Activism: ‘Mixed year’ comes to a close with rise in small-cap campaigns

Shareholder activists have seemingly found greater success with smaller-cap campaigns than when targeting mid and large-cap firms this year.

That’s according to new research delving into what has been a ‘mixed year’ for activism and M&A, though interest in the small-cap space is apparently at levels not seen since Q4 2020.

While figures are ‘somewhat cloudy’ for the second half of 2023, with a number of campaigns yet to reach a conclusion, research shows that in H1 2023 the majority of large-cap campaigns (81 percent) ended in failure for the activist.

‘This trend reversal and increasing success in the smaller-cap space could be a result of many different factors, such as the activists’ ability to buy a larger stake in a smaller company, the costs associated with a lengthy proxy contest for issuers, perceptions of a near-term recession for both sides, and others,’ writes FTI Consulting in its final activist vulnerability report of the year.

FTI also points to the universal proxy card (UPC) as a possible driver of the successes being found at small-cap targets.

‘The new rules certainly seem more burdensome for smaller companies as it becomes more costly to defend each and every incumbent director up for election,’ the firm notes. ‘Perhaps it is not surprising that we are seeing activists win more often in this segment of the market than in the large-cap segment, where companies have much more capital to fend off any advances.’

While UPC might be making small-cap wins more likely, FTI says the rule change ‘did not influence outcomes when measured by changes to board seats’. In fact, activists gained 95 board seats at US companies in H1 2023, down on the median gain of 132 seats in the first half of each year from 2017 through 2022.

Interest rates and double dipping

Researchers point to the current rate environment as a further factor in the shift toward smaller-cap campaigns.

‘Higher interest rates inhibit the ability of smaller funds to use leverage while executing a campaign,’ hypothesizes FTI. ‘As a result, the ability of such funds to build meaningful positions in larger companies is limited unless they are willing to take on a much higher level of risk. With rates as high as they are, one advantage of larger activist funds is their ability to hold an equity stake for a longer period of time, despite market volatility.

‘Smaller funds may find it difficult to hold a leveraged position in a large company experiencing a downturn. Therefore, investments in smaller firms are more attractive because an influential stake is attainable with less capital.’

Indeed, the firm points to a trend of ‘double dipping’ at big funds. Citing examples of Starboard Value at LivePerson, Legion Partners at OneSpan and Trian Fund Management at the Walt Disney Company, FTI says that ‘instead of cutting losses on underperforming investments and finding new opportunities to allocate capital, [large activist funds] double down and reignite their previous campaigns.’

Inside UPC

Going back to the introduction of UPC, FTI notes that original expectations – that there would be an uptick in campaigns, as well as a higher likelihood of success – have not materialized so far.

‘Looking at the top-line numbers, this year’s proxy season initially appears similar to the last few seasons,’ points out FTI, citing Insightia numbers that show 403 US-based companies were publicly subjected to activist demands in the first half of 2023, similar to the 362-448 figures seen in the first half of any year between 2017 and 2022.

‘[But] a deeper look reveals several notable differences,’ adds FTI, including the fact that ‘in the past, activists winning board seats without support from both major proxy advisers – ISS and Glass Lewis – was extremely rare. This year was a different story.’

Biotechnology most vulnerable

Each quarter, FTI assesses sector vulnerability to activism campaigns. And as the year draws to a close, research points to the biotechnology industry as the sector most vulnerable. ‘Post-pandemic cash flow normalization, more expensive financing and increased regulatory pressure have taken a toll on the industry,’ note researchers. ‘As a result, operating performance is down, which has dragged down share prices and opened the door for activists.’

Elsewhere, Tom Kim, managing director for activism and M&A solutions at FTI, notes in a statement: ‘The consumer durables industry experienced a sharp upward move to the 10th spot based on our screener. We attribute this to softening demand for higher ticket goods and weaker financial conditions due to the impact of higher interest rates. Looking ahead, we would expect ongoing softness to persist until borrowing costs decrease.’

Other big movers include the automotive industry (up nine places to 12th), restaurants (up seven places to 15th) and financial conglomerates (up 12 to 19th).

‘Since our previous report, workers at several automakers went on strike, seeking a new contract. The strike is now over but, in the short term, it disrupted production,’ says Kurt Moeller, another managing director for activism and M&A solutions at FTI. ‘Longer term, the increased labor costs may result in lower profits for shareholders at automakers.’

The firm also shares insights into the rise in vulnerability in the restaurant sector, with Ryan Chiang, also a managing director for activism and M&A solutions at FTI, describing the industry as having been ‘battered in 2023’. While it rose seven places over the previous quarter, the sector has in fact gone from 30th in Q1 2023 to 15th today.

‘Inflation has hit the industry hard, driving up food and labor costs while simultaneously draining consumer sentiment, resulting in slowing sales growth,’ continues Chiang. ‘Activist activity has already emerged within the industry, particularly in casual dining, where consumer traffic and same-store sales have diminished while margins remain compressed. Activist activity will likely continue in this industry until we see substantial operational and demand changes.’