This article will discuss strategies and tactics shareholder activists employ in the controlled and blockholder-influenced company universe of Hong Kong, where 80–90 percent of all listed public companies (or listcos) are controlled by families or at least dominated by significant blockholders, and the best ways to counter them. This remarkable shareholder concentration in Hong Kong stands in stark contrast to the US and UK where a quite different distribution of share ownership prevails and public corporations predominantly exhibit free float, dispersed and widely held share ownership. In fact, the shareholder distribution pattern of Hong Kong is much more similar with the share ownership concentration on the European Continent and in Germany, where approximately 60 percent of all public companies are either controlled or blockholder-dominated.
Shareholder and hedge fund activism have ascertainably become an influential, if not dominant, force in corporate governance and corporate law evolution in the US and in Britain. Additionally, the movement received worldwide attention and fueled imagination about value creation, corporate strategy, operative efficiency and corporate governance improvements on a global scale, a debate that spilled over to the European Continent and to Asia and triggered intense controversies; but even informed observers have remained divided about its impact in jurisdictions outside the US and the UK. While there is growing awareness in Hong Kong and Germany about activism as a market phenomenon, widespread misperception about or even denial of activist campaigns and interventions having any impact on governance and the corporate markets in China and Continental Europe still obfuscate reality and prevail, when, in fact, shareholder engagement and activism have become influential, if not pervasive, in these markets just the same.
This three-part series will discuss shareholder and hedge fund activism in Hong Kong and Germany. In Part 1, we discuss the parameters and framework for shareholder activist demands and hedge fund activism across both jurisdictions. In Part 2, we delve into further commonalities and dissimilarities between activism in Hong Kong/China and Germany/Continental Europe by introducing empirical evidence of wide-ranging shareholder engagement and hedge fund activist interventions in both jurisdictions, belying the frequently encountered denial of their very existence. In the final Part 3 (which will appear online only), we argue that the dominant theme in Hong Kong and simultaneously the pragmatic common ground of shareholder and hedge fund activism between Hong Kong/China and Germany/Continental Europe is the notion of shareholder engagement; and we will conclude with a couple of strategic and tactical recommendations for outside counsel and solicitors interested in this evolving practice area.
Hong Kong-Germany Connection
In spite of Hong Kong’s English legal heritage and indebtedness to US legal evolution, it may be surprising to learn that there are deeper commonalities between the Hong Kong and German public company market structures than between Hong Kong and either the US or UK markets.
Such varying degrees and differences in shareholder population concentration impact on minority shareholder rights and how activist shareholders proceed strategically and tactically in order to influence portfolio companies with deliberate interventions and campaigns designed to unlock shareholder value. Thus, analyzing activism trends in Hong Kong and Germany, given their similar ownership distribution and concentration in companies, seems fruitful from a comparative legal and economic perspective in that it helps to illuminate how corporate governance and corporate law may evolve in response. Also instructive is the fact that Germany is representative of Continental Europe, while Hong Kong is somewhat emblematic for China as her gateway to international capital markets; at the same time, Hong Kong/China and Germany have two of the most powerful economies outside of the US and UK.
Influencing Decision-Making through Informal Mechanisms
Since activists have a limited ability to formally influence the decision-making of a fully controlled firm, when they decide to target German or Hong Kong controlled companies, they rely more heavily on informal mechanisms. Given the commonalities between German and Hong Kong markets, it should come as no surprise that a striking commonality exists between the informal approaches used by activists in both jurisdictions. In Germany the adoption of informal channels seems primarily a matter of corporate culture and etiquette and not so much shareholder distribution pattern, while in Hong Kong, informality is caused by the power of controllers who may block out any confrontation.
If a controller owns 50 percent or more; and if in the jurisdiction (such as Hong Kong or Germany) minority shareholders may not elect independent directors, any activist campaign challenging such controlling shareholder for underperformance (in my definition) must be classified against all odds – the controller can stonewall and ignore an activist petition or request for a meeting, rendering it extremely difficult to prevail in any contest.
When preparing to host a conference on shareholder activism in Frankfurt, we were told there were only a handful of German cases, when, in fact, independent research uncovered that there had been 400 campaigns against approximately 200 public targets in the past 15 years (out of a total of 650 publicly traded corporation in Germany of what was a peak of about 1,000 German listcos 10 years ago). However, only 70 to 80 of these interventions ever became publicly known.
Similarly, when preparing to host a similar conference in Hong Kong, we were told that shareholder activism did not really exist in Hong Kong either, an assessment that was also proven to be untrue. It is presumably a reflection of the perceived lack of dialogue between legal practitioners and investment bankers in Hong Kong on one hand, and local Hong Kong activists actually doing the transactions and enlivening the global activism debate with a particular Hong Kong brand of what might be called “giving advice” or constructive activism. Just like in Germany, our Hong Kong findings suggest that over the last 12 years or so there have been hundreds of such activist interventions and campaigns as well.
Investment Process and Strategic Objectives of Equity Investor and Hedge Fund Activism
To our understanding, hedge fund activism stands for minority investments in undervalued or poorly managed public companies by one or several investors, investment partnerships or activist funds based on strategic objectives and tactical measures carefully formulated in advance (ie, successful value restoration to the benefit of all shareholders, enhanced corporate governance monitoring and increased operative efficiency as the aimed for outcomes).
After exhaustive due diligence and analysis, an activist fund makes an informed investment decision in the approximate range of one to 10 percent (depending on target size, but usually no more than 15 percent) of the voting stock of a target corporation. This decision is implemented over time by acquiring such stock position through various stealth methods.
Thereafter, an attempt is made to communicate with senior management/executive board members (and supervisory board in Germany) and, down the road, inform fellow shareholders about the fund’s considered view about the best possible strategic course of action compared to the plans of incumbent management for value recovery at what has become an underperforming portfolio company of the fund compared to its peers.
According to conventional theory, engagements with controlled companies (the base case in Hong Kong) should be rare, since the presence of a controlling shareholder is to dramatically reduce the chances of an activist campaign to threaten credibly, wage and actually win a proxy contest when negotiations with the target board on a variety of value-enhancing, governance-monitoring and efficiency-improving demands break off. With the two conferences we hosted, we attempted to outline detailed arguments, strategies and action plans on how to convince reluctant controlling shareholders or blockholders about the necessity for change and acceptance of value- and investor relations-enhancing shareholder proposals.
Role of Controlling Shareholders
The justification for ownership concentration in Hong Kong is that a controlling shareholder has both the skills and incentives to properly conduct the business of the company and closely monitor its professional managers so as to also benefit the minority shareholders.
This justification includes a number of implicit (and occasionally false) assumptions, namely that:
- controller’s strategic decisions are, on average, superior to those of other public shareholders (including activists);
- even when an activist articulates a value-enhancing proposal, the controller is the main beneficiary of any increase in firm value; and
- controllers everywhere like to claim that the lower percentage of activist campaigns in controlled companies is the result of superior management skills of controlled companies, rendering them less attractive targets for activism than ill managed widely held companies.
However, not all controllers have superior business skills. A high percentage of controlled Hong Kong companies are family firms managed by the heirs of the founders. Economic literature has firmly established that over time, firms run by generations of decedents of founders underperform in relation to firms that are managed by hired CEOs. This results because the heirs of the original founders often lack the spunk, mental robustness, business expertise, talent, or motivational drive of the founders.
Even if controlling shareholders maintain a large economic interest and possess superior skills, they may pursue interests not aligned with the interests of other investors, such as entrenchment, capital preservation, entering into new (risky) businesses they don’t understand or engaging in various forms of self-dealing transactions that transfer value from minority shareholders to the controller. They may also be motivated by non-pecuniary factors such as pride, envy, or animosity, inducing controllers to reject activists’ demands for all the wrong reasons – to the detriment rather than benefit of minority shareholders.
Commonalities and Dissimilarities
By exploring a broader paradigm of activism, we discovered that there are two significant factors that explain activist campaigns and market acceptance of shareholder activism in Germany and Hong Kong corporate governance debates.
For one, 60 percent of the 650 German publicly listed companies are dominated via share block ownership by families, founders, management teams, investors or holding companies; as opposed to 80 to 90 percent of the 900 Hong Kong public companies (not counting another 900 PRC listcos). Only 250 German and 100 Hong Kong public companies thus lend themselves to the US/UK presumption that activism is dependent on dispersed shareholder ownership so that upon breakdown of negotiations with management, the activist resorts to launching a confrontational proxy fight in order to replace some or all members of the supervisory board (Germany)/executive management board (Hong Kong) with directors in line with the activist’s strategic game plan.
Second, there is a certain long-term, consensus-orientation in both German and Hong Kong corporate culture, etiquette and decorum that favors negotiated solutions with management as rather than publicity and adversarial campaigns, proxy fights or resorting to litigation.
These findings should encourage us to broaden our view on shareholder activism. Just because a proxy fight approach, litigation and making activist demands public are less prevalent or promising tactics in Germany/Continental Europe and Hong Kong/China than in either the US or the UK, the more consensual tactics adopted there may still be considered part of the global activist playbook. One simply needs to broaden the perspective on tactically feasible moves of engaging target management and the controllers.
In Hong Kong, activist targets are usually controlled public companies. In Germany – except for such transactions as TCI’s investment in Volkswagen AG preferreds (a controlled company), activists invested in companies in free float with dispersed ownership – with most campaigns never becoming public knowledge.
This requires clarification: there is a particular segment of active investors in Hong Kong who primarily identify underperforming HK listcos that exhibit dispersed ownership (ie, are widely held and therefore somewhat atypical for the Hong Kong equity markets). If the target board is not amenable to constructive dialogue, they increase their position and opt for a hostile takeover of the target company.
Our experience suggests that because of the similarities in shareholder concentration, corporate culture, etiquette and decorum between Germany and Hong Kong, the tactics employed by shareholder activists in both jurisdictions are quite similar, with shareholders having an almost identical catalogue of specific value-enhancing measures and governance-improvement proposals to the respective portfolio companies at their disposal (compare the similarities of the respective right columns of both Appendix A and B). Activist in both Hong Kong and Germany appear to break the taboos of publicity, litigation or proxy fights only as a matter of last resort.