Shareholder Engagement & Activism in Asia
Reflecting on our experiences of shareholder engagement and activism in Japan and Vietnam
This Insight is not investment advice and should not be construed as such. Past performance is not predictive of future results. Fund(s) managed by Seraya Investment may be long or short securities mentioned in this Insight. Any resemblance of people or companies mentioned in this Insight to real entities is purely coincidental. Our full Disclaimer can be found here.
This Insight is an extract adapted from the Panah Fund letter to investors for Q2 2018.1
In an era where the popularity of ETFs seems to grow by the day, we think it important to remember that passive investment effectively freerides on the hard work being performed by active managers. The capital allocation work performed in aggregate by active managers has an extremely important role to play in maintaining the integrity of capital markets.2
Of course, it is not just fundamental analysis and stock-picking where there is hard work to be done. Engagement with company boards and management can also effect real change, bringing tangible benefits to all shareholders.
It is a small subset of active public market funds which tends to become deeply engaged with companies, providing constructive advice and/or making demands of their managements and boards of directors.3 While such activism is well known in the US, which has well-developed capital markets and protections for minority shareholders, historically it has been harder to have the same impact in Asia.
In recent years, however, activists have also started to launch many more campaigns in Asia. A mere 10 Asian activist campaigns launched in 2011 has increased to a total of 106 campaigns initiated in 2017.4 These figures only count public campaigns, and do not account for the undoubtedly extensive engagement between investment funds and companies which happens under the radar. The true amount of engagement between funds and companies is thus much higher.
In this quarter’s letter, we reflect on our own recent attempts to engage with and influence the management and boards of directors of the companies in which we invest. This is an anecdotal and incomplete account rather than a comprehensive review, and it only reflects our own experience of shareholder engagement and activism.
Engagement with companies of course starts with voting ones shares at each shareholder meeting. This is a basic fiduciary duty, though one that is neglected surprisingly often by shareholders.5
There are also many other ways that shareholders can make their voices heard…
TABLE OF CONTENTS
A Gentle Start to Engagement in Japan
Panah first found itself engaging in a rather low-key manner with the management of some of the companies in our portfolio, in an attempt to give advice – from the perspective of a long-term shareholder – on how they could better unlock value.
For instance, when it became clear two years ago that one of our holdings (a Japanese consulting firm with venture capital investments)6 had experienced difficulties with two of its recent investments, we wrote a letter to the board of directors and management asking them what lessons they had learnt. We also suggested ways in which the company might look to strengthen its investment committee and investment process. In the letter, we also requested that the company should start providing more information in English. We felt that many overseas investors would be extremely interested in the story that management had to tell, if only they could access the company’s financial statements and investor relations material in a language they understood!
This led to a constructive discussion. The company had already started to implement various measures to improve its investment process, although management also took on board our suggestions concerning the necessity to hire more accountants and to conduct more thorough background research on the principals of its investment targets.
The company also immediately moved to publish English-language presentations for the semi-annual results meeting, alongside the Japanese-language version. We are still waiting, however, for the regular publication of English financial statements, and believe that the company could do a better job of producing investor relations material in both languages that better explain management’s goals and vision.
We maintain a constructive dialogue with the company. Following conversations with numerous members of management and the board at the latest AGM, we have recently composed a new letter with fresh recommendations. We look forward to further discussions in the future.
Pain and Progress in Vietnam
In late 2016, we started to engage more actively with a Vietnamese jewellery company in which Panah was a shareholder. This was after we became aware that the company was considering a private placement.
Our decision to get involved more actively was because two directors with financial experience had recently stepped down.7 The company’s confusing announcements concerning the potential capital raising suggested to us that it would be helpful if there were at least one board member with expertise in financial matters.
Encouraged by the company’s initial positive response, we launched a search for appropriate directors in early 2017. At that point, however, the chairwoman and her colleagues then refused to meet our proposed candidates, and the company instead managed to locate two ‘independent’ directors of its own (who have since proved to be anything but independent).
This process of more detailed engagement with management also highlighted a series of growing discrepancies within the company’s reported financials. This new information negatively impacted our assessment of the balance of risks, leading to our decision to sell Panah’s holding in the company. Without this more detailed engagement with company management, we think it would have been difficult to identify the irregularities which prompted our divestment.8
While the share price of this company has continued to perform well since we sold our shares a little more than a year ago, we believe that from a fundamental perspective, the decision to divest was the correct one.
Even as sell-side analysts continue to push ‘buy’ recommendations, the de facto financial controller of the jewellery company (also a board member) was reportedly arrested last month for her part in a scandal at a related company. In our view, this arrest, as well as the key role that this financial controller played at the jewellery company, should once again raise serious questions concerning the integrity of this firm’s financials.
On another note, regular readers of our missives know that we have experienced repeated headaches owing to the popular Vietnamese practice of issuing Employee Stock Ownership Plans (‘ESOPs’) in large size and at a significant discount to market. Such ESOPs are not accounted for properly under Vietnamese accounting rules.9
So, imagine our disappointment in April 2017, when one of our portfolio holdings – a stationery and office supply company which had hitherto had a constructive attitude towards corporate governance and shareholder engagement – unexpectedly announced that it had plans for a ~5% ESOP issuance at a substantial discount to market price.10
Thankfully, this issue proved to be less about disregard for minority shareholders, and more a lack of understanding over dilution and the other pernicious effects of Vietnamese-style ESOPs. Over the course of several months, we communicated our concerns to management via email, letter and telephone.
As a result, the chairman of the company agreed to reduce the size of the ESOP from ~5% of outstanding shares to ~1.5%, and to introduce a one-year lock-up for ESOP-recipients. While we would have liked to see a longer lock-up period, as well as a higher exercise-price for the ESOP, we were encouraged that management chose to listen to the suggestions of a foreign minority shareholder.
Other companies which have issued ESOPs with more egregious terms have been somewhat more cynical in their intentions! We were extremely happy to see progress on this occasion, as we are optimistic about the long-term prospects for this business and hope to be a shareholder for many years.
Panah Goes Activist (Though Still Attempts to Fly Beneath the Radar)
Panah’s first red-blooded activist campaign has been in Japan. It has been an interesting learning experience.
Our ‘target’ company manufactures refrigeration showcases for convenience stores and supermarkets. It enjoys a particularly strong relationship with its leading convenience store customer.
We first acquired shares around three years ago. The initial attraction was that the company appeared to be trading at among the cheapest valuations in the world: net cash was at ~120% of market cap, and the company had a further ~19.5% of shares in treasury. Moreover, the company had a negative working cycle capital and no investment plans, and thus did not have any real need for its substantial cash-pile. Even as the cash continued to grow each year, it was kept on deposit at extremely low interest rates.
The potential room for improvement regarding capital allocation decisions was painfully clear. The recent publication of Japan’s Corporate Governance Code (in mid-2015) had indicated the new rules by which Japanese companies were expected to play, emphasising their duty towards minority shareholders. Initial conversations with a director of the company were encouraging, and indicated that there were members of the board who would likely support higher dividends in coming years.
Panah attempted to induce such an outcome by engaging with management and encouraging a greater focus on capital allocation, both in regular meetings and through letters to the board of directors. While management was happy to discuss the ongoing business of the company, unfortunately they were unwilling to respond to any of our proposals to increase the dividend, cancel treasury shares, create a growth plan, or improve their capital allocation framework, and so our letters went unanswered.
Our push for higher shareholder returns appeared to be running into particular opposition from the CEO-Chairman of the company (a member of the founding family) who appeared to be uninterested in creating value for himself or other shareholders. This was important, because he and his family (and friends) controlled a substantial stake in the company.
All this changed in late 2016, however, when the longstanding CEO-Chairman sold most of his remaining share stake back to the company. This was reportedly for tax planning reasons, in preparation for his imminent retirement. The company bought back these shares at a valuation below cash on the balance sheet, inadvertently creating substantial value for remaining shareholders.
Notably, this brought the level of the company’s treasury shares to an incredible 43.4% of outstanding stock! And as the family had now substantially reduced its stake (and treasury shares cannot be voted), this made the company more vulnerable to external pressure. We thus increased our stake.
Our pressure was a year in the planning and required that Panah set up a separate custodial account in Japan in the name of the Panah Fund. This was required so that we were permitted to attend shareholder meetings and make formal shareholder proposals.
During this period, we continued discussions with the company and wrote more letters. Despite the fact that the new CEO (appointed from within the company) seemed to be more sympathetic to our proposals, we were still unable to elicit a written response from the company regarding our suggestions to improve capital allocation.
Panah decided to make judicious use of all available negotiating leverage, which included scheduling formal shareholder proposals for the 2017 Annual General Meeting (‘AGM’), to be held in early 2018, to increase the company’s dividend payout ratio, and to pay a large special dividend to all shareholders.11
These shareholder proposals finally caught the attention of the CEO and board of directors, as they realised that our proposals had a good chance of being voted though at the AGM. After some initial negotiations, we sat down in February 2018 to hammer out a compromise.
Panah agreed to withdraw its shareholder proposal, and in return the company agreed to make a fresh start on corporate governance, including the creation of a special independent advisory committee to consider growth planning and capital allocation. A few weeks later, the company held the first-ever shareholder results meeting in its 100-year history! We have been impressed with the flexibility of the new CEO, who was quick to apologise for the company’s historical disregard for minority shareholders and has been thoughtful about embracing new ideas.
While Panah is of course not party to the discussions of the independent advisory committee (which was appointed in June), we are hopeful for further positive announcements in the coming six to nine months regarding use of excess cash, cancellation of treasury shares and other important issues.
The market has also started to pay attention, with the share price rising by +33.0% in H1 2018, and by +80.8% in the 12 months to end-June 2018. Nevertheless, valuations still remain cheap: adjusting for treasury shares, the company is trading on an EV/EBITDA of less than 1.0x. If the board were to decide to pay special dividends and cancel its abundance of treasury shares, we anticipate that there is still ample room for share price appreciation.
During this process of engagement with management, it has thankfully not been necessary for Panah to go public with our concerns or seek media coverage of our efforts.12
Although this story is not over yet, our achievements to date have been as a result of constructive compromise. We are aware that publicity is a double-edged sword, as while it can help to achieve success in some activist campaigns, there is no guarantee that public attention will always remain favourable. Moreover, it requires a substantial amount of time and resources to prevail in public activist campaigns, even more so than in private engagements.
Finally, it is not necessarily advantageous to gain a public reputation for aggressive activism, as this can make it harder to interact with the management of the fund’s investee and potential investee companies in the future, especially in Japan. For those reasons, we would have to give careful consideration on a case-by-case basis before Panah were to go public with an activist campaign. The bar is high, and we have no plans to do so at present.
Recent Developments and New Opportunities in Japan
Thanks to the Japanese Corporate Governance Code, first formally introduced in 2015, the nature of discussions with Japanese companies has subtly shifted in recent years.
The managers of many of the companies with whom we communicate (even those companies which are not listed on the First or Second Sections of the Tokyo Stock Exchange) now often feel it is necessary to explain any deviation from the principles set out in the Code, and how they plan to rectify any shortfalls.
This change in attitude also includes the management of some companies which were previously reticent or even recalcitrant when it came to minority shareholder rights. Indeed, we have often found it helpful to quote the Corporate Governance Code in letters and meetings with companies.
We are thus also hopeful that the latest revisions to Japan’s Corporate Governance Code (implemented in H1 2018) will have a further positive impact, particularly on reducing cross shareholdings and increasing the number of external directors.
Meanwhile, we think that the recently revised Stewardship Code, which encourages institutional investors to disclose voting records for each investee company on an individual agenda item basis, might well help to shake up the historically cosy relationship between various Japanese institutional investors and the companies in which they invest.13 It might even change voting habits, as Japanese institutions are now strongly encouraged to disclose all voting decisions, including their votes on controversial but beneficial shareholder proposals which have been launched by activists.
Finally, we see potential for a change in corporate practices as a result of tax code changes on 1 April 2018. Before that date, capital gains taxes were levied on any acquisition made in stock. Under the new rules, however, any acquisition made in scrip (i.e., new stock or treasury stock) will no longer mean the crystallisation of a capital gain for shareholders of the acquiree. For tax purposes, the capital gain is instead deferred until the shares of the acquiree are sold (if ever).
We have observed that there has already been a modest uptick in the number of scrip takeovers as a result of these new rules. We would expect to see an increase in listed company roll-ups in the future. (Indeed, this new rule may well be one way that cross-shareholdings and parent-subsidiary listings are reduced over time.)
We are actively searching for investment opportunities which might emerge as a result of these recent developments. As well as searching for engagement opportunities of our own, we have in several recent cases also decided to invest in companies which are being targeted by other engaged and activist funds, thereby ‘piggybacking’ on their efforts and campaigns when we believe that these have merit.
Of course, in such cases we also attempt to engage with these companies ourselves - in a manner consistent with local regulations and the best corporate governance and stewardship principles - rather than simply ‘freeriding’ on the work done by other shareholders.
In summary, our experiences to date suggest that we are most likely to have positive results in engagement and activist campaigns where management has left the door half-open for minority shareholders, rather than firmly closed.
And when management seems tempted to slam the door shut in an effort to shirk their responsibilities, it helps if you can remind them of the lock-pick that you carry in your pocket, thereby encouraging cooperation!
If they then bolt the door, well, it might just be easier to find another door that still stands ajar…
Thank you for reading.
Andrew Limond
The original source material has been edited for spelling, punctuation, grammar and clarity. Photographs, illustrations, diagrams and references have been updated to ensure relevance. Copies of the original quarterly letter source material are available to investors on request.
Our more detailed thoughts on the active-passive divide can be found in the Panah Fund letter to investors for Q2 2017 and the following Seraya Insight: ‘Passive Aggressive’.
HFR estimates that at end-2017, of a total global hedge fund asset base of US $3.21tn, direct activist strategies accounted for $125.6bn of AUM. This had risen from US $50.9bn in 2011.
These figures are sourced from SharkRepellent and Activist Insights (1 March 2018), as quoted in a recent research report ‘Shareholder Activism in Asia, Confrontation Gaining Momentum’ by JP Morgan. Perhaps it attests to the opportunities in this area that a top-tier investment bank is publishing pitch books for potential activist funds (and their targets).
Panah has a policy of voting its shares at all shareholder meetings, so long as the relevant information is available on a timely basis (preferably in English). When information is not readily available, we make representations to the relevant company’s management and board to improve disclosure. (Timely availability of information has been a particular problem in Vietnam, although we do note some improvement in the last few years).
The investment case for this holding can be found in the Panah Fund letter to investors for Q4 2016 and in the following Seraya Insight: ‘“Capital Allocators” versus “Capital Alligators”’.
One private equity fund had previously owned a significant stake and had seconded a director who resigned as the fund sold its holding. Another fund (still a shareholder today) changed its policy on allowing fund managers to serve as directors of portfolio companies, leading to the resignation of their board representative.
Our growing concerns, which led to the divestment of this holding, are chronicled in the Panah Fund letter to investors for Q2 2017 and in the following Seraya Insight: ‘The Art of the (Graceful?) Exit’.
For more information regarding Vietnam’s ESOP challenges, see the Panah Fund letters to investors for Q2 2016 and Q1 2018, as well as the following Seraya Insights: ‘The Investment Case for Vietnam’ and ‘Vietnam Has Outperformed – What Now?’.
More details can be found in the Panah Fund letter to investors for Q3 2017.
It would have required a change in the company articles to cancel treasury shares, requiring a two-thirds majority.
Although an astute journalist appears to have worked out that something has been going on behind the scenes.
The Stewardship Code was first published in early 2014. The Code was then revised most recently in May 2017. Some of the important changes focus on the requirement for institutional investors to disclose and explain the way that they have voted at AGMs.
