by Dr Shaoting Pi, Research Associate, Cambridge Centre for Finance and Cambridge Endowment for Research in Finance
Activist shareholders, who exert a large influence on firms’ policies, typically only own small stakes and frequently interact with fellow shareholders of target firms. Recent empirical evidence (eg, Crane, Koch, and Michenaud (2019), McCahery, Sautner, and Starks (2016), and Wong (2019)) also suggests that shareholder collaboration has been substituting for concentrated holdings on corporate governance and is orchestrated rather than spontaneously arising. However, it is largely unexplored how a lead activist shareholder organises shareholder collaboration in the first place. In particular, how does the lead activist shareholder convince fellow active shareholders to collaborate on activism? How does the lead activist win over passive shareholders? Is a larger coalition including more fellow active shareholders more convincing to passive shareholders? What is the optimal size of the lead activist’s coalition?
To answer these questions, I present a model in which an activist with small stakes launches a shareholder campaign to force her proposal on the target firm. The model captures the heterogeneity of the activist’s fellow shareholders; there are two types of fellow shareholders, active and passive. On the one hand, active shareholders can actively engage in the activist’s campaign, such as by communicating or collaborating with the activist. On the other hand, passive shareholders do not actively join the campaign but can vote with their shares if a proxy fight occurs. Passive shareholders will vote against the activist unless convinced that the activist’s proposal has sufficiently high value.
My analysis underscores two problems that the small activist must simultaneously overcome. The first problem is how to afford the shareholder campaign. The second problem is how to win support from passive shareholders. I first analyse how the lead activist shareholder overcomes these two problems, respectively. Then, I analyse how the interplay between these two problems can endogenise the optimal size of the activist’s coalition with fellow active shareholders.
To mitigate the first problem, the lead activist shareholder seeks to communicate and collaborate with fellow active shareholders. The activist needs to figure out a persuasive communication strategy and design the optimal collaboration contract. I find that the activist, to persuade coalition members to collaborate, must reveal her information to them. As a result of the communication and collaboration with coalition members, the activist’s coalition is akin to a fictional large shareholder who collectively owns the shares of the activist and coalition members. Thus, building the coalition with fellow active shareholders enables the lead activist to afford shareholder activism costs more easily, mitigating the first problem.
We might expect that the activist would therefore enlarge the coalition as much as possible. However, perhaps surprisingly, I show that the activist must limit her collaboration with fellow active shareholders to win over passive shareholders. I first show that the activist’s messages are not persuasive to passive shareholders in equilibrium. The intuition is that passive shareholders do not take the activist’s messages at face value, while the lead activist has incentives to exaggerate the value of her proposal. So, when the activist launches the costly proxy fight, passive shareholders know that the activist’s payoff from implementing her proposal is higher than her expenditures on the proxy fight. In other words, passive shareholders’ expectation of the proposal’s value is conditional on the activist’s expenditures on the shareholder campaign. The higher expenditures the activist has to undertake, the higher expectation of the proposal’s value passive shareholders have. From passive shareholders’ perspective, if the activist is willing to undertake more costs from having a smaller coalition, then this can convincingly signal that the activist’s proposal has a high value. Consequently, to convince passive shareholders that the value of the proposal is sufficiently high, the activist needs to limit the size of her coalition.
Recall that the lead activist must solve the two problems at the same time. The analysis above reveals that building a coalition with fellow active shareholders mitigates the first problem (how to afford activism costs) but exacerbates the second problem (how to win over passive shareholders). Accordingly, the activist must strike a balance between enlarging the coalition to have more fellow active shareholders share more costs and shrinking the coalition to convince passive shareholders of the value of her proposal. Taking this quest as a starting point, I derive the optimal size of the activist’s coalition.
In equilibrium, because the activist can optimise her coalition-building to simultaneously overcome the two problems (how to afford the campaign and how to win the campaign), the activist’s coalition makes the proxy-fight threat more credible to the board in equilibrium. As a result, considering the higher risk of losing the proxy fight due to potential shareholder collaboration, boards are more likely to reach agreements with activists before proxy fight voting.
Overall, this paper finds that collaborating with fellow active shareholders spreads activism costs but jeopardises passive shareholders’ support, which endogenises the optimal boundary of shareholder collaboration. It also suggests that the prevalence of shareholder collaboration may contribute to the new trend that activists and boards reach agreements before proxy-fight voting much more often than in the past.
Crane, A.D., Koch, A. and Michenaud, S. (2019) “Institutional investor cliques and governance.” Journal of Financial Economics, 133(1): 175–197
McCahery, J.A., Sautner, Z, and Starks, L.T. (2016) “Behind the scenes: the corporate governance preferences of institutional investors.” The Journal of Finance, 71(6): 2905–2932
Pi, S. (2020) “Speaking with one voice: shareholder collaboration on activism.” Available at SSRN 3599237.
Wong, Y.T.F. (2020) “Wolves at the door: a closer look at hedge fund activism.” Management Science, 66(6): 2347-2371