On the 61st floor of the iconic 30 Rock building in Midtown Manhattan, Jim Rossman’s team is embarking on a big data project this year. Its mission: analyzing shareholder ownership in a way that could help chief executive officers hang on to their jobs.
Rossman, who heads the corporate preparedness group at Lazard, has expanded his team globally to more than a dozen activist-defense bankers over the past three years. Among their tasks is a comprehensive study of every investor reporting holdings in any of 1,000 companies, including all of the S&P 500 constituents. The bankers are calculating how much of each stock is owned by an exchange-traded fund, a mutual fund, a hedge fund, or other asset manager. That way, Rossman says, he can start to predict how influential an activist investor may be.
“If you are the CEO of a very large or midsize company in the United States, you’ll find that 30 to 40 percent of your stock is being managed by no one you can talk to,” Rossman says. “That raises an issue, right?”
The flood of money into ETFs has posed a special problem for CEOs: How do you influence investors who are automated?
Rossman’s thesis is that activists could gain more clout as stock ownership is concentrated among fewer owners, with funds shifting to indexed strategies. “It’s become a lot easier for activists to influence the shareholder base, because they have fewer and fewer shareholders that they have to talk to,” says Rossman, who calculates that the top 25 investors hold almost 40 percent of the S&P 500. Research published in September by the National Bureau of Economic Research (NBER) outlined a finding similar to Rossman’s — that activists may become more powerful with the rise in passive investing.
The ETF industry surpassed $3.5 trillion in assets globally at the end of last year as investors sought cheaper alternatives to hedge funds and other investments. According to EY, the industry is expected to expand to $6 trillion in the next three years, with inflows forecast to be twice those of mutual funds over the period. Last year alone, almost $1 trillion moved from actively managed funds into passive ones — the biggest dollar move on record, according to data compiled by Bloomberg, Investment Company Institute, and EVestment.
Donald Keim, a Wharton School professor of finance who helped author the NBER study, had a similar thesis to Rossman’s. “With higher passive ownership of the stock of an activist target, there is a higher likelihood the activist obtains board representation, and the success rate of activists is higher,” Keim says.
Rossman’s study shows that activists took 107 board seats in the nine months through September, even while waging proxy battles for only seven of the directorships. That suggests that the preferred mode of influencing change at companies was from “inside the tent,” Lazard said in a report. What’s more, when activists have negotiated or won directorships, CEOs left their jobs at twice the normal rate, according to a review of about 300 contests from 2011 to 2015 monitored by FTI Consulting.
Rossman’s findings got the attention of Ron O’Hanley. The president and CEO of State Street Global Advisors cited Lazard’s research in October when he voiced concern that long-term shareholders could be burned as companies ceded to the shorter-term interests of activists.
Rakhi Kumar, State Street’s head of corporate governance, echoes that concern, pointing to the relative openness of a proxy battle compared with activists negotiating behind the scenes. “In the past we had this public mechanism where the market could get to know a bit more about the strategy,” Kumar says. When companies settle with activists for board seats, “then the public discourse that we need or rely on to inform our voting decisions just was not available anymore.”
Kumar says State Street is likely to support activists when there’s a good strategy or in cases where management hasn’t previously been responsive to governance concerns. Vanguard CEO Bill McNabb, meanwhile, has warned companies for years that his firm would likely take a more involved approach as a shareholder — and sometimes side with activists.
On one wall in Rossman’s office, a whiteboard is covered with charts drawn in red and black marker that graph data such as the shift in retirement money away from corporate pensions and the expansion of mutual fund assets from 1924 through the 1990s. On the other side of the office is a Bloomberg terminal Rossman uses to pore through shareholder data of his clients and other companies.
The banker has been producing 100-page-plus reports quarterly for at least a year, profiling activists such as Dan Loeb and Carl Icahn, as well as notable investors like Neuberger Berman and Franklin Resources that have waged activist campaigns at companies as they seek higher returns. Kumar says she’s relied on the Lazard reports for insight into how an activist might behave in a certain stock.
Rossman’s theory that passive investing will help activists comes with a couple of caveats. History shows that State Street voted in favor of activists in proxy battles only 24 percent of the time in 2015, according to the most recent report distributed by investment bank Houlihan Lokey. For Vanguard and BlackRock, that figure is 21 percent and 45 percent, respectively. “Historically, the passive ETF businesses have not taken, by definition, an active role by making corporate decisions,” says Jeff Levi of Casey Quirk by Deloitte, who consults asset managers on strategy. And Wharton’s Keim says even with the rise of passive investing, active managers still oversee 70 percent of institutionally invested portfolios.
Yet Rossman is part of a growing Wall Street cohort seeking to explain the phenomenon and the role that BlackRock and Vanguard will play on the activists’ chessboard. Last year, Evercore Partners hired Bill Anderson away from Goldman Sachs to build out a team for activism defense. Most investment banks, including Morgan Stanley, have scooped up talent as they seek to strengthen corporate relationships with activist preparedness and defense advice.
On the mild early January day that Rossman sat for an interview, few of his colleagues were around. “Where is my team today?” he says. “They’re up in Boston meeting with Fidelity, BNY Mellon, and State Street.” Those are some of the largest managers of index funds and ETFs in the country, Rossman explains. “And we’ve built relationships with the people who manage the voting.”
Basak covers insurers and boutique investment banks at Bloomberg News in New York. Jinks covers activists in San Francisco. With assistance from Brandon Kochkodin.