19 September 2019
Well-funded, well-informed activist investors could change the way some of Hong Kong's biggest firms do business, to the ultimate benefit of all shareholders, not just the controlling families. Photo: Bloomberg
Well-funded, well-informed activist investors could change the way some of Hong Kong's biggest firms do business, to the ultimate benefit of all shareholders, not just the controlling families. Photo: Bloomberg

Why Hong Kong should embrace active investors

The place: the Bank of East Asia boardroom.

Huddled around chairman David Li Kwok-po — whose family holds a controlling stake — is a who’s who of powerful Hong Kong bankers, as well as a son of Li Ka-shing. 

The topic: a braggadocious investor 13,000 kilometers away telling the world that the bank’s board is incompetent or worse.

Paul Singer, whose New York hedge fund accumulated a HK$1.6 billion (US$210 million) stake in the bank, is upset about a planned HK$6.6 billion private placement to Japan’s Sumitomo Mitsui Banking Corp.

Bank of East Asia Ltd. (00023.HK) doesn’t need the capital, Singer insists, and he publicly questions the board’s motivation for the move.

The backdrop is important: Bank of East Asia has been a dismal investment, underperforming the Hang Seng Index over the previous one, five and 10 years.

Since 2007, earnings have grown 61 percent, but earnings per share have advanced just 14 percent.

Part of the cause? The number of shares has ballooned from 1.6 billion to 2.3 billion.

The bank explained the Sumitomo deal, announced in September, as preparatory for Basel III capital requirements.

The bank’s 11.6 percent core Tier 1 capital ratio was healthy, though, so Singer saw a more nefarious reason for the placement: the Li family’s control of the bank was threadbare; a sale to a friendly party would help secure their grip on the company.

Implicit in such boardroom thinking, common in Hong Kong and Asia generally, is that minority shareholders will suffer their dilutive mistreatment silently.

Activist investors, however, don’t keep silent: prominent in their playbook is making a very loud, very public ruckus.

Loud, public fights may seem too brazen for the Hong Kong market.

Controlling tycoons certainly hope so.

But underlying Singer’s brassy ploy is a simple truth that David Li — and numerous other company leaders — cannot ignore.

His responsibility is not to maintain control. It is to maximize shareholder value.

Challenge on the horizon

The Bank of East Asia story is not unusual in Hong Kong.

“The vast majority of Hong Kong-listed companies have a controlling shareholder, either a family or a government,” local investor activist David Webb said, “so there is little scope for activism at the investor level.”

Hong Kong famously ranks No. 1 — ahead of Russia and Malaysia — on The Economist magazine’s crony capitalism ranking, which measures the tendency of those in economic control (billionaire tycoons) to use power, politics and favors to charge higher-than-fair prices or squeeze competition out of industries.

Crony capitalism isn’t illegal, but it doesn’t create economic value.

In fact, it scares value creation away, as Bank of East Asia investors know.

There may now be a light at the end of that tunnel.

Finally, activist investors are being both pulled and pushed toward Hong Kong.

Investors, regulators and even management teams should welcome them with open arms.

If they don’t, managers with something to hide will increasingly see their dirty laundry aired by activists.

If they do embrace the change, Hong Kong stands its best chance at maintaining its position as a global financial center despite the increasing (and deliberate) opaqueness of control from the mainland.

From villain to superhero

Activist investors have been around since the 1980s, when they were better known as corporate raiders, who developed a reputation for gutting weak companies for a quick profit.

Unfortunately, that perception — especially in Asia — hasn’t kept up with their evolution over the past three decades.

These days, activists are closer to Good Samaritan superheroes than villains.

For one thing, their time horizon has lengthened.

Established activist funds lock in their clients’ investment for one or two years, much longer than the typical hedge fund lock-up period of a few months.

And in 2014, prominent activist investor Bill Ackman raised US$3 billion of permanent capital via a publicly traded closed-end fund on the Amsterdam exchange.

Nowadays, when an activist investor takes a stake in a company, he is more likely to be looking to unlock value by improving the long-term position of the business than by dismembering the firm for a hasty return.

Such “unlocking” might take the form of a sale of all or part of the business, or it might entail changes to capital allocation, dividend policies, management teams or even products and operating details.

A study by The Economist of the 50 largest activist positions since 2009 showed that, most often, capital investment, research and development, and profits rose after activist involvement.

Another study by academics showed that stock prices of US companies that respond favorably to activist suggestions outperform those of companies that resist or fight such suggestions.

Activists generally want what’s best for the company.

Their reach has grown.

Fewer than 1 percent of hedge funds are activists, Hedge Fund Research figures show, yet they claimed 20 percent of hedge fund inflows last year.

Singer’s Elliott Capital directs US$25 billion, enough to strike fear in the hearts of even colossal firms like Bank of East Asia, whose directors see a very serious investor behind what otherwise might seem a paltry US$232 million investment.

To date, though, activist investing remains a primarily American phenomenon.

About 80 percent of activist interventions occur in US stocks.

If you’re the CEO of an S&P 500 company, there’s a 50-50 chance that an activist investor was among your shareholders some time during the past six years.

And that’s the first reason that activists are turning their attention east: the American markets are beginning to feel saturated.

There will always be underperforming firms, but activists don’t want to pile on top of each other to pounce on them, and their swelling capital bases mean they need to focus on big-time companies.

And there’s the second reason: welcome to Asia, where shareholder underperformance — Hong Kong is the cheapest major market in the world — and conflicts of interest have long been the norm.

Cold reception

Activists will encounter neither a warm welcome nor a friendly environment in Hong Kong.

First of all, only about 15 percent of companies primarily listed on the Hong Kong exchange are actually Hong Kong entities.

Most are legally domiciled in the British Virgin Islands, the Cayman Islands or Bermuda.

Litigation can become complex quickly.

Even after winning a judgment or court order in Hong Kong, shareholders may need to do the same in the relevant offshore domicile, which the company likely selected for its propensity to thwart external pressures.

Potentially worse is the short-term trading mentality of Greater China investors.

Activists typically take a relatively small stake and rely on other shareholders’ solidarity (more on this later) to gain approval for their views.

The shorter an investor’s time horizon, though, the more likely he is to view himself as a renter rather than an owner.

Renters don’t concern themselves with structural improvements, rezoning plans or other considerations that lead to long-term value creation.

There is also the dearth of class-action lawsuits in business-friendly Hong Kong, which waited until 2012 to finally enact its antitrust Competition Ordinance (it comes into full effect only on Dec. 14 this year).

Class-action suits, in which a single person files suit against a company on behalf of all people in a similar situation, are commonplace in the United States, but they’re virtually unheard of elsewhere.

The nascent beginnings of such lawsuits are evident in Hong Kong, but they’ll likely develop first in the consumer arena — representing everybody who purchased a diesel Volkswagen, for example — before spreading to capital markets.

Curiously, mainland China may unleash a securities class-action mechanism before Hong Kong: under an amendment to Chinese securities law, representative cases for insider trading and securities fraud could become possible before the end of the year.

Unstoppable force

These obstacles won’t stop the activists.

Despite all the hurdles, Singer is more likely to be a forerunner than an anomaly.

Pushed by the need for more fertile pastures and pulled by the unharvested grassland of underperforming conglomerates, activists are coming to Hong Kong.

In doing so, they might shake the market out of its slump and attract better, more productive, longer-term investors in their wake.

In the US, the prospect of an activist campaign keeps American CEOs alert.

This is in the best interest of everybody.

CEOs stay focused on creating value for shareholders.

Shareholders earn a healthy return on their investment.

The job of regulators becomes easier, as managers have more compelling fears than an audit.

Hong Kong managers don’t face the same threat.

Smaller firms may fear private takeovers, but few private equity firms have the capital to challenge a company as large as Bank of East Asia.

Those that do typically employ a large amount of debt, and a decent slug of the profits they earn investors is eaten up by fees.

Activist investors, though, needn’t take a large stake, use debt or charge exorbitant absolute fees to win.

The typical activist assumes a stake less than 5 percent of the target company’s equity. (Singer held just 2.5 percent of Bank of East Asia’s shares).

The first move is often a private, friendly offer of suggestions to management.

We’d expect most Hong Kong managers to ignore these suggestions.

The private, friendly suggestions are made earnestly, but they’re proof that the activist tried to be cordial.

If they don’t work, the activists begin to unveil their arsenal of weapons.

They’ve spent hundreds of hours researching the company and evaluating paths toward value creation.

They likely know the financials, competitors and industry dynamics better than most board members.

They’ve hired experts on corporate law and often have enough cash to chase the company to any offshore domicile.

And they’ve already met with other major investors, such as banks and pension funds, and likely convinced at least several that a change in company policy — or management — is best for shareholders.

That last tactic is key, because activists don’t control enough shares to be powerful alone; they rely on other investors joining their cause.

One of the best possible outcomes in Hong Kong is for activists to provide a channel for subtler investors to voice grievances.

Asian market etiquette generally forbids outright conflict between investor and manager.

Activists break with this tradition.

Joining them puts existing institutional investors in a sensitive but undeniably healthy position.

When an activist campaign goes public, institutional investors will be forced to make a choice.

They can remain silent, essentially siding with incumbent management.

That’s fine if they agree with management, but if management is clearly wrong or inept, visible passivity potentially makes institutional investors appear spineless or conflicted.

Or they can side with the activist investors, provoking uncomfortable but necessary conversations with the management team, but potentially creating higher share prices.

Hong Kong should embrace, and not fear, activists

As far as the Hong Kong market has come, it is still undeniably Chinese in its controlling ownership structures and often conflicted ownership culture.

It is unsurprising that this situation has persisted so long.

Entrenched families have the incentives and the means to maintain their power.

The Hong Kong legal system favors big business, and Hong Kong decorum hinders criticism from minority shareholders.

Activism will force the Hong Kong shareholder system to decide its priorities.

And things are already changing: in June, a court agreed with Singer that Bank of East Asia’s board had failed in its duty to review the Sumitomo Mitsui transaction adequately, and the bank is now considering some business and board changes.

This is how activism’s healthy pressure should work.

The public company was never meant to be a clubby bureaucracy or an instrument of power.

Activist investors will insist that Hong Kong executives, board members and investors remember this.

Let’s hope they listen.

James Early is chief executive and Alex Pape, CFA, is chief investment officer of Iwaitou.

The article first appeared in Chinese in the November 2015 issue of Hong Kong Economic Journal Monthly.

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James Early is chief executive of Iwaitou. Alex Pape is Chief Investment Officer of the firm.