-activist institutional investors. In selecting the targets, the activist funds therefore tend to concentrate on issuers whose shareholder base has a significant presence of institutional investors.

This does not mean, however, that the activism of alternative funds focuses only on public companies with dispersed share ownership: listed companies with controlling shareholders are also targeted. Among the factors that contribute to making this result possible, a key one is a regulation of company law that favors instruments to protect minority shareholders, such as the right to appoint so-called minority board members. This right is guaranteed in Italy by the list voting system and is made possible in other systems by virtue of various mechanisms. The potential aggregation of significant voting power in support of minority members, due to likely support of other co-shareholders, encourages the launching of activist campaigns even in companies with controlling shareholders.

It is precisely with reference to this type of company that there is widespread conviction that the activism of hedge funds can have the effect of disciplining controlling shareholders. Such activism is believed to mitigate the conflict between majority and minority shareholders and favor the exercise of stewardship by non-activist institutional investors.

These potential benefits of activism, however, must be assessed on the basis of a necessary and fundamental distinction between situations of legal control and situations of de facto or working control. One Italian case can be a good example. In 2018, a big Italian company was the target of an activist campaign led by a major US hedge fund, which seized on the difference between control based on the absolute majority of voting rights in the shareholders’ assembly (legal control), and control is based on a relative majority, however stable (working control). In that case, the interrelation between factual and legal instruments determined the overcoming of voting power by controlling shareholders and the passage of the majority of seats on the board to minority shareholders, with consequent termination of the former’s control despite the absence of any change in ownership structure and voting rights.

Potentially, the most significant, and probably unexpected, effect is that corporate governance could become less efficient than that in a normal situation of de facto control. The presence of a controlling shareholder with greater exposure to the performance of the business strengthens its commitment to the company and pursuit of the entrepreneurial vision, which benefits all shareholders. However, the instability inherent in a situation where the normal majority-minority relationship gets reversed increases the likelihood of conflict within the board regarding strategic orientation, without ensuring that traditional institutional investors maintain their support for controlling shareholders. On the other hand, the activist fund that imposes its agenda on the board runs the risk of being in term qualified as a de facto controlling shareholder, something which would subject it to heavier regulatory requirements. That would have an adverse impact on the hit-and-run business and investment model which is typical of hedge funds.