Activist investors - current trends and implications for boardrooms in Germany

Activist investors have been a part of the capital markets environment in which listed companies operate in Germany for many years. While the financial means available to them and the number of campaigns have continued to increase in recent years, their strategies and basic approach have not changed substantially. What has changed are the issues that activists are now focusing on and their coordination with other investors, stakeholders and proxy advisors. The management board and the supervisory board of German listed companies should be prepared for this.

An activist investor generally attempts to exert influence on the management board and supervisory board through a small shareholding which is often below the 3% reporting threshold under German capital markets law. Their aim is to achieve changes in the company’s corporate strategy, capital structure or corporate governance or to leverage special situations (such as M&A transactions). Usually they do not primarily put pressure on the boardroom through legal means, i.e. minority rights available under stock corporation law. Often, such rights are not even open to them because their stake in the target is too small. Instead, they rely on the public, other investors and stakeholders and on influential proxy advisors such as ISS and Glass Lewis to add weight to their demands.

ESG Activism and back end speculation in German takeovers

Over the last years, there has been a remarkable change of focus towards topics from the realm of ESG (ESG Activism). Depending on the target company, the emphasis is more on the E (environment), S (social) or G (governance) aspects; sometimes the arguments are also combined. Institutional investors and proxy advisors are often supportive when it comes to ESG aspects. They have become increasingly mindful of these matters, partly because of regulatory changes and partly because they know that sustainability risks cannot be diversified. Additionally, the idea of stewardship, i.e. the active involvement of investors in their portfolio companies, has gained ground in recent years in Germany as well.

One prominent example of an ESG-driven campaign is the engagement of Enkraft Capital in German energy company RWE this September. Enkraft, who reportedly holds a stake of only 0.074%, called on RWE in an open letter to wind down its brown coal operations faster than planned and to divest them at short notice. It claimed that otherwise a debate about board composition might be inevitable. Another example this year is the campaign by hedge fund Engine No. 1 at Exxon Mobil in the USA. Although the newly created fund holds a stake of just 0.02%, they criticised Exxon Mobil’s strategic approach and called for it to move towards creating long-term and sustainable value. Supported by large institutional investors (BlackRock, Vanguard, State Street and various pension funds) as well as ISS and Glass Lewis, Engine No. 1 managed to persuade the general meeting to elect three of the four candidates proposed by Engine No. 1 to the twelve-member board of directors.

Apart from changes in corporate strategy, financing or corporate governance, certain hedge funds have specialised in public takeovers in Germany. They buy a stake in the target company during a public takeover and try to tender just enough shares to ensure that the minimum acceptable threshold in the takeover bid is reached and the offer is successful in the first place. Their actual aim is to retain a large block of shares in order to benefit from the bidder trying to achieve the usually higher thresholds necessary for a subsequent corporate reorganisation (e.g. intercompany agreement, squeeze-out or delisting). If the hedge funds do not tender enough shares during the tender offer, the bid can initially fail, as could recently be seen in the takeover of Deutsche Wohnen by Vonovia. Since the pay-out to the minority shareholders in the corporate reorganisation under German corporate law is in principle based on the intrinsic value of the target company, it can happen that the bidder has to pay a higher consideration than in the takeover bid (even if the bid initially was successful). Thus, this special situations tactic can be financially attractive from the point of view of hedge funds, despite the fact they ultimately exploit the corporate law rules designed to protect minority shareholders.

Generally speaking, German law does not set any hard and fast limits on these activities of hedge funds. While it is true that civil law and corporate law set boundaries for rather extreme cases (e.g. through the duty of loyalty applicable to shareholders), these limits are rarely relevant in practice. Capital markets law also sets certain limits by prohibiting market manipulation and insider trading. Apart from this, it provides for transparency requirements such as the disclosure of shareholdings of 3% or more of the voting rights, the investor’s declaration required for holdings of 10% or more (in which the investor’s intentions and the origin of the funds have to be disclosed), and the transparency of net short positions starting at 0.2% towards the German financial regulator BaFin and 0.5% towards the public. Also, if the criteria for acting in concert are met, this can lead to reciprocal attribution of voting rights for reporting purposes and under takeover law which can have an impact on the joint actions of shareholders. Hedge funds, however, are not fazed by such things. They have ample resources and often plan their campaigns over a longer term and on a sufficiently professional basis. As a result, they are rarely caught out by “legal accidents”.

What does this trend mean for management boards and supervisory boards in Germany?

Larger listed companies and especially conglomerates should have a standard activism preparedness programme in place which includes in particular (i) an outside-in review of potential areas of weakness (focusing on operational and strategic aspects, capital structure, equity story and corporate governance, including executive compensation), (ii) actively managing the business portfolio through spin-offs and divestments to reduce valuation discounts, (iii) reviewing investment opportunities and strategic acquisitions, (iv) considering distributing excess cash to shareholders, and (v) preparing teams and communications for potential activist campaigns.

Alongside these measures, active shareholder management is a must. This covers three things: firstly, the management board and supervisory board need to know who the company’s owners are. The EU Shareholder Rights Directive II can help to identify major shareholders; in addition there are capital markets providers specialising in identifying key ultimate shareholders. It is crucial to look beyond the immediate owners and to know who makes the decisions on how voting rights are exercised. For example, if a fund manages pension assets from California or Canada, it makes sense to look at what drives these underlying owners. Secondly, the management board and (within the legal framework) the chair of the supervisory board should be in close contact with key investors. Activist investors prepare their campaigns and pinpoint potential support in the shareholder base before going public. Communicating with key investors helps identify potential issues that could become the subject of a campaign. Insider rules may limit this communication in certain cases, but generally do not stand in the way of close interactions with key shareholders. Thirdly, it may be advisable to actively seek an anchor investor to stabilise the shareholder base and prop up the company’s long-term corporate strategy. In principle, while looking for an anchor investor is legally possible, the details depend on which structure is chosen (for example if a cornerstone investors buys a stake in a 10% capital increase).

Additionally, the key task of the management board and the supervisory board – to take responsibility for the company’s strategy taking into account key stakeholder interests – is becoming increasingly important. In contrast to a pure shareholder value approach, German corporate law has a broader concept of corporate interest. For example, employees, customers and suppliers are typically also counted as relevant stakeholders. The currently prevailing view in Germany is that the environment or other matters of public interest are as such not relevant stakeholders, but they can play a role in corporate decisions within the framework of the “business judgment rule”, in particular due to the effects of business decisions on the company’s reputation. This broader understanding of corporate interest gives the management greater leeway when determining what is in the company’s best interests and what promotes the long-term strategy than a pure shareholder value based approach. Of course, the German-style pluralistic concept of corporate interest is no excuse for obvious performance issues; shareholder interests play a key role when determining the corporate interest. However, taking into account also the dualistic board system (where the supervisory board is primarily responsible for monitoring the actions of the management board), the management board is conceptually further away from shareholder interventions than for example the board of a publicly listed company in the USA.

This has implications when preparing and responding to hedge fund activities: if a hedge fund calls for an action to be taken (such as the divestment of a business unit due to sustainability risks, the investment of high cash balances in new business areas, e.g. to promote digitalisation or sustainability, or the return of capital to shareholders) it is the management board’s and the supervisory board’s task to assess these demands against the backdrop of the company’s interests. This requires a comprehensive assessment taking into account the relevant stakeholders of the company. Even though ESG-related goals are increasingly at the forefront of activists’ campaigns, it may well be that the actions called for are primarily aimed at improving the share price in the short term. Activists can provide input and push for necessary changes (such as actively reviewing the investment portfolio in order to create a clearer corporate strategy). But they can also put the long-term value of the company and material stakeholder interests at risk. It is the key task of the management and supervisory board to decide on the right strategy within the scope of their entrepreneurial discretion and then communicate it to the capital markets and the public. In times where hedge funds campaigns are becoming more and more comprehensive, emphasising sustainability issues and ethical standards, the factors reliability, creditability and a true long-term approach play a key role on the public stage and the capital markets. Looking at the planned measures of the European Union (e.g. on sustainability reporting and sustainable corporate governance – the latter being highly controversial) and the strong flow of capital into ESG and sustainability-related funds, these issues are likely to become even more crucial. This also makes being prepared for the new, comprehensive hedge fund activism all the more important, especially for companies that have done little in this area up to now.